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About the Authors

GORDON PEPPER has the unusual combination of an economics degree from Cambridge and actuarial training. Immediately after he finished taking examinations, he became a dealer on the Floor of the London Stock Exchange. His ‘postgraduate university’ was the market place, where he underwent the harshest of disciplines. Forecasts based on conventional theories were often wrong. The inescapable conclusion was that these theories were either incorrect or incomplete.

Pepper was the joint founder of W. Greenwell & Co’s gilt-edged business (that is, the UK government bond business), which arguably became one of the leading bond-advisory businesses in the world, the advice being about both the best investments and the optimum way to execute business. For more than ten years he was the premier analyst in the gilt-edged market and was often described as the guru of that market. He was the principal author of Greenwell’s Monetary Bulletin, which, in the 1970s, became one of the most widely read monetary publications produced in the United Kingdom

Pepper is the author of three books and the co-author of a fourth: Money, Credit and Inflation (1990), Money, Credit and Asset Prices (1994), Inside Thatcher’s Monetarist Revolution (1998), and (with Michael Oliver) Monetarism under Thatcher – Lessons for the Future (2001). He is also chairman of Lombard Street Research Ltd, which is one of the UK’s leading independent firms carrying out investment research and specialising in analysis of money, credit and flows of funds. Summarising, Pepper’s particular strength is the combination of practitioner and academic. Above all, he writes with great authority from his knowledge of what actually happens in the marketplace.

MICHAEL J. OLIVER is currently Professor of Economics at École Supérieure de Commerce de Rennes and a director of Lombard Street Associates, UK.

He graduated in economic history at the University of Leicester and was awarded his PhD in economics and economic history from Manchester Metropolitan University. He has held posts at the universities of the West of England, Leeds, Sunderland and has been a Visiting Professor at Gettysburg College, Pennsylvania and Colby College, Maine.

He is the author of several books, including Whatever Happened To Monetarism? Economic Policy-making and Social Learning in the United Kingdom Since 1979 (1997); Exchange Rate Regimes in the Twentieth Century (with Derek Aldcroft, 1998) and Monetarism under Thatcher – Lessons for the Future (with Gordon Pepper, 2001). He has just finished co-editing a book (with Derek Aldcroft) entitled Economic Disaster of the Twentieth Century, which is being published by Edward Elgar in 2006. He has contributed articles to Economic History Review, Twentieth Century British History, Economic Affairs, Contemporary British History, Economic Review and Essays in Economic and Business History.

The Liquidity Theory of Asset Prices

By Gordon Pepper Michael Oliver

John Wiley & Sons

Copyright © 2006 Gordon Pepper
All right reserved.
ISBN: 9780-470-02739-4

Chapter One

Types of Trades in Securities

A corporation's annual accounts normally consist of a trading account, a balance sheet and a cash-flow statement. The trading account gives details of the corporation's income, expenditure and profit or loss during the corporation's financial year. The balance sheet gives details of its assets and liabilities at the end of the year. The cash-flow statement reconciles the changes in the balance sheet between the start and the end of the year. Managers of small businesses, who may never produce a trading account or a balance sheet, understand the vital need to watch their cash flow. Individuals with bank accounts normally have a bank balance below which they are unhappy and have to take action, either by curtailing expenditure or selling something. Similarly, they have a maximum for a balance that is not expected to be temporary. If their current balance exceeds this amount, either they will be tempted into incurring additional expenditure or they will take action to find a better medium of investment for their surplus funds. In each case, they manage their cash. For non-accountants, cash-flow accounting is simpler than trading accounts and balance sheets.

1.1 LIQUIDITY TRADES AND PORTFOLIO TRADES

There are two basic reasons why someone purchases or sells a security. The first type of transaction occurs when someone either needs to raise cash or has surplus money to invest. This type of transaction may be called a liquidity trade. The second type of transaction occurs when someone switches from one stock into another, or into or out of cash, in the hope that the transaction will improve the return on a portfolio. A transaction of this second type may be called a portfolio trade (Figure 1.1).

1.2 INFORMATION TRADES AND PRICE TRADES

Another distinction is between two types of portfolio trade. A trade can occur either because there has been some unexpected new information that affects the value of a stock, or because the price of a stock has altered in spite of there not being any new information justifying the alteration. The first type of portfolio trade may be called an information trade; the second may be called a price trade (Figure 1.1).

1.3 'EFFICIENT PRICES'

When new information becomes available, market-makers adjust their prices, and information traders act very quickly if they think that they can make a profit, with prices responding until no one else can do so. Prices then become efficient once again.

Information trades establish efficient prices, but liquidity trades move prices away from the efficient level. A sale of a stock to raise money will initially depress the stock's price. If the price falls without there being any news justifying the fall, price traders will normally judge the stock to be cheap and will purchase it until the price reverts to the efficient level. In the opposite case of a liquidity purchase, the price of the stock will initially rise. If there is no news justifying the rise, price traders will normally judge the stock to be dear and will sell until the prices revert to the efficient level.

Summarising, liquidity trades move prices away from the efficient level and price trades normally push prices back again. There is an enormous number of potential price traders. Anyone can buy stock. Potential sellers include everyone who holds stock and anyone who is prepared to sell stock that they do not own. The potential number of price trades is, accordingly, very large compared with liquidity trades, and they are usually sufficient to be able to correct any price discrepancies caused by liquidity trades.

1.4 EXPECTATIONS OF FURTHER RISES OR FALLS

The analysis so far has been conventional. There should be no dispute about it. Disagreement comes because there is a remaining possibility, which some academics ignore. It is that a rise in the price of a stock can lead to expectations of a further rise in price, and a fall in price can lead to expectations of a further fall; in other words, expectations can become extrapolative (that is, expectations assume that the current trend in prices continues). If this happens, prices will depart further from the previous level.

It might be thought that there is a remote possibility of expectations becoming extrapolative. Indeed they are rarely so for an individual stock, but expectations can easily become extrapolative for a market as a whole. It will be argued that they do so when liquidity transactions persist in one direction: that is, when there are more liquidity purchases than sales, or vice versa, for any length of time. There are three stages to the argument. Each will be described in turn in the following three chapters.

1. The balance of liquidity transactions can persist in one direction for many months.

2. This leads to extrapolative expectations.

3. Why price traders who understand what is happening do not push prices back to the level justified by fundamentals.

(Continues...)

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