Buy-and-Holders believe that stock investors pursue their self-interest in a rational manner. That’s why we don’t have to worry about timing the market in response to huge swings in valuations. If prices ever really got out of control, rational investors would jump in to exploit the mispricing. The market takes care of things. Prices never get so out of whack that it makes sense to engage in market timing.
Q1 2020 hedge fund letters, conferences and more
I of course do not agree. I believe that investors are certainly capable of rationality and in many circumstances make good use of it. But I also believe that investors are humans. That means that they are highly emotional creatures. There are circumstances in which they throw their rationality to the wind and do outright crazy stuff. Prior to the onset of the coronavirus crash, the CAPE value was near 30. Yikes!
Extreme Irrationality In The Beachfront Property Market
John Tamny recently wrote an article for Real Clear Markets making the case that extreme levels of irrationality have evidenced themselves in the market for beachfront property. He notes that a property that Michael Ovitz purchased in the late 1990s for $5.5 million sold in 1019 for something in the neighborhood of $120 million. This despite the fact that a study from the European Union’s Joint Research Center warned that climate change could bring on “the near-extinction of almost half of the world’s sandy beaches by the end of the Century.”
Climate change was not as nearly as widespread a concern when the Ovitz property sold for $5.5 million. Now it is a major concern and the price has increased more than 20-fold. Does that make sense?
It does not make sense. Leave aside the question of whether the risks of climate change are over-hyped. That shouldn’t matter too much when it comes to the pricing of assets. If climate change is perceived as real (and it is certainly perceived to be more of a problem that it was perceived to be over 20 years ago), that perception should cause the prices of assets affected by climate change to fall. Yet that clearly has not happened in the case of beachfront property. Could it be that investors are not as rational as the Buy-and-Holders make them out to be?
Investors are human. That means that, yes, they are capable of rationality. But they are also entirely capable of compartmentalizing their rationality. They make full use of it in some circumstances. And they forget where they put it in others. Investors are circumstantially rational and also circumstantially irrational. As a broad approximation, the market is kinda, sorta efficient. But invest your money as if the market were efficient and you will not be able to retire until many years after your Shiller-reading friend will have been able to pull off the trick.
A Roller Coaster Ride In The Stock Market
Stock prices have been on a roller coaster ride since the coronavirus crash began a number of weeks back. One day we see one of the biggest price drops in history and on the next we see one of the biggest price recoveries in history. Sometimes we are treated to thrilling ups and death-defying downs in the same session. Are we truly expected to place our confidence in the economists who tell us that this is all the product of sober rationality?
The case that they make is that the reason why huge gains turned to huge losses in a matter of hours is that those wily investors came across some new piece of information that offered insight into how bad the crisis was going to get and how long it was going to be causing economic destruction. It certainly is so that news developments that in theory could affect stock prices are reported on an hourly basis. So, when the analysts explain why investors turned suddenly in favor of or against stocks, those explanations sound plausible.
But only if you accept the premise that investors are rational beings!
Bad Economy Developments
Once you give up that belief, many of the choices that investors make no longer make sense. It is true that there have been both positive and negative news developments in recent weeks. But shouldn’t truly rational investors have figured out by now that that is the way it always goes in a situation like this? If investors had been expecting good and bad economy developments to be following each other in quick succession, wouldn’t the thing to do have been to not be terribly impressed by either type of development, to lower the price of stocks a the the onset of the crisis but then to let prices fall into a more smooth line except for when truly remarkable developments took place?
If a major beachfront property were destroyed, tomorrow, prices for all beachfront properties would crater. And the Buy-and-Holders would say that that’s perfectly rational, that the market was once again demonstrating its efficiency. Few would ask -- Why did the market not take into consideration the studies showing that this was going to happen sooner or later and anticipate the development? The answer is -- that’s not the way the often irrational and inefficient humans do it. We go into denial about things we do not want to consider until there’s no denying them any longer and then we overreact.
And we overprice stocks wildly for a time and then we underprice them wildly for a time. We do it over and over and over again. And we write books assuring ourselves that we don’t do it so that we can continue pretending that we are more rational creatures than a mountain of evidence standing before us shows us to be.
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