Keynes's beauty contest and the stock market.

Keynes was dismissive of stock markets in the determination of asset prices likening them to a beauty contest. I have some thoughts on this.

In Keynes’s beauty contest the voters form expectations about the judgement of others about the beauty of the contestants. And if everybody behaves like this no one may pay any attention to their opinion about the actual beauty of the contestants. The result is an emergent reflection of the opinion of other people’s opinion. There is no feedback from the ‘fundamental’ beauty of the contestants. There actually is no such thing, since beauty is in the eyes of the beholder anyway. And when the contest is over it is over. Nobody cared about ‘true beauty’.

On the stock market, people form expectations about other people’s expectations of the future price of the stock. And if everyone behaves this way, then the price of the stock depends simply on everyone’s expectations of everyone’s expectations of the future price of the stock. And no one may actually have any expectations about the future price of stock apart from these expectations of expectations (of expectations, …, ?). And the emergent outcome is thus a reflection of these optimistic or pessimistic expectations about expectations. A process without an anchor, says Keynes.

Except that is not the whole story. Unlike the beauty contest, things happen in the world outside of the stock market that affect the price of the stock. Most importantly the company, whose stock is in question, either does or does not have a cash flow from profits. Negative or zero profits means borrowing. This can go on for a while, but “at some point” the absence of profits must impinge upon those expectations because ‘everyone’ knows that the future price of the stock depends ‘fundamentally’ on future net earnings. The palpable uncertainty associated with these asset prices is a result of the ambiguity of the concepts “future”, “at some point”, etc. How long could Amazon actually have gone on without showing any real profits? It went on much longer than many thought possible, and many dot.com companies failed for want of earnings, even while Amazon endured. What determines the strength of investor forbearance in some cases and not in others? For that one needs a valid theory of expectation determination, probably an impossibility.

The stock market, for that reason, however, is not a beauty contest. Earnings, in a sense an ‘objective’ measure of performance depend upon revealed consumer preferences – whether *consumers* not *investors* think the product is beautiful. There is an *outside* judge who is not concerned about the asset price or even the future earnings of the company, but, rather, only about the value to him of the product being produced. That lends the crucial anchor to the process that is absent in the beauty contest. (Again we see the importance of capital accounting).