Ah, one of my favorite movies of all time. For anyone unfamiliar with the movie “Happy Gilmore”; Mr. Gilmore is a new member of the professional golf tour, and is partnered with Bob Barker in a pro-am golf tournament. Barker was making a cameo appearance as himself, at that time the host of the gameshow, “The Price is Right”. Gilmore is playing awful golf, and emotions get chippy between the two. Eventually a fight breaks out, and Gilmore head butts Barker knocking him out. While standing over the seemly knocked out Bob Barker, Gilmore yells, “The price is wrong, bitch!”
Efficient Market Hypothesis: The Foundation
In finance, the Efficient Market Hypothesis (EMH) has been pioneered as gospel for decades, and its conclusion states that market prices are always right. EMH believes that since all information is known by market participants that the price of a stock is inherently correct. You may shutter at this notion as I did for years; just thinking I was dumb for not understanding, but after 4 years at university, spending tens of thousands of dollars on tuition, I entered a world in which I realized I had to unlearn the thesis.
Efficient means “orderly”, but throughout history, markets have been proven to be anything but orderly. The crash of 1929, Black Monday in 1987, the Dotcom crash of 2001, or the Housing Crisis of 2008 to name a few. These events have proven that markets can get very inefficient, and it is worth noting the last crash occurred when investors were equipped with the most information available, ever.
The price of stocks (or any investment for that matter) are typically priced higher or lower than the efficient price, and instead of exclaiming market prices are efficient, market participants should always be asking: how wrong are they?
Price discovery works like an oven. When you set your oven for 400 degrees the oven will heat up, and overshoot its 400 degree target. Next, as the oven regulates itself, the heat will stop and eventually fall below the 400 degree target. This process continues throughout the baking process, and the oven is very rarely at the exact target temperature.
Markets work the same way. While the market is trying to discover price, it will overshoot and undershoot the efficient price. Ovens have become much more efficient over time; overshooting and undershooting less, but markets, armed with more information than ever, have seemly become increasing less efficient. Why is this?
The answer lies in the psyche of humans mixed with todays media. Market prices are not determined by a structured formula, but rather by what humans believe the price should be. There are several phycological processes that can distort asset prices much higher or lower than the efficient price. Entire books have been written on market behavioral psychology, but let’s briefly look at two factors that contribute to asset prices raising above the efficient price:
Confirmation bias: As the price of stock raises the human psyche can create confirmation bias. Example, Betty buys a stock. The stock appreciates in value. Due to the stock appreciating, Betty confirms with herself that she made the right decision, regardless of whether the stock went up for the reason she bought. As the stock goes up Betty continues to buy more, and each time she buys more and the stock goes up, her confirmation bias grows. As her confirmation bias grows, so goes her confidence.
Fear of missing out (FOMO): Example, Chuck heard his buddies talking about stock ABC. He doesn’t buy at first, but then sees the stock explode to the upside. Chuck can’t stand watching his friends get rich without him, and buys the stock at a much higher price.
Both of these psychological processes create asset prices to appreciate higher than efficient prices. Mix in media which help inflate these emotions and reach a larger audience, and you get bigger bubbles each time.
The Dotcom bubble is one of the best examples of how behavioral psychology can effect market prices. The Dotcom bubble expanded because of the notion that the internet would change the world. That thesis was exactly correct. The internet would change the world and be an excellent investment opportunity, so how did investors lose so much money? Market participants engaged in both confirmation bias and FOMO. During the Dotcom bubble a stock would increase by 100% or more in one day, and each stockholder would confirm with themselves they made the right choice. As confirmation bias grows, so does confidence. So next time they have an opportunity to invest in a hot Dotcom stock they poured even more money in. The FOMO increased assets prices even higher, and due to these to factors investors poured money into internet and technology stocks regardless of price. The basic fundamental investment question: “how much cash can this company realistically return to me” no longer mattered.
Price always matters
Price always matters. For most decisions in life we never forget that, but when humans invest many market participants simply stop caring. Imagine being at the beach. I for one love an ice cold Corona at a beach bar, but when does the price of a Corona become to expensive? Every person has a different propensity to spend. What is your limit? Three dollars, five, ten, twenty, a hundred dollars? There is clearly a point in the price spectrum in which you would not buy, and even be offended the bar would consider charging such a price. That is because the value of the Corona disappears after a certain price point. All products reach a price outside of value, and stocks are no different.
The difference between products and stocks is that investors believe stocks can grow into high prices. Bubbles and crashes occur when prices get so outstretched that it is virtually impossible for that type of exponential growth to occur. The higher price creates higher expectations, and when those expectations are not met the crash ensues.
Back to our oven example: imagine we set the oven to 400 degrees and it warmed up to 1,000 degrees, then down to 200 degrees, and it continued back and forth. Would we claim the oven to be efficient? Would we give the engineer a noble prize? Of course not, but that is exactly what the investment community has done for decades with EMH. After decades of proof against EMH the industry and academics continue to cling to the idea. Human emotion ultimately dictates stock prices, and as long as humans are involved in investing, it is absurd to believe markets prices are efficient.
The Road to Todays Inefficiency
EMH is absurd, and it is important to understand that it has been the bedrock of financial theory for decades, and through that foundation it has created other theories and financial products. The history is long, but I will be brief: out of EMH, Modern Portfolio Theory was created. Modern Portfolio Theory helped create Index Investing. Index Investing created “passive” investing strategies, and this all lead to the creation the Exchange Traded Fund (ETF).
The ETF is the end product of multiple decades of financial fallacy. (A look into how ETFs function and their flaws can be found in a previous article, Market Jujitsu.) EHM’s premise “all prices are correct” leads one to the idea: why think at all? The ETF gives investors the ability to do just that. I’m not kidding. Don’t think about which company is better than the other, just buy them all. The ETF bundles securities not on merit, but on whether they are part of an index, sector, or industry. There is no other thought process.
While an oven is only as efficient as its insulation and sensors, a market is only as efficient as its participants.
The ETF has created millions of inefficient market participants who are now investing trillions of dollars around the world. These participants are the definition of inefficient because they do zero due diligence, do not understand what they own, and believe they can liquidate to cash quickly in any market condition. They are ordering $100 Coronas, and throwing away the receipt without looking at it because they trust the market is efficient.
The proponents of Index Investing will show you a chart of how successful it was been over the past 20-30 years, but what you need to understand is indexing has been successful in the past because it was a small sliver of the market. In previous decades, market prices were dictated market participants that did extensive research on individual companies, and had years of market observation to help them understand a fair price in which they would buy or sell individual companies. This efficient allocation of capital would bring good companies into indexes while expelling bad companies out of indexes. Indexing worked because index investors piggy backed off the research of money managers. While professional money mangers still dictate prices, their influence has been greatly diminished as more inefficient participants enter the market.
Today ETF investing has expanded exponentially. ETF assets in just four providers: BlackRock, Vanguard, State Street, and Fidelity comprise of 16 trillion dollars in assets under management. 37% of US equity funds are now passive. These products have distorted the efficient application of capital, and will continue as ETFs continue to grow.
Short Term Memory
Toxic products have cycled through Wall Street for decades, and the short term memory of the public (financial amnesia) lets it continue. Here is the ETF pitch: “We will bundle these investments for you. Trust us. No need to do any due diligence what-so-ever. These instruments very safe because they are diversified, and since there is a lot of trading volume they are very liquid as well.”
The funny (or not so funny) thing is if you swap the acronym ETF with CDO you get the exact same pitch and product. Collateralized Debt Obligation’s (CDOs) were the instruments that helped create the 2008 housing crisis. A mere 10 years ago Wall Street was telling you CDOs were safe because housing prices have never seen a collective national decline of over 3%. The mortgages are diversified. Trust us. This time they are telling you ETFs are safe because the stock market always bounces back.
Never assume the market is efficient. Peel the onion back, look at the individual securities that make up the bundle, and ask; how wrong are prices today? I will tell you, stocks at the moment are greatly mis-priced. While ETF’s are not solely to blame, they have created the vehicle for weak market participants to be complacent, and buy at any price. The participants do not understand what they own, believe diversification protects them, and believe they can get out before the market falls.
I can get out before the market falls fallacy
ETFs gained popularity over the years because they can be bought and sold throughout the trading day. Mutual funds on the other hand can only be settled out once at the end of each trading day. The ability to trade ETF’s intraday has given many ETF investors the assumption of liquidity, because quite frankly, it has worked over their short lifetime. Markets have been liquid, but it has created the idea that these instruments will be able to be liquidated in any market environment. Many believe they can “get out” before the market drops. It has been lost on many ETF investors that it is still a marketplace; meaning there must be a buyer present for the seller to get to cash. It’s not a video game; a game in which whoever hits the “button” first wins. To sell you need what is called a “bid”. If one day you wake up and nobody makes a “bid” to buy your stock, and you must sell, your price gets moved down until someone decides it’s a good price. My fear is one day the ETF world wakes up to no bids while the ETF holders are all hitting the sell button all at once. This could cause the greatest “rush to the door” event ever seen in market history, and only a few will get out.
To understand this dynamic imagine you bought tickets for an NBA basketball game. The Cleveland Cavilers are traveling to play the New Orleans Pelicans. Market price for tickets is $200 each. It is a hot ticket because it is likely the only chance Pelican fans have to see LeBron James play live. But a day before the game LeBron decides he needs to rest, and is not going to play. Once the news hits, the ticket price instantly drops to $50. Those who bought a $200 ticket will never get the chance to sell the ticket for $175, $150, $125, etc. The price goes to $50, instantly.
In my opinion the stock market is setup for this type of crash. Furthermore, the sell off could be even more severe due to ill sighted regulations and index investing strategies. Many seasoned market participants have left the markets. Hedge fund mangers, mutual fund money managers, and bank trading desks have folded up shop either because of regulations and/or money flowing away from active to passive funds. Historically in market panics these participants would come in and buy at reasonable prices, but this time around many of these participants will be absent.
Market prices will aways be driven by fear, greed, dreams, hopes, and visions of the future because these are human emotions, and they ultimately dictate prices. In “Happy Gilmore” Happy lets down his guard because he believes he has won the fight. At that moment Bob Barker jumps back to life, throat grabs Happy, and knocks Happy out. Today many of us fundamental money managers are Bob Barker, seemly knocked out, and out of touch with the “new normal”. But just like Happy’s fortunes instantly turned for the worst, so will many of todays market participants.
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