Section 2.3

Castles in the Air

In Burton Malkiel’s modern investment classic A Random Walk Down Wall Street, the author describes two fundamental paradigms of stock pricing.  The fundamental analysis described in the last section is known as the Firm Foundation Theory,  The problem with fundamental analysis, it seems, is that the psychology of investors won’t allow it to work well enough to be a very good predictor of stock prices in the short and mid-terms.

Psychological forces that are less than rational are always at play, and this prevents the analysis of fundamentals from being a perfect predictor of stock prices.  Perhaps the most compelling argument that fundamental analysis does not paint the whole picture, especially in the short run, is the history of bubbles that Malkiel provides.  If you know about the tulip craze of yore, it is hard to think that markets are at all rational.  Think we’ve come too far since then for the same thing to happen today?  Look at the Dot Com Crash and the Subprime Lending Crash to get a modern perspective on how the same thing can happen today.

The competing paradigm is the Castles in the Air Theory, which is based on the idea that the psychology of investors is the ultimate driver of stock prices.  This is closely related to the Greater Fool thesis and can be used to explain bubbles throughout economic history.  The simple premise of this theory is that the stock market is nearly efficient and most everybody is wasting time attempting to find inefficiencies to exploit.  You can think of the idea of efficiency in several ways.  One is in terms of news.  If everyone has the same news very quickly and trades on it very quickly, then it is difficult to trade on that news for a profit.  The internet and artificial intelligence AI have made the retail investor powerless in this regard.

Another way to think about efficiency is like a social scientist with a theoretical model.  We can apply the idea of theory testing to markets with a theoretical model that has been translated into a mathematical regression model.  If our theory is a good one, then we can predict where a stock will be now, and if we can predict the predictors, then we can predict where it will go in the future.  Some predictors can do a good job with individual securities.  The easy ones, such as the passage of time and interest rate changes made by the Fed, are telegraphed months ahead of time and are already factored into stock prices at any given time.  This means that every time the efficiency of your predictions is improved, so are the predictions of all other market participants.

The Random Walk through stock market history that Professor Malkiel leads us on demonstrates a convincing pattern that we can expect to see again in the future.  There are “normal” times when fundamental analysts would consider the markets fairly valued, at least somewhat.  Then, seemingly out of nowhere, irrational exuberance strikes and P/E multiples start to expand, and prices start to climb.  In the beginning, the euphoria is limited to Wall Street insiders, but, near the end, retail investors get the fever and start to invest in stocks at massively inflated prices.

When greed rules the day and fear is forgotten, the market behaves quite irrationally.  We start to get theories that the paradigm has changed and this sort of price inflation is here to stay and that the bull will run forever.  Like the intrepid soul that began the Marathon, the bull runs, and runs, and eventually spends his energy and falls over dead.  The death of the bull tends to be rapid, and prices plummet back to the point where fundamental investors regard prices as cheap again (which is how the new bear market ends) happens fairly quickly.  When the bottom is hit, the “bottom feeders” take over and prices start to climb again in fits and starts.

Over a period of three or so years (on average), the prices go back to “pre-crash” levels.  In the final analysis, madness in the markets will always be put in check by the inexorable force of market efficiency reasserting itself.  This may seem like a bold prediction, but it is based on past performance.  Markets have always recovered and gone higher over time.  Of course, as I hope that you are painfully aware by now, past performance may not be indicative of future performance.

It is important to realize that irrational exuberance is not limited to equity (stock) markets.  If something is sold in a market, it can form bubbles, and those bubbles can burst.  There have been real estate bubbles, there have been tech bubbles, and there have been (as oxymoronic as it seems) value stock bubbles.  Bonds are rarely considered to be in “bubble territory,” but protracted bull markets in bonds can be of great concern to bond traders.

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