Enrich Your Future 36: The Madness of Crowded Trades

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, and continuing my discussion with Larry swedrow, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in Episode 645, Larry stands out because he bridges both the academic research world and practical investing today we're diving into a chapter from his recent book, enrich your future the keys to successful investing. Specifically, we're going to be talking about chapter 36 fashions and investment folly. Larry. Take it away. Yeah,

Larry Swedroe 00:34
well, psychologists have long known that individuals allow themselves to be influenced by a herd mentality, right? And, you know, this was known back even in 1841 Charles McKay wrote a great book. I'd highly recommend it for those who are interested in history and finance and economics and markets really had a big impact on me to see history repeating itself often and again, right into the 1990s when I read the book and again with AI, all kinds of bubbles happen because of fear of missing out and this herd mentality. He wrote a book called extraordinary Delusions and the Madness of crowds, right? And Isaac Newton said he could predict the movement of stars, but not the madness of crowds, right?

Andrew Stotz 01:33
Crazy quote, you know, it just shows that intellect, you know, it's hard to win with intellect, you know, in a crazy market,

Larry Swedroe 01:42
yeah, exactly. Markets can remain irrational longer than you can remain solvent. It is another famous line, which is a warning not to bet against bubbles, because they can get bigger and bigger, totally irrational eventually, like a rubber band that gets stretched too far, it snaps back, and all those fake gains that weren't fundamentally based get erased and investors get wiped out. That's happened over and over again. South Seas bubble, for example, the Mississippi River bubble, there were railroad bubbles. There were even in the US bowling alley bubbles and.com bubbles, and maybe there's an AI bubble around. And I gave it this title because we know that there's a herd mentality in fashion. You know, you saw in the 60s, Twiggy wear this really short skirt, a mini skirt, and that became the immediate fashion, whether women should have been wearing those appropriately or not, and fat ties or skinny ties, whatever's in, everybody follows that fashion. So there really should be no surprise that we would see, or at least expect to see this madness or crowds, and what I would call recency bias, where people forget all of the economic history that they may have learned if they have knowledge of history, and focus on whatever is the current madness, whether it's Bitcoin or whatever it might be. And one of the to me, one of the great anomalies, if you think about it from a rational perspective, in finance, I don't think we've even talked about this one, Andrew, there are about 10,000 mutual funds and about 10,000 hedge funds and Lots of SMA or separately managed accounts, and there are only about 3600 stocks today. Why do we need so many funds? And what we know Wall Street's marketing machines are great at creating product. So whenever a fad comes about, and there was a.com era, so there were dozens of funds immediately that had the name.com somewhere in the mutual fund. Now there'll be artificial intelligence fund and crypto funds, and whatever it'll be, there'll be hundreds, if not 1000s, of them. What most people don't know is 7% of all mutual funds disappear every single year, and that's mostly because most of these funds shouldn't exist in the first place. It's the advertising machines of Wall Street that create these in the 1960s and 70s and into the early 80s, small cap stocks dominated, you know, far outperformed large and guess what? Mutual funds came out with lots of small cap funds to try to take advantage of it. And then growth stocks outperformed in the 90s, and then you got all that. And so investors really need to be careful and not get caught up in these fashions. And the follies and fear are missing out. Have a well thought out plan that's based on empirical evidence, long term results, and avoid the concern about, hey, my neighbor made all this money. I gotta make sure I don't miss out on what he's doing.

Andrew Stotz 05:20
This chapter was particularly interesting because it kind of shadowed my life in some ways, because in the final second, second to last page of this chapter, you said, A perfect example is the asset class of emerging markets, when the asset class was providing great returns in the period of 1987 through 1993 and then you highlight 35% per year. There was a tremendous proliferation of emerging market funds. Now, before I go on to your main point, the after that, the point, from my perspective, was that I became an analyst in an emerging market in September of 1993 the first four months of my job, the stock market doubled. And by January of 1994 the Thai stock market had hit its peak. And we still haven't reached that peak

Speaker 1 06:15
yet. And 32 years later, now it's

Andrew Stotz 06:19
incredible, yeah. I mean, how, how long? I mean, I'm pretty much convinced that that's just generational. You know, you just got a huge generation. A generation gets wiped out, and then it takes so long they never get back in the market. At least, I think that's happened

Larry Swedroe 06:31
in Japan, of course, right? 35 years now of no real return. Well, it

Andrew Stotz 06:36
happened in the US too, after the Great Depression that it took many decades to get the US market back up. So that was just a little personal. The beginning of my career was right at the end of that bubble. Luckily, I was able to, you know, ride the wave down and survive. But yes, our stock market fell from 1994 it fell 90 90% roughly. And in US dollar terms, it fell about 95% so if you had put $100 in, you would have gotten $5 out if you if you bought at the peak and you sold at the bottom, which was about 2021

Larry Swedroe 07:13
I think it was Wow, and it's Oh. And I'm sure a big part of the crash was 98 when long term capital went under, took the emerging markets with them, yeah.

Andrew Stotz 07:23
So that was just more like that was Russia and other things that were happening at that time, all at the same time, yeah, yeah. But you know, the big question I had in my head when I was reading this chapter is, how do we reconcile the efficient market hypothesis with these kinds of madness. And I thought I wanted to ask you a question, which is, you know, normally, when we talk about the efficient market hypothesis, we talk about what it is, you know, in other words, it's semi strong form, or it's weak form, or it's strong form, or, you know, those technical terms. But I would like to ask you what, what is an efficient market? Not so, for instance, just be is efficient market? We know is assimilating information extremely quickly. But what is it that we should don't ascribe to an efficient market? For instance, if you say, well, there's bubbles, therefore the market can't be efficient. Can you tell us, like, what the efficient market does not mean?

Larry Swedroe 08:27
Yeah, so the first thing is there. It's called, for a very good reason, the efficient market hypothesis. It's a theory or hypothesis. It's not a law like we have in physics, and it's basically a model to help you think about how the world works. That's number one. Number two, what the efficient market hypothesis says. Really, it never says if the current price is the right price. It says the current price is the best estimate of the right price. Okay? And the way you test whether markets are then efficient is whether you have evidence that there are more investors who outperform than would be randomly expected to do so. So a good example, we've used this before. I think a few times. You put 1000 people in a stadium and ask them to flip coins, and they flip ahead, they win. If the tails, they are eliminated. At the end of 10 flips, maybe have 10 people left, Andrew, are you going to bet that they will be successful in the next coin flipping contest? Nope, nope, right? And because, in a world of investing today, 2011 farm and French published the. Paper, and they found that about 2% of active managers were outperforming, on a statistically significant basis, beyond the randomly expected, which was less than what you would have expected randomly Okay, SPIVA S and P publishes what they call the SPIVA, which is active versus passive scorecard. And again, this year in the US, they showed that if you're a quartile one performer in the first year, there's a 25% chance randomly you would expect to repeat that performance, and then there is a, say, a 6% chance you'd repeat that again, okay? And the answer is, then do more than 6% or whatever the right number is, repeat for three years in a row, and in every asset class, they found that less than that did so so you can't tell. It's hard to at least then there's no one has found a way to do it yet. How do you differentiate between skill and luck? And if you can't, then it's hard to say the market's not efficient because people can't exploit persistently mispricing. Now, why do anomalies exist? If the market is efficient, anomalies are for example, I've talked about this before, lottery stocks. So stocks that have a distribution of returns that is far from normal. Most of the time. Like lotteries, the return is zero. The mean return, if the state is taking 50 cents on the dollar, of course, is minus 50 cents. So if you buy $1 ticket a million times, you'd expect to end up with a half a million dollars. But of course, your distribution. If a million people are playing, you know, a few people will hit big home runs, and the most will lose 100% right or close to it. So it looks like a lottery ticket. Stocks that have that kind of distribution, which means they have God, awful returns. They actually this group, which I'll mention in a moment, have returns that underperform treasury bills which are totally riskless, right, at least for US investors. So they are stocks in bankruptcy, penny stocks, large cap growth stocks with high investment and low profitability. Well, a lot of.com stocks, for example, you know, fit that definition, but people get enamored by the fashion of the day, or some, you know, Reddit post that tells them you should buy GameStop or whatever. And so these prices get overvalued. But the problem is the risk and the cost of shorting are so great that it's the sophisticated investors can't risk betting against it to drive the price down, to drive the price down, you have to go short. So Melvin capital, a highly successful hedge fund for decades, noticed that Gamestop had been rising, rising, and this company had horrible financials, and it shorted it. And the way you short it, you borrow the stock, sell it. Say the stock was 35 and they thought it was worth 10, okay? And now you hope to buy it back at 10, and then there's your profit. The problem was people on Reddit ganged up on them and able to do it, and drove the price up, I think, to like 400 and Melvin capital lost four or 5 billion, and basically lost all of its assets and returned the capital shut down after decades of strong performance and and ever since that incident where the markets learned that these retail investors had figured out how to game the system, and I'll touch on that for A moment, very few people are willing to go short stocks, which means I think you'll have more in, you know, inefficient pricing on these smaller stocks. It's hard to do that on Microsoft, because you can't squeeze an investor in those stocks. The market cap is too large. But in these small companies, these people in gang up. And the way they did it is they figured out you didn't have to buy the stock itself. What you did was to buy an option, probably even an out of the money option. So if Gamestop is trading at 35 you could buy a call, say. 40 or even 45 and the more out of the money, the less you have to pay. So you don't have to put up a lot of money. The people who write there and sell you that option have to hedge that risk. So will they go in and let's say they sold the option on 1000 shares, they may go out and buy 50 shares, and if the stock starts to rise towards the exercise price, they are doing what's called delta hedging, increasing their exposure so or at their holdings, so they can't get killed. And so these people come in and start buying calls, and they tell everybody else to buy calls, and then the hedgers have to go in and buy the stock, and it's dropped, and there's little liquidity. And that's how Melvin capital got squeezed. And they figured out they can gang up. They look for low capitalization stocks with large short positions by some institutional investor, and they can gang up. Institutions can't do that. It's illegal. Individuals can and you know, so that game, sadly, has been played, and they're all cheering, but it's made the markets more inefficient, and it will lead to people losing fortunes, likely because they'll engage in this stuff. And eventually, Melvin capital went from 400 think last time I looked, it was trading at 35 again. So how

Andrew Stotz 16:31
would you describe let's say, take the.com bubble, where we were at the peak of the bubble, and market optimism was super high. Number one, we could easily say that, you know, information was getting into the market very, very quickly. That's, you know, part of the efficiency. You could also say it was the best estimate, you know, of the price based upon the feeling of the time or the expectations of the time. Could you say that? And then I wouldn't say that and say that, in the end, was the price wrong?

Larry Swedroe 17:04
Yeah, I think Gene farmer has argued you can't tell a bubble till after the fact. And in general, I would agree with that. However, to me, there that particular bubble, which burst in March of 2000 was easy to tell and known before. The only problem is you can't bet against it, because bubbles could get bigger and bigger, and you don't have enough capital to last until it burst. And the reason I can say it was irrational Was this the best predictor we have of long term stock returns is valuations, and a good one is the cape 10, or the sickly adjusted price earner. And almost as good ratio as the current P E ratio, okay, not quite as good the P E ratio of the Q, Q, which was the high flying tech stocks, the NASDAQ, you know, 100 was over 100 that meant the expected real return was 1% when tips were yielding 4% no credit risk, no inflation risk, to me, that could be resolved one of two ways. Tip yields, how to collapse, or P E ratios, how to collapse, because there is no way that these 100 companies could ever justify their earnings and get them to grow so fast to justify 100 P E, they would have been more than 100% of the whole economy. It was someone did some math and showed you can't make the earnings. Maybe one company could, and Google, maybe, you know, became that one company and the other 99 you know, like Intel and Cisco, you know, they still, in some cases, haven't passed their high price of that period and have been horrible investments. So I think again, it comes back to you can have bubbles because of what is called these limits to arbitrage. And the key to investors is don't get caught up with these fashions and folly and just have a broadly diversified portfolio that you can stick with, you know, and ignore the noise of the market, and don't care what your friends are doing. So

Andrew Stotz 19:31
I want to go back to my question about, you know, what efficient market isn't? Let's say someone doesn't know anything about the market, and they hear people saying, Oh, the market's efficient. Blah, blah, and then they look at that, and they see it go up to this huge bubble, and then they see it collapse. And they say, I don't understand how that's efficient, but I want you to answer what is. What is not? What are we not saying efficiency is?

Larry Swedroe 19:52
Yeah, one was saying it's not impossible to outperform by spotting bubbles or finding. Individual stocks and trying to time the market. However the overwhelming body of evidence is that playing that game, we can call it, active management, is gives you about the same odds of winning as playing at the casinos in Las Vegas. You can win, but the odds of doing so are so low. And if the vast majority of institutional investors, who are run by people with PhDs in physics and you know, mathematics and finance and their rocket science, the best databases, and you know, they are spending 100% of their time on this stuff. What odds if you look yourself in the mirror and say that I can outsmart these guys when they fail most of the time to outperform? And Warren Buffett, the greatest investor maybe of all time, hasn't outperformed for the last almost 20 years. The market efficiency caught up with you know, with Buffett, he was able to exploit inefficiencies over time, and as my book The Incredible Shrinking Alpha showed, Buffett was able to exploit things that people didn't know, and once those papers get published, those anomalies disappear, and Buffett couldn't outperform anymore.

Andrew Stotz 21:28
Yeah, it doesn't mean he didn't end up with a huge amount of money, but Right? And in fact, you know, out performance in your early years is extremely valuable, because generating the capital that's compounding at, let's say, a market rate for the past 20 years, exactly. So, okay, well, interesting discussion. And I know I for a lot of people out there, you know, we think about the efficient market hypothesis, and we think about what it means, what it is, and what it isn't. I think what we can clearly say is that when there is a narrow, real focus of the efficient market hypothesis, and that is the dissemination of information into the market, and also the efficiency of the market is proven by the fact that very tiny number of people, even less than would be predicted through simple statistics, managed to outperform.

Larry Swedroe 22:26
Well, let's add to this one other thing. If you doubt the markets are efficient, all you have to do is look what happens when a company announces an earnings surprise just the other day, maybe it was today, even aber Combi and Fitch announced better than expected earnings. Now the price didn't go up, like, from, say, 30 to 30 and an eighth to 30 and a quarter. It went from 30 to 40 like instantly on like the first two trade in one of my books, I cited a study that the vast majority of the performance after news is on the first trade that tells you how quickly the market incorporates new information.

Andrew Stotz 23:14
Yeah. And the funny thing is, that may not be a very profitable trade. Their next quarter could be terrible.

Larry Swedroe 23:20
Well, in the long term, that's so the market incorporates this new information. It moves when you get surprises, which by definition, is what unpredictable? Yep. Well, Larry,

Andrew Stotz 23:34
I want to thank you again for this great discussion, and I'm looking forward to the next chapter, which is chapter 37 Sell in May. Wait a minute, it's May, and go away a great old saying in the market. And for listeners out there who want to keep up with all that Larry's doing, find him on X or Twitter at Larry swedroe, you can find him on LinkedIn and also follow him on sub stack. He's relentless. They just keep coming into my email box. It's hard to keep up with all that you're writing. You got two of them today. Incredible. You know that's, that's, this is wonderful. I've enjoyed it. So this is your worst podcast host, Andrew Stotz saying, I'll see you on the upside. You.