Sense and Nonsense in the Markets (originally posted in August 2008)
It has been said that man is a rational animal. All my life I have been searching for evidence which could support this: Bertrand Russell
Rational behavior is one of the most accepted assumptions in social science. Much of financial theory is based on the notion that everyone acts rationally – attempting to maximize their gain and minimize their pain when making investment decisions. Modem portfolio theory, for example, assumes that investors seek to earn the highest return at any given level of risk. The arbitrage pricing theory says that two identical securities cannot sell at different prices for very long, because rationally minded traders will buy the cheap and sell the dear until both are priced identically. And the efficient market theory (EMT) preaches the futility of using new information to generate excess return, because the universe of rational investors will act in such a way that the information is instantaneously reflected in asset prices. Hence, with so many millions of investors studying the market, the theory goes, no stock can ever sell for more or less than its true intrinsic worth.
But how far is that a fair assumption? How efficient are the markets?
Looking at the chart below, it is difficult to opine that the markets were efficient between late last year and now. One can pick up almost any company’s stock performance during this period to prove this but lest that appear as a recommendation, we have chosen a company that we referred to in one of our earlier letters, viz., BASF (we have sold the stock since – with higher than the initially expected results). Can we say that BASF’s intrinsic worth increased 140% from August 2007 to Jan 2008 and then fell over 50% by July 2008? Judging from the stock price, it sure did.
It has been said that man is a rational animal. All my life I have been searching for evidence which could support this: Bertrand Russell
Rational behavior is one of the most accepted assumptions in social science. Much of financial theory is based on the notion that everyone acts rationally – attempting to maximize their gain and minimize their pain when making investment decisions. Modem portfolio theory, for example, assumes that investors seek to earn the highest return at any given level of risk. The arbitrage pricing theory says that two identical securities cannot sell at different prices for very long, because rationally minded traders will buy the cheap and sell the dear until both are priced identically. And the efficient market theory (EMT) preaches the futility of using new information to generate excess return, because the universe of rational investors will act in such a way that the information is instantaneously reflected in asset prices. Hence, with so many millions of investors studying the market, the theory goes, no stock can ever sell for more or less than its true intrinsic worth.
But how far is that a fair assumption? How efficient are the markets?
Looking at the chart below, it is difficult to opine that the markets were efficient between late last year and now. One can pick up almost any company’s stock performance during this period to prove this but lest that appear as a recommendation, we have chosen a company that we referred to in one of our earlier letters, viz., BASF (we have sold the stock since – with higher than the initially expected results). Can we say that BASF’s intrinsic worth increased 140% from August 2007 to Jan 2008 and then fell over 50% by July 2008? Judging from the stock price, it sure did.
How rational are human decisions?
A pair of powerful spectacles has sometimes sufficed to cure a person in love: Friedrich Nietzsche
If a computer is asked to choose between two alternatives, it would use logic and mathematics to calculate potential gains or losses before making its choice. But humans, with their limited cognitive abilities, cannot take a decision based solely on strict mathematical calculation or logic. There would likely be an element of ‘biases’ in that decision.
This aspect of human decision making and its impact on stock markets has been studied by scholars since the early part of the century. In his 1938 book The General Theory of Employment, Interest, and Money, John Maynard Keynes coined the term animal spirits to describe ‘the spontaneous urge to action’ frequently exhibited in manias and market crashes.
In more recent times, this behavioral aspect of finance has been even more widely embraced to explain the baffling volatility of financial markets. In their 1985 paper “Does the Stock Market Overreact?,” Richard Thaler and Werner DeBondt suggested that the tendency of stocks to fall in and out of favor is the result of the human tendency to think more about recent events and to lose sight of the long run. How often does it happen that the analysts and the investing public give up on a company because of recent bad performance? So very often that this provides every practiced investor an opportunity to buy into a good company at prices they like.
Another human tendency is to pay more if they feel that they might lose out to someone else. Richard Thaler described this in a book called The Winner's Curse. This explains why purchasers tend to bid more aggressively in an auction as the number of competing bidders increase and why gamblers go for long shots at the end of a losing day. It also explains why at times you will notice a stock rising immediately upon market opening (or just before closing). People want to grab it before ‘it goes too high’ or ‘it is discovered by others’ etc.
There can also be simple Demand and Supply related reasons for market irrationality: Foreign institutional investors were the major sellers on the Indian bourses in the last 7 months, accounting for outflows equivalent to $15Bn. Some of the bigger US and European financial institutions form a bulk of the pull out. Given that the original reason for the pull out (which really started in January 2008) was the Sub-Prime issue in the US, how possible is it that they pulled out the funds in order to bolster the financials of their parent institution?
There are many other kinds of biases and there can be other reasons for the irrationality but that that is a topic deep enough to be taken up much more elaborately, perhaps at a later stage. Suffice it is to say that there are times when irrationality does exist in the market.
Role of Information and Experts in biases
If a computer is asked to choose between two alternatives, it would use logic and mathematics to calculate potential gains or losses before making its choice. But humans, with their limited cognitive abilities, cannot take a decision based solely on strict mathematical calculation or logic. There would likely be an element of ‘biases’ in that decision.
This aspect of human decision making and its impact on stock markets has been studied by scholars since the early part of the century. In his 1938 book The General Theory of Employment, Interest, and Money, John Maynard Keynes coined the term animal spirits to describe ‘the spontaneous urge to action’ frequently exhibited in manias and market crashes.
In more recent times, this behavioral aspect of finance has been even more widely embraced to explain the baffling volatility of financial markets. In their 1985 paper “Does the Stock Market Overreact?,” Richard Thaler and Werner DeBondt suggested that the tendency of stocks to fall in and out of favor is the result of the human tendency to think more about recent events and to lose sight of the long run. How often does it happen that the analysts and the investing public give up on a company because of recent bad performance? So very often that this provides every practiced investor an opportunity to buy into a good company at prices they like.
Another human tendency is to pay more if they feel that they might lose out to someone else. Richard Thaler described this in a book called The Winner's Curse. This explains why purchasers tend to bid more aggressively in an auction as the number of competing bidders increase and why gamblers go for long shots at the end of a losing day. It also explains why at times you will notice a stock rising immediately upon market opening (or just before closing). People want to grab it before ‘it goes too high’ or ‘it is discovered by others’ etc.
There can also be simple Demand and Supply related reasons for market irrationality: Foreign institutional investors were the major sellers on the Indian bourses in the last 7 months, accounting for outflows equivalent to $15Bn. Some of the bigger US and European financial institutions form a bulk of the pull out. Given that the original reason for the pull out (which really started in January 2008) was the Sub-Prime issue in the US, how possible is it that they pulled out the funds in order to bolster the financials of their parent institution?
There are many other kinds of biases and there can be other reasons for the irrationality but that that is a topic deep enough to be taken up much more elaborately, perhaps at a later stage. Suffice it is to say that there are times when irrationality does exist in the market.
Role of Information and Experts in biases
Be careful about reading health books. You may die of a misprint: Mark Twain
Information is an important reason for many of the human biases since it is neither universally available (the common investor cannot visit companies regularly, speak with trade associations, suppliers, distributors, or sit in on conference calls with management), nor is it interpreted identically. Hence most of us depend, in varying degrees, upon newspapers and other published material including reported comments from the senior functionaries and experts. Unfortunately if one was to pick up more than one newspaper describing a single event, it is entirely possible that one would come across different sets of analysis on the same event.
The ‘experts’ themselves often think nothing of changing their tune along with the latest song. Pick up an oil expert’s comments of around 30-40 days ago and compare them to the latest ones and you will get the drift. Example, on June 25th, CNN reported the OPEC president as saying that the oil prices would rise to $150-170 a barrel during the northern hemisphere summer. The same gentleman caused a flutter when on July 28th, merely a month after the earlier utterance, he said that crude prices were abnormally high and that the longer term prices will be around $78 a barrel. (Note that the last price quoted is quite precise, not even in a range.)
Do we ever learn from the past?
Information is an important reason for many of the human biases since it is neither universally available (the common investor cannot visit companies regularly, speak with trade associations, suppliers, distributors, or sit in on conference calls with management), nor is it interpreted identically. Hence most of us depend, in varying degrees, upon newspapers and other published material including reported comments from the senior functionaries and experts. Unfortunately if one was to pick up more than one newspaper describing a single event, it is entirely possible that one would come across different sets of analysis on the same event.
The ‘experts’ themselves often think nothing of changing their tune along with the latest song. Pick up an oil expert’s comments of around 30-40 days ago and compare them to the latest ones and you will get the drift. Example, on June 25th, CNN reported the OPEC president as saying that the oil prices would rise to $150-170 a barrel during the northern hemisphere summer. The same gentleman caused a flutter when on July 28th, merely a month after the earlier utterance, he said that crude prices were abnormally high and that the longer term prices will be around $78 a barrel. (Note that the last price quoted is quite precise, not even in a range.)
Do we ever learn from the past?
I am always ready to learn although I do not always like being taught: Winston Churchill
If one reads some about the Tulipomania of 1637 when the Dutch speculators saw tulip bulbs as their magic road to wealth (this was a time when, it is said, a bulb of no previously apparent worth might well have been exchanged for a new carriage, two grey horses and a complete harness), it would be clear and humans have and will remain driven by the twin devils of greed and fear.
Hence, in the tangible, sensible world of say, clothing, electronics, oil or cars, when prices increase we tend to buy less. But the stock market? That has to be one of the only institutions where most participants feel more secure while buying a stock that is MORE expensive than one that is cheap. As ridiculous as it may seem while reading this, for most people, a rising stock price indicates an improvement in the company's intrinsic value, and a declining price represents the opposite! Therefore, at higher prices it is almost a rule that the quantity of stock demanded also rises. Don’t the newspapers also encourage this by highlighting stocks that show ‘technical strength’ (meaning that a stock is on its way up) and those pushing through a ‘higher moving average’?
As an example, we had written about a stock in our last write-up called EID-Parry. To recall, we had mentioned that considering the market value of their listed subsidiary company and the anticipated receipt (in cash) of the proceeds of a non-core business, the base business was coming for free. This stock had 20 times higher volume (sale/ purchase) at a price of Rs 254 (average price on Aug 7th) than at a price of 172 (Jul 21st). The marked portions in the chart below show how volumes in this stock jumped as prices went up. Obviously many investors were more comfortable buying at a higher price 250+ than when it was languishing at 170 or thereabouts. Meanwhile many others would have profited by selling at the higher price, earning a profit of 60% from the low just about a fortnight ago.
If one reads some about the Tulipomania of 1637 when the Dutch speculators saw tulip bulbs as their magic road to wealth (this was a time when, it is said, a bulb of no previously apparent worth might well have been exchanged for a new carriage, two grey horses and a complete harness), it would be clear and humans have and will remain driven by the twin devils of greed and fear.
Hence, in the tangible, sensible world of say, clothing, electronics, oil or cars, when prices increase we tend to buy less. But the stock market? That has to be one of the only institutions where most participants feel more secure while buying a stock that is MORE expensive than one that is cheap. As ridiculous as it may seem while reading this, for most people, a rising stock price indicates an improvement in the company's intrinsic value, and a declining price represents the opposite! Therefore, at higher prices it is almost a rule that the quantity of stock demanded also rises. Don’t the newspapers also encourage this by highlighting stocks that show ‘technical strength’ (meaning that a stock is on its way up) and those pushing through a ‘higher moving average’?
As an example, we had written about a stock in our last write-up called EID-Parry. To recall, we had mentioned that considering the market value of their listed subsidiary company and the anticipated receipt (in cash) of the proceeds of a non-core business, the base business was coming for free. This stock had 20 times higher volume (sale/ purchase) at a price of Rs 254 (average price on Aug 7th) than at a price of 172 (Jul 21st). The marked portions in the chart below show how volumes in this stock jumped as prices went up. Obviously many investors were more comfortable buying at a higher price 250+ than when it was languishing at 170 or thereabouts. Meanwhile many others would have profited by selling at the higher price, earning a profit of 60% from the low just about a fortnight ago.
Conclusion
Despite all the biases that exist, can we conclude that there is NO efficiency in the market? No, we do not wish to say that. Usually, the stock market as a collective institution is fairly efficient. Whenever market prices diverge from fundamentals, smart investors buy that stock and keep buying till the anomaly vanishes. A similar thing would happen in reverse (if an asset was artificially expensive). Isn’t that how the cheaper stocks that one buys eventually reach their potential and we are able to profit from it? There are, however, short windows of time in which such opportunities do become available. These could happen because of a variety of reasons, for example when fear rules the street in a bear market. Or at an industry level it could happen due to a short term event like the recent interest rate hike (bad for rate sensitive industries like auto or the banks). And at a company level it could happen because of a bad quarter or bad press. Etc. But eventually, the price does reflect value. Meanwhile the intelligent investors have profited.
It is fair to say that larger the number of smart (professional or otherwise) investors, the faster the prices would return to fundamental levels. In that sense, a country like the US is bound to have more efficiency (most of the time) than, say, India. Opportunity for us. Also, the larger capitalized stocks are normally considered better in terms of efficiency, than the smaller capitalized companies, simply because they tend to get more attention from analysts (too much attention can also trigger a herd mentality but that’s another topic). Again, this could provide an opportunity to the alert to pick up something in the latter category.
We would prefer to end by saying that humility is normally the best policy. Unless you can spot a clear inefficiency - and come up with a plausible explanation of why others have not pounced on it already - it is probably wise to assume that the markets are efficient. Some people, some of the time, will be able to outsmart the markets. But not most people most of the time.
Despite all the biases that exist, can we conclude that there is NO efficiency in the market? No, we do not wish to say that. Usually, the stock market as a collective institution is fairly efficient. Whenever market prices diverge from fundamentals, smart investors buy that stock and keep buying till the anomaly vanishes. A similar thing would happen in reverse (if an asset was artificially expensive). Isn’t that how the cheaper stocks that one buys eventually reach their potential and we are able to profit from it? There are, however, short windows of time in which such opportunities do become available. These could happen because of a variety of reasons, for example when fear rules the street in a bear market. Or at an industry level it could happen due to a short term event like the recent interest rate hike (bad for rate sensitive industries like auto or the banks). And at a company level it could happen because of a bad quarter or bad press. Etc. But eventually, the price does reflect value. Meanwhile the intelligent investors have profited.
It is fair to say that larger the number of smart (professional or otherwise) investors, the faster the prices would return to fundamental levels. In that sense, a country like the US is bound to have more efficiency (most of the time) than, say, India. Opportunity for us. Also, the larger capitalized stocks are normally considered better in terms of efficiency, than the smaller capitalized companies, simply because they tend to get more attention from analysts (too much attention can also trigger a herd mentality but that’s another topic). Again, this could provide an opportunity to the alert to pick up something in the latter category.
We would prefer to end by saying that humility is normally the best policy. Unless you can spot a clear inefficiency - and come up with a plausible explanation of why others have not pounced on it already - it is probably wise to assume that the markets are efficient. Some people, some of the time, will be able to outsmart the markets. But not most people most of the time.
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