Merton Miller and Modern Finance

Financial Management (Financial Management Association), Winter, 2000 by Rene M. Stulz

Merton Miller never argued that markets should move continuously. In fact, on May 27, 1987, he gave a paper at the Mid-America Institute that was remarkably prescient about the possibility of price gaps. [7] In that paper, he points out that greater liquidity in markets makes it possible for individuals separately to withdraw their capital whenever they want to, but by the nature of equity capital, it is not possible for society to withdraw its investment. Generally, individuals who sell and buy largely balance each other out. At times, however, it is possible for an imbalance to develop where many more individuals want to sell than there are individuals who want to buy. In such a situation, there is a possibility that the buffer stocks of the market makers and the resources of liquidity providers will be exhausted. This creates the equivalent of a bank run--those that get to sell first are the lucky winners, while those that come last cannot sell because there are only sellers. He then discusses the implicat ions of his argument for the organization of markets, arguing that it is important to put in place mechanisms that enhance the capacity of exchanges to absorb the demand for transactions. After comparing periods where everybody wants to sell to a brown-out, he concludes that "No economically feasible amount of added capacity will guarantee against any recurrence of market brown-outs of course; but it can at least make them even rarer events" (Miller (1991 a), p. 48).

Though Merton Miller thought that prices might change with dramatic speed because of the limited capacity of financial markets to provide transaction services, he did not think that such price gaps were necessarily evidence of "bubbles" bursting. He pointed out in a keynote address to the Pacific-Basin Finance Association that with low dividend yields, most of the value of a stock resides in cash flows that will accrue a number of years in the future. [8] This implies that small changes in expectations about growth rates, interest rates, or risk premia can lead to large changes in prices. In his example, he starts from a dividend yield of 3%, a discount rate of 10%, and a growth rate of dividends of 7%. With these assumptions, the share price would be worth 33 times the current dividend. He then points out that if the growth rate falls to 6.5%, a half a percent less, and the discount rate raises to 10.5%, a mere half a percent more, the stock price falls to 25 times dividends, or a fall of 24%. With his examp le, it does not take much to generate a fall in the stock prices of the magnitude of the one that took place on October 19, 1987.

Merton Miller did not pick these numbers because he thought they were the right numbers to plug in Gordon's growth model to explain the crash of 1987. He made it clear that all he was doing was providing a set of numbers that would be consistent with a fundamental explanation of the crash. While a fundamental explanation of the crash is possible, he did not think that we would be able to reject empirically either the hypothesis that the crash was a bursting bubble or that it was a stock price move resulting from a change in fundamentals. His view was that "we are faced with competing theories that can seemingly account for the same facts and we have no way of conducting decisive experiments that can distinguish between them" (Miller (1991a), p. 103). Confronted with this problem, he then went on to a careful discussion of the policy implications of the two views of crashes, concluding that the "wiser and ultimately more conservative policy, even for those who still believe in bubbles, is not to seek to preven t stock market crashes at all costs, but if one does occur, to localize any damage and keep it from spreading to other sectors of the economy" (Miller (1991a), p. 106).