This post is derived from a similar post I made on TopCoder.

There's a simple model of stock pricing that's even cleaner than price earnings ratios. Adjusted for risk and inflation, stocks are priced, in an efficient market, based on the estimation of all future profits.

This is actually a terrific mental model for long term trading, and holding companies such as Berkshire-Hathaway use similar models.

However if all you are trading are shares of real companies proving regular goods or services, then trading in the short term implies that you're making a bet regarding the first derivative of its market price.

In recent years there is a lot of trading in what are called derivatives. The prices of the derivatives themselves estimate value at some future date, and short term funding of these is then dependent on the second derivatives of equities.

The system blows up and becomes non-linear very quickly: in particular many of the nice properties that are derived from the efficient market hypothesis become less and less valid, and short term gains become quite accessible.

Additionally, the managers of big money funds (venture capital, private equity, hedge funds) have asymmetric incentives: that is, given a choice between an investing making 30% on average with a 1% SD, or an investment making 28% with a 10% SD, they'll take the latter. Why? Performance fees are structured so that fund managers receive some percentage of the profits each year (around 20% - 50%, in some cases), while they do not have to pay any of their own money on a downswing (indeed, they would still incur a management fee on the original principal!).

As a result, short-term traders, as represented by say, hedge funds, do not trade towards new future income, and do not, in many cases, such as in financial bubbles and credit crunches, move the market any closer towards the efficient model commonly described and referenced to, in both finance and academia. The following article here documents a slice of these phenomena in time: http://www.princeton.edu/~markus/research/papers/hedgefunds_...

In particular, the housing bubble and subsequent credit crunch was largely aided by the new lending model the banks had devised. In previous years, the banks would lend their own money to home owners, and as a result were less likely to take risks funding mortgages that might not be paid-off, for property at unusual values.

In the new model (as described in the topic post), banks would appraise the property and, in a sense, broker a deal through a mortgage bond market. Like brokers there are incentives to 'churn' deals - to move more volume to grab fees. Now the mortgage bond market itself was open to public investment to the stock market, and quickly swelled due to short term investments.

Hedge funds, largely computerized, would notice a high-growth, high-beta (volatility uncorrelated with the existing portfolio) stock and feed into the bond market, yielding billions in performance fees for the industry (the first movers were particularly satisfied).

Unfortunately, mortgage bond markets are very unlike normal public companies, where at least there's quarterly financial reporting, and many other windows into operations as well. The risk depends, in aggregate, on the risk of funding all these individual home owners. It turns out that the banks had done a poor job vetting home owners, because many started, well, not paying. Additionally, since the housing prices, exposed inadvertently to the public market's fickle derivative pricing schemes, had hit a peak and started to turn downwards, many people were left with negative equity on their homes. Human nature being what it is, many refused to pay mortgage on negative equity, which rapidly accelerated the spiral.

The hedge funds, rather quickly, pulled out of the mortgage bond market, and then most of the mortgage bonds went bankrupt.

Some might blame human nature, or say it was just a strange market inefficiency, but it was bound to happen really. The consequences of investment were not aligned to the risks, and short term investors could make a fortune without improving the economy as a whole.

I think this summarizes my picture of corporations as well. When they represent small groups, risks are quite commensurate with effort and rewards. As they get larger, many corporations more resemble the structure of fascist governments, rather than free markets, internally, and the decisions are often not made to maximize the welfare of the corporation, nor the economy as a whole, but rather the comfort of the individuals within the system's constraints. At the turn of the century, that meant Enron's and WorldCom's shenanigans, this summer, it meant hedge fund managers selling short on the mortgage bond market after pumping them up, and sometime later, it's going to mean people being individually greedy on the circus that is the financial markets.