We live in the Information Age and the signal to noise ratio is abnormally low. There is far too much noise, and for the most part there is no signal. Moreover, the reporting about the daily happenings in the Stock Market has acquired a cult status. We are in an environment, where anyone and everyone opines about the future direction that the market is likely to take. So, we have an army of experts, and at the end of the day, no one is any wiser.
Among the many human biases that we all have, one of them is that we tend to believe what we read. And if someone prognosticates doom and gloom it is considered to be intellectually stimulating and draws a lot of attention. Hence, not only are calls for a crash in the indices rampant, most investors seem to take them pretty seriously as well.
One of the most popular words that is used is the word ‘bubble’ or the B-word, as I like to call it! So, the stock market is in ‘bubble’ territory and we are in one of the biggest ‘bubbles’ of all time. Needless to say, the conclusion that follows is that the bubble will burst and doom and gloom will follow. Given the demographics, I thought it might be a nice idea to unpack what all of the ‘bubble talk’ actually means for the layman investor.
- What is a stock market bubble? The prices of stocks that we see on the screen are an indication of the value of the underlying business. When these values get inflated to a point where they are totally unhinged from the underlying business, pundits refer to the phenomenon as a Bubble.
- What exactly happens when the stock market is in a bubble? When we invest in a house or in gold, we tend to think long-term. When we invest in the stock market, most of us think short-term. In the stock market, everyone wants to buy low and sell high, and they want to do both the buying and selling as rapidly as they can. The more the churn, the richer we get, is the prevailing ethos.
- So, when stock prices move up continuously (as they have been doing for the last 11 months), it attracts a lot of so called investors nay speculators. Most of the time, participants start with good intentions, but they are eventually drawn in by the noise and unknowingly start speculating, instead of investing. Lord Maynard Keynes, the great economist of yesteryears, put it succinctly when he said: A speculator is one who runs risks of which he is aware, and an investor is one who runs risks of which he is unaware. It is safe to say that most of the so-called investors in todays environment, run risks of which they aren’t aware. Why is that?
- I’ll quote Peter Bernstein who wrote the seminal book titled: Against the Gods, the Remarkable Story of Risk: Markets are shaped by what I call “memory banks.” Experience shapes memory; memory shapes our view of the future. In 1958, younger people were coming in who had a different memory bank, who did not carry all that extra baggage of depression and world war and tariffs. The bond market went down and the stock market didn’t go down, because people with a different memory bank didn’t know that wasn’t “supposed” to occur. That’s also what happened [in 1999] when tech stocks were enormously exciting; most of the new participants in the market had no memory of what a bear market is like, and so their sense of risk was muted.
- The above Bernstein quote is very true as on date. Most of the current breed of participants don’t have any Muscle Memory. They mistakenly think that markets are supposed to go up on every single day, that interest rates can never go up, inflation is dead and a host of such market related characteristics that they have never seen or experienced. Reality is nuanced, an element of surprise and the attendant volatility are immutable features of the stock market. Stocks don’t go up every day like they have done for most of 2020, that is not normal and most of the newbies think that this is the new normal. So, a 10 or even 20 percent correction in the benchmark indices is pretty normal. In fact, I would even consider it to be healthy.
There is one very peculiar thing about stock market bubbles. The asset management community (those who run the Mutual Fund Schemes that almost all investors invest in) will never tell you their frank opinions about elevated valuations. And if you’re waiting for your friendly neighbourhood investment advisor to warn you about a bubble or to stay away from the market, it won’t happen. Why is that? Why are these guys permanently bullish? Jeremy Grantham who is a renowned and very highly respected investor, has written a piece titled Waiting for the Last Dance and in his words:
So, don't wait for the Goldmans and Morgan Stanleys to become bearish: it can never happen. For them it is a horribly non-commercial bet. Perhaps it is for anyone. Profitable and risk-reducing for the clients, yes, but commercially impractical for advisors. Their best policy is clear and simple: always be extremely bullish. It is good for business and intellectually undemanding. It is appealing to most investors who much prefer optimism to realistic appraisal, as witnessed so vividly with COVID. And when it all ends, you will as a persistent bull have overwhelming company. This is why you have always had bullish advice in a bubble and always will.
The point is that the game that asset managers are playing is materially different from the one that we are playing. They are playing the game of asset accumulation and fee gathering. We, as investors are not playing that game and we shouldn’t be taking advice from them. Since we need to be playing a different game than the one that is being played by these asset managers, I’ll close with this bit of wisdom from Kwame Anthony Appiah: “In life the challenge is not so much to figure out how best to play the game; the challenge is to figure out what game you’re playing.”
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