UK Stock Markets
Myopic and inefficient?

It is widely believed that the UK stock market is myopic. In a recent survey, for example, 85% of managers felt that the market takes a short-term view of investment, and many politicians, civil servants and journalists share this belief. Previous empirical analyses, however, have endorsed the efficient markets hypothesis, which holds that a firm's share price correctly reflects all the available information relevant to its performance. There has been no indication, for example, that the market values current dividends more highly than future dividends or dividends more highly than capital gains. At a lunchtime meeting on 5 March, Sushil Wadhwani reported new evidence which suggests that the UK stock market is indeed myopic. The new research, which allows for the effects of stock market 'fads', indicated that the UK stock market is not efficient: it places a much heavier weight on current (relative to future) dividends than the efficient markets hypothesis would suggest. The research also indicated that, contrary to conventional wisdom, the growth in institutional ownership of equities in Britain had not been accompanied by any increase in stock market myopia. Individual UK investors appeared to be just as myopic as UK institutions. Encouragement of wider share ownership was therefore unlikely to reduce 'short-termism', according to Wadhwani. He suggested that measures to make hostile takeovers more difficult might reduce the harmful effects of a myopic stock market.

Sushil Wadhwani is Lecturer in the Working of Financial Markets at the London School of Economics and a Research Fellow in CEPR's programme in Applied Economic Theory and Econometrics. He is also co-author of an article in Issue No. 4 of Economic Policy on 'Profit-Sharing and Employee Share Ownership'. Wadhwani's analysis, based on joint research with Research Fellow Stephen Nickell of the Institute of Statistics and Economics in Oxford, is available as CEPR Discussion Paper No. 155. The lunchtime meeting at which Wadhwani spoke was one of a series in which CEPR Research Fellows discuss policy-relevant research and was sponsored by the German Marshall Fund of the United States. The views he expressed were entirely his own, however, and not those of the German Marshall Fund or of CEPR, which takes no institutional policy positions.

Previous econometric analyses, which have examined the relationship between a share's price and current and future dividends, have found no evidence of myopia. Most financial economists also raise theoretical objections to securities market myopia: speculative arbitrage should eliminate the 'inefficiency' arising from myopia, they argue. Wadhwani reminded the audience of Keynes's famous 'beauty contest' parable: investors may rationally value shares in terms of what they think other people think they were worth, since this determines the potential for speculative gain, rather than what was suggested by the underlying economic 'fundamentals'.
Previous statistical tests of myopia, Wadhwani noted, have made no allowance for the existence of stock market 'fads': for example, it is possible that the stock market is subject to waves of pessimism (as in 1974) or of optimism (as in the 1960s) that are not justified by the economic fundamentals. This intuition has been formalized by Robert Shiller in his 'fads' model of stock markets. Wadhwani and Nickell estimated this model using data on the share prices and dividends of 195 UK industrial firms for the period 1973-80. They estimated an equation in which the current share price of the firm was explained by the current level of dividends and by the share price in the next period (which captured the effects of the firm's future dividends or earnings). The model also included variables which captured the effects of firm-specific and market-wide 'fads'. Their estimates indicated that in this period the market attached a weight to current dividends that was 6 to 8.5 times 'too high', relative to that suggested by the efficient markets hypothesis. The heavy weight attached to current dividends indicated that investors were indeed myopic. This is a new result and was evidence against the efficient markets hypothesis.

Many of those who have argued that the stock market is myopic have laid the blame at the doors of the financial institutions. Wadhwani and Nickell's analysis suggests that this argument is incorrect: although the institutions owned a higher proportion of ordinary shares in 1980 than in 1973 (59% versus 42%), their results did not indicate any measurable increase in the relative weight attached to current dividends over this period. This suggested that individual shareholders were just as myopic as financial institutions. Personal Equity Plans and other tax incentives to encourage share ownership by individuals were therefore unlikely to reduce 'short-termism', Wadhwani argued. He recommended measures to allow managers to pay less attention to short-term movements in the share price of their firm. The advantages of such a system were apparent in Japan, where managerial remuneration is not tied to the firm's share price, hostile takeovers are very rare, and many shareholders are also customers or suppliers of the company concerned. These factors give managers considerable autonomy, and they are free to concentrate on long-term growth. Wadhwani admitted that it might be dangerous to attempt selective transplantation of Japanese practices to Britain. Government measures to make hostile takeovers more difficult might, however, reduce the harmful effects of market myopia.

The discussion which followed focused on the treatment of fads: this was essential to Nickell and Wadhwani's analysis. Wadhwani noted that these fads were not measured, but were represented by dummy variables. Some members of the audience wondered whether the new results, which overturned 'the best documented proposition in the social sciences', were robust. Had the Japanese stock market been analysed in this fashion? The UK data might be studied at the sectoral level as well. Wadhwani agreed that more work was needed to examine whether these new results held for different data sets and for other countries.