Merton Miller and Modern Finance

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

Recently, many financial economists have argued that the high stock prices we have experienced are evidence of a bubble. The recent debates on the level of the stock market have made extensive use of results from a new branch of finance, behavioral finance. For instance, Shiller (2000) uses behavioral models to explain how investors at times could get carried away by theories supporting high stock prices. He points out that the late 1990s were the fourth period this century where people were enthralled by so-called new economy ideas. The first such period was at the turn of the century, the second one was before 1929, and the third in the 1960s. The previous three periods where stock prices increased dramatically fueled by new economy visions did not end well. Though Shiller provides evidence that is supportive of the view that there was a stock price bubble in the late 1990s, we should remember Merton Miller's cautions. An efficient market is not one that gets things right every time. It is perfectly possibl e for investors to rationally expect great things from technological progress and be disappointed ex post. We do not have the tools that would permit us to conclude that the markets were wrong--or right--when it turned out that the stock market increases associated with new economy ideas were followed with poor returns.

IV. Liquidity, Regulation, and Arbitrage

Merton Miller's crisis mechanism is in many ways perfectly consistent with having investors motivated by behavioral considerations that are not outcomes easily understood with the simple utility functions that much of finance typically uses. However, in Merton Miller's world, the forces of arbitrage, broadly understood, eventually prevail. If random or poorly understood actions of a mass of individual investors were to lead them to exit the markets in a hurry, profit opportunities would exist and investors could exploit them, bringing prices back to where they should be. This mechanism presumes that arbitrageurs will always be there in force to prevent overshooting and systematic biases in prices relative to what they should be based on fundamentals alone. How can we be sure that the free fall of October 19, 1987, stopped just where it should have? How can we know that the dramatic emerging markets collapses were not excessive? Perhaps we will never know. Such drops or gaps in markets will not be excessive on ly if there are enough investors who do not succumb to panic and are not moved by emotions that step in and start buying. This means that such investors have to have enough capital at their disposal.

Recent history makes it relevant to question both whether investor stampedes can take place more easily and whether there is enough arbitrage capital to prevent markets from overshooting when large numbers of investors stampede in one direction or the other. Investors can make trades faster than they ever could. This is undoubtedly a great benefit for investors and the markets, but at the same time, there is the potential for investors to herd in ways that they never did before. We have seen dramatic reversals in investor sentiment