Is the market losing touch with reality? Tesla, bitcoin and some other frothy tech stocks seem to be signalling growing risks; speculation rather than fundamentals. In individual investments, bubbles and crashes happen all the time and need not hurt the broader market. But they remind us that inefficiencies abound, and that irrational behaviour offers opportunity for thoughtful investors.
The puzzle of bubbles is that they contradict the concept of stock market efficiency but allow those involved to rationalise their position. And nothing drives confidence like big unrealised gains. Having an investment that has doubled in value brings pride and the self-assurance for an investor that they are just that bit smarter.
How much confidence is just right? The gains of the last year were largely unexpected yet are already woven into investment manager narratives as the inevitable result of wisdom and foresight. This is a lesson for all investors – bull markets polish our ego every day and impose no burden of patience or stress.
Investment managers may have some brief thoughts about rotation from growth to value or stock liquidity, but there is little incentive to step outside the box and question it all. This is not an environment that necessarily points to a market setback, but undoubtedly investors’ guards are down.
Academic research points to momentum as the strongest and most persistent factor in stocks, and today’s economic climate reinforces this. Network effects create a winner-takes-all environment for scalable businesses that have the potential to dominate their niche. Businesses such as Tesla that enjoy meteoric stock performance see their cost of capital falling as it becomes easier and cheaper to raise more capital, even if it is not really needed.
Classical economics has been turned on its head, yet it underpins much of the theory of market efficiency and asset pricing. Analysts put much effort into learning how to price capital, but listed businesses are using less of it and more of the economy is now in private markets.
Momentum carries through to the investment process itself. Flows into the stock of ‘successful’ companies tends to push up prices further. Funds that enjoy success and secure a position on buy lists can benefit from regular inflows and continue to pour new money into the same stocks.
In time there may be a reality check and star managers can fall from favour, but the self-fulfilling circle of success fuelling success can continue for a few years. This may explain the crashes in major companies such as Wirecard last year. ‘Winners’ can rebuff a lot of criticism for a long time, drawing in regulators and index funds.
Also driving some share prices up recently have been short squeezes, with hedge funds forced to buy back stock to cover a position as the price rises. We saw this most notably in the cases of US videogame store GameStop and cinema owner AMC Entertainment. Investment banks and market-makers have little incentive to intervene, leaving a price forced higher by desperate attempts to buy stock, rather than fundamental price formation.
Similarly, many smaller and medium-sized companies, or recent initial public offerings, have limited coverage from non-house brokers. There is little financial incentive to initiate negative research. Options trading from newer entrants to the market may also now be adding to volatility. Despite its impact, there is little public transparency on this.
In a world of easy money, we should expect more individual stock bubbles. But any broader setback for the market might more likely come left field; from politicians, social conflict or international tensions. Investors should at the very least not let stock market gains drive riskier position sizing. And they should recognise that an extraordinary period in markets does not mean we are all smarter.
A version of this article was published on Citywire Wealth Manager on 16/02/2021.