Arnold Kling  

Stock Prices and Scandals

Comment of the Week... Economics of Hydrogen...

Jeff Madrick describes disparate economic views on whether stock prices should guide managers.

The modern theory typically depends on the idealized efficient-markets theory, which asserts that at any given moment the stock price is not only the best measure we have of the future value of a company, but usually an accurate one. The stock price will thus send the right signals to reward appropriate managerial behavior.
...Mr. Jensen, however, began to see something he had not fully thought about. "What we learned from the 1990's," he said in an interview, "is that when a company's stock is overvalued it sets in motion a set of organizational pressures that can destroy rather than create shareholder value."
...But Mr. Jensen remained dismissive of views that corporations owe anything to other constituencies, like employees, and of "score carding," which balances a range of measures of performance.

I think that what Jensen would say is that even though stock markets are imperfect, the stock price still provides a better guide to managers than other performance measures, which also have their flaws.

For Discussion. Some people have suggested that incentive stock options should be indexed to overall market performance, so that managers would be rewarded and punished for how their company performs relative to the market, rather than for stock market behavior as a whole. Would this solve some of the concerns expressed by Jensen and others? What adverse incentives might it create?

COMMENTS (3 to date)
Bernard Yomtov writes:

It sounds like what Jensen is saying is this:

1. Managers may have private information that leads them to conclude that the stock is overvalued, since the market value is determined by public information.

2. They expect there private information to become public eventually, driving down the stock price.

3. If they hold stock or options they then have a huge incentive to keep the bad news private, or even to distort information.

This really doesn't seem to me to have a lot to do with EMH since the problem arises from private information.

By the way, I'm not sure it's correct to say that EMH holds that the price is the "best measure.. of the future value of a company." That's a tricky statement.

David Thomson writes:

“Managers may have private information that leads them to conclude that the stock is overvalued, since the market value is determined by public information. “

This is why as a layman, I have a difficult time understanding the overall concept of insider trading. I concede that there are instances where it’s obvious the law has been broken. Nonetheless, often the color gray best explains the issues involved. Am I being overly cynical to suspect that the more brilliant manger runs the risk of being arrested?

Bob Coleman writes:

According to some academic theory of corporate governance, managers can be evaluated by one single all-encompassing measure of performance. This is ridiculous on its face.

As far as tying the compensation of managers to a strict quantitative formula in advance of their performance period, this practice invites "gaming the system" and tends to absolve the compensation committee of the Board of Directors from responsibly reviewing company results and then ex post facto deciding on a fair reward based on quantitative and qualitative indicators of varying number and identity that they may choose as most relevant in each period.

What is needed to mitigate against corporate scandals are more-independent directors and less incentive stock OPTIONS in contrast to incentive stock, with no financing by the corporation of the managers' leveraged stock purchases.

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