Faith and Magic: Investor Beliefs and Government Neutrality
Posted: 10 Jul 2000
Date Written: 2000
This article analyzes investor beliefs as to stocks, the inadvertent role government plays in shaping those beliefs and thereby contributes to a rise in stock prices, and the need for government "neutrality" among investor belief systems. It suggests that, contrary to conventional wisdom, there is no inherent conflict between respecting market primacy and dealing with investor demand for equities. Concerned policymakers are offered an end-run around having to determine if a bubble exists. This article has three key themes:
First, most investors have faith in the superiority of stocks as an asset class and the magic of time in dealing with the risks of stock ownership. The article shows that, in their simple strong forms, the core beliefs of the current stock-based investor "religion" are not axiomatic. Long term historical statistics, the equity premium puzzle, time diversification, current valuations, and related issues are examined, relying in small part on a hypothetical new derivative ("fountain of youth swap").
Second, the Federal Reserve Board and the Securities and Exchange Commission have acted in ways that further this religion. In departing from neutrality, they play a role in the very stock market ascent they are concerned about. At issue are SEC mutual fund performance disclosure rules and the moral hazard of Federal Reserve actions in the bailout of the hedge fund Long Term Capital Management and of use of the Exchange Stabilization Fund in international crises.
Third, regardless of whether there is "irrational exuberance," government should move toward neutrality. The SEC can consider changing mutual fund disclosure to more of an asset class focus and enhancing disclosure of liquidity risks linked to mutual fund shareholder redemptions. The Federal Reserve can consider pre-announcing policies precluding it from bailing out mutual funds and from buying equities and equity derivatives.
JEL Classification: D81,E44,E58,G11,G12,G18,G23,G28,G38,K22,K23
Suggested Citation: Suggested Citation