Markets: Sometimes you just have to love them (Part 2)
Over the past several weeks, as discussed in last week’s column, Americans have experienced the upside of worldwide market activity in the energy sector. Specifically, despite the notion that Big Oil can manipulate activity in both the short and long run to their advantage, markets are far too big and adaptable to allow such self-serving activities to continue forever. While they may not be perfect, they seem to do an outstanding job over time bringing together buyers and sellers in a way that is mutually advantageous to both groups.
In this atmosphere of competitive markets, businesses must always be on the lookout for new opportunities and ways to adapt to changing market circumstances. When they do this properly, they will generally be rewarded with higher profits. However, should their activities prove unwise, markets will punish them with an unwanted outcome which may fundamentally change the way they do business thereafter.
A few examples of these unwanted outcomes have been exhibited within the American business community of late.
Perhaps the most visible is the debacle at JPMorgan-Chase. Through an incredibly complex derivative financial instrument known as a “credit default swap,” Chase stood to make huge profits if markets moved in the anticipated direction. So confident were Chase operatives in their abilities to see what others could not that Chase took positions (which Chase said was for hedging purposes) amounting to some $100 billion. Unfortunately, market movements did not occur as planned and massive losses resulted.
Initially, the losses were reported to be approximately $2 billion. As time has progressed, however, more information suggests some of these derivative instruments may have a life that extends out to 2017 and could cause losses — depending upon future market movements and whether Chase nets out of the positions quickly — that might multiply to within the $5 billion to $8 billion range.
Payback! Markets can be brutal to those who guess wrong. In this case, while the numbers seem astronomical, Chase profits may offset such losses in a quarter or two. But with the horrible publicity that comes with this episode and the loss that shareholders will see from the reduction in Chase stock prices, the poor decision making by involved senior executives may be dealt with brutally. And all of this will be done by the natural functioning of markets. No doubt, particularly in this election year, politicians will get involved and may eventually fine the company for engaging in “risky” activity not permissible under what is known as the Volcker Rule. But any government actions will be chump-change compared to the size of the market losses and the damage to the reputation of Chase.
Another example of market payback may be occurring for a major U.S. retailer: J.C. Penney. Earlier this year, Penney decided to forego the usual retail practice of seemingly never-ending sales and stick with everyday value pricing (with “sales” occurring only rarely). To date, it seems as though the effort is not being well received by potential customers. The latest monthly figures (on a year-over-year, comparable sales volume basis) are falling at double-digit rates even as many of their competitors are booking positive year-over-year sales results. While it is certainly far too early to declare this huge retail gamble a failure, the early results are not tremendously encouraging and could suggest the marketplace is not yet ready for such everyday value pricing on an on-going basis within a retail setting. Apparently, consumers love sales.
Finally, the recent Initial Public Offering (IPO) of Facebook shows the power of the marketplace and its inability to be manipulated on a large scale basis. For months, news reports proclaimed that buyers were hungry for Facebook stock and share prices were likely to surge. But just before the IPO, General Motors indicated they would not be paying for future advertising (about $100 million) and some 50 percent of Americans indicated in a survey they thought Facebook would be a passing fancy. Come IPO day, the initial price was set at $38 per share. For a short time, prices did go up that day, but then came down near the starting price by day’s end. And since then, the price has not generally been treated kindly within the marketplace.
The moral to these stories is that markets are efficient and will determine where they want to move regardless of the beliefs of seemingly intelligent businesspeople or interfering politicians.
Next week: the proper role of government.
Dr. James Newton serves as chief economic advisor to Commerce National Bank and is an auxiliary faculty member in economics and statistics at OSU-Marion and OSU-Newark. Dr. Newton’s views do not necessarily reflect those of Commerce National Bank or OSU-Marion/Newark.