What Do Asset Prices Tell Us about the Future?

Consider, for example, the routine betting that takes place daily on horse races. Before the race starts, no one knows for sure which horse will win. Suppose that $1 would get you $2 if you bet on Streak of Lightning to win while the same $1 would pay you $20 if bet on Molasses to end up in the winner's circle. Stated differently , the " price " of a stake in Molasses is much less than that of the same stake in Lightning because bettors view a future in which Molasses wins as much less likely than one with Lightning wearing the flowers. In the same way, prices, or variables derived from prices, aggregate bettor views concerning what they think will happen in the future—in this case, which horse will win the race. Purchasing securities is much like horse betting. Payment today entitles one—one hopes—to cash flows in the future. Logically, the larger future cash flows are expected to be, the more one is willing to pay. But securities are just claims against real assets; so, the logic goes, if investors start bidding up the prices of securities, they must do so because they, collectively , anticipate a future with economic growth stronger or less volatile than what they expected before the change in prices. Indeed, one can carry the argument further by saying that the price system, if operating properly, should direct resources to their best uses, on the basis of collective information, some of which is public knowledge and some of which is known only to subsets of the population. Prices act as signals, informing decision makers where resources should go. This argument regarding the informational role of prices is articulated eloquently by Friedrich Hayek: " We must look at the price system as. .. a mechanism for communicating information if we want to understand its real function.. .. The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action.. .. [B]y a kind of symbol, only the most essential information is passed on " (quoted in Grossman 1981, 555). But if the price system has this ability to be a kind of shorthand for society's collective knowledge of the future, then prices today, whether relative to money or relative to each other, …