In light of the recent collapse in worldwide financial markets this post will attempt to analyze two somewhat contradictory theories of behavior and how they relate to investors and markets in general. The two theories are wisdom of the crowds, individuals arriving at a decision independently where the average group decision is best, and groupthink, where groups tend piggyback on the ideas of others. At the time of writing this paper the S&P 500 is trading at the same levels as early 1997, fully erasing over 12 years of gains in many investor’s portfolios. What do these two ideas tell us about market behavior and what can we learn from this going forward?
“Wisdom of Crowds” is a 2005 booked authored by James Surowiecki. In this book the author puts forward the idea that under certain circumstances groups of people as a whole reach better and more accurate decisions than any one member of the group, no matter what their level of expertise. The certain circumstances or criteria where Surowiecki posits groups reach superior decisions are: when the group is diverse, the decision made independently and the group is decentralized. The wisdom of crowds can be applied to three types of problem; cognitive, coordination and cooperation. Coordination problems specifically relate to market behavior, essentially this is buyers and selling finding each other and agreeing on a price.
Wisdom of Crowds would suggest that since groups, such as equity investors in aggregate, are capable of making better decisions than any one expert, or group of experts, that the market is efficient. The market is after all a collection of millions of investors’ view of the value of all the individual companies that make up the total market. Looking at the market on a day to day basis it appears incredibility efficient in bringing buyers and sellers together and coming to a market clearing price. However, when looking long term it does not appear the market was so wise. There were several experts; Peter Schiff, Nouriel Roubini (a.k.a. Dr. Doom) and John Paulson, who predicted the collapse of the housing market and subsequently the equity market.
According to the chart below, investors expectations about the market and actual returns are actually negatively correlated. Data is taken from a Gallup poll asking people, “is it a good idea to invest in the market right now?” Percent responding “yes” is on the x-axis with corresponding 2 yr return on S&P 500 on the y-axis. The two year returns of the S&P 500 when investor confidence was less than 50% is positive 81% of the time compared to only 36% of the time when investor confidence was over 50%. It is clear that the consensus of those polled had the wrong idea on how the market would perform in the future.
Source: Gallup.com and S&P 500.
Another theory that fits with the Wisdom of Crowds idea is the Random Walk. The theory was born in 1973 after it was put forth by Burton G. Malkiel in his book “A Random Walk Down Wall Street.” It says that securities are priced at random and not based on past events. Future events cannot be predicted therefore random stock selection should fare as well as the best trained security analyst would fare with his or her own selection. This idea, that all known information about a security is reflected in the price of the stock is also referred to as the weak form efficient market hypothesis.
Again, this theory seems to hold up under a short-term time horizon but when looking at a longer period of time seems to fail. This idea that security prices are not based on past events or norms does not seem valid. The following histogram (See chart 1) shows P/E ratios from 1950 through today. The smoothed P/E (calculated by Robert Shiller at Yale University) is based on 10 year smoothed earnings and not the typical trailing twelve months or last calendar year earnings. The blue bar in the chart represents the average P/E10 for the period. As seen in the chart, the majority of P/E10 ratios fall below 29 with the average about 19. At the peak of the most recent market cycle the P/E10 was near 28.
To me it seems clear that there are definitely market cycle that drive prices and upper bounds on how far prices will move up in relation to the underlying value of the asset. Reasonable deductions about favorable versus less favorable times to enter the market should be made.
Continued in Part II.
Surowiecki, James. The Wisdom of Crowds.
New York. Double Day, 2005.
 Carroll, Joseph. “Americans’ Optimism about Stock Market Highest Since 2000.” Gallup. Accessed 03/11/2008. http://www.gallup.com/poll/24979/Americans-Optimism-About-Stock-Market-Highest-Since-2000.aspx
 Malkiel, Burton Gordon. A Random Walk Down Wall Street. New York : Norton, c1981
 Damodaran, Aswath. Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. New York: John Wiley & Sons, c2002
 Shiller, Robert. “Online Data.” Yale University. Accessed 03/11/2008. http://www.econ.yale.edu/~shiller/data.htm