Wisdom of Crowds or Groupthink: Analyzing the financial system collapse (Part II of II)

Continued from Part I.

If the crowds of investors were not all that wise during the recent market cycle what is another possible explanation for the behavior driving the markets?

Herd Mentality is used to describe how people and businesses are influenced by those around them when making decisions. People may act in conjunction with the herd simply because they are influenced by those around them, there is comfort in sticking to the status quo or they are afraid on missing out on what everyone else is experiencing.

Alan Greenspan, the former Chairman of the Federal Reserve, in a Financial Executive article summarized banks willingness to follow the herd in the following way;

“One difficult problem is that much of the dubious financial market behavior that chronically emerges during the expansion phase is the result not of ignorance but of the concern that unless firms participate in a current euphoria, they will irretrievably lose market share.”[1]

Another executive put it more succinctly saying, “No one ever made money by sitting out a boom.” [2]

In his January 2008 article Michael Carroll suggests the financial sector was caught in a “Thundering Herd Mentality.”[3] In a rush to keep up with competitors, institutions were anxious to follow their competition into the subprime lending and structure credit markets. While this strategy worked in the short-term, creating record profits, it has since backfired colossally. The bubble in the house prices could not be maintained forever and when these prices collapsed banks’ fortunes did as well.

How were these ultimately disastrous decisions allowed to be made? Bowditch and Buono suggest groupthink fosters three illusions that lead to poor decision making. The most relevant to the current situation is the illusion of invulnerability. This “leads to over-optimism and encourages high risk taking by group members.[4]

I think this illusion of invulnerability coupled with a rush to keep pace with competitors is largely to blame for the current situation of banks and the market in general. The short-term success and profit turned out by some in the industry lead the other financial institutions to throw themselves headlong into subprime lending and structure credit markets so as to not miss out on what was viewed as a once in a generation profit opportunity.

So if there is evidence of groupthink in the market and our financial intuitions and they are not completely efficient long-term as wisdom of crowds would suggest what can be done. What can be done to protect a portfolio from massive market downturns?

John Maynard Keynes, the 20^th century British economist whose economic theory revolved around demand-side actions as a framework to conduct economic policy, famously said “The market can stay irrational longer than you can stay solvent.” Contrarian views may eventually prove correct but may be a long timing in coming. An example of this would be M. King Hubbert, a geophysics, who in 1956 predicted that U.S. oil production would peak in 1970.[5] He was ridiculed at the time of the prediction but this and his other predictions about worldwide oil production have proved to be accurate.

Gary Shilling, the Stanford Ph.D. in economics who invests $100 million dollars for clients, predicted a collapse in housing prices in 2004.[6] He was a little early but the prediction proved true. Predicting timing is nearly impossible but I believe the long term trends can be spotted.  Research shows that even missing the 10 best days of the market has a dramatic effect on investment returns. Over a ten year period if you missed the 10 worst days in the S&P your return would swing from a 4.23% annual gain to a 4.7% loss (8.9% total difference). See chart 3. This is missing 10 days out of 2,515 or .4% of all days.[7] It would be nearly impossible to correctly predict when these 10 days would occur. Another study showed that from 1900 – 2008 only missing the 10 best days, 2/3 of the cumulative gains in the Dow would be erased.[8] Ten days out of 29,694 had that big of an affect on returns!

This goes to show the difficulty of picking any one of the best days in the market but I don’t think it rules out the possibility of predicting long term periods when the market is over valued or under valued.

I think that while the market may behave efficiently in the short term there are long term trends that can be spotted. Using Shiller’s P/E_10, the Monthly Housing Affordability Index[9] and other macro indicators I believe it is possible to spot times when long term investments have either favorable or unfavorable tailwinds. A portfolio can then be adjusted as more aggressive or defensive based on these views. The key is independent thinking based on data and not getting caught up with the herd.

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[1] Marshall, Jeffrey. “Lessons from the Abyss.” Financial Executive; May 2008, Vol. 24 Issue 4, 36-43.

[2] Marshall, Jeffrey. “Lessons from the Abyss.” Financial Executive; May 2008, Vol. 24 Issue 4, 36-43.

[3] Carroll, Michael. “Thundering Herd Mentality.” Institutional Investor; Jan 2008, Vol. 42 Issue 1, p5-5.

[4] Bowditch, James L. and Anthony F. Buono. A Primer on Organizational Behavior. New York: John Wiley & Sons,  c2005

[5] K. Deffeyes. “Hubbert’s Peak in the 21st Century.” Princeton University. Accesses 17 Mar. 2009. http://www.princeton.edu/hubbert/the-peak.html

[6] Light, Larry. “With Deflation Possibly Near, This Economist Is All Abuzz.” The Wall Street Journal. 13 Mar. 2009.

[7] “The Perils of Market Timing.” American Funds. http://www.edgarfinancialgroup.com/files/13337/AF%20perils%20of%20market%20timing.pdf

[8] Zweig, Jason. “Why Market Forecasts Keep Missing the Mark.” The Wall Street Journal. 24 Jan. 2009.

[9] “Affordable Housing Real Estate Resource: Housing Affordability Index.” The National Association of Realtors. http://www.realtor.org/research/research/housinginx

Wisdom of Crowds or Groupthink: Analyzing the financial system collapse (Part I of II)

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.[1] 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?”[2] 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.

Chart 1

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.”[3] 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.[4]

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.[5]

Chart 2

Source: www.hussmanfunds.com

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.

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[1] Surowiecki, James. The Wisdom of Crowds. New York. Double Day, 2005.

[2] 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

[3] Malkiel, Burton Gordon. A Random Walk Down Wall Street. New York : Norton, c1981

[4] Damodaran, Aswath. Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. New York: John Wiley & Sons,  c2002

[5] Shiller, Robert. “Online Data.” Yale University. Accessed 03/11/2008. http://www.econ.yale.edu/~shiller/data.htm