Dynamics of Value-Tracking in Financial Markets

Abstract: The efficiency of a modern economy depends on what we call the Value-Tracking Hypothesis: that market prices of key assets broadly track some underlying value. This can be expected if a sufficient weight of market participants are valuation-based traders, buying and selling an asset when its price is, respectively, below and above their well-informed private valuations. Such tracking will never be perfect, and we propose a natural unit of tracking error, the 'deciblack'. We then use a simple discrete-time model to show how large tracking errors can arise if enough market participants are not valuation-based traders, regardless of how much information the valuation-based traders have. We find a threshold above which value-tracking breaks down without any changes in the underlying value of the asset. Because financial markets are increasingly dominated by non-valuation-based traders, assessing how much valuation-based investing is required for reasonable value tracking is of urgent practical interest.