Market madness has never been hard to diagnose. It’s almost two centuries since Charles Mackay published Extraordinary Popular Delusions and the Madness of Crowds. Benjamin Graham pioneered value investing in the 1930s by inviting everyone to think of “Mr. Market” as a manic-depressive who makes mistakes that can be exploited. And the Israeli psychologists Daniel Kahneman and Amos Tversky documented in seminal work in the 1960s and ’70s the behavioral biases or mental shortcuts — known as heuristics — that are hot-wired into the human mind and distort markets. For example, we are all driven by loss aversion and will take greater risks to avoid a loss than to make a profit of the same size.
Market prices are set by humans, who are fallible, so none of this should be surprising. There’s also voluminous research to show that in the very long term, our human foibles tend to cancel out and stock markets do expand in line with corporate profits and the growth in the economy. The language to describe these issues has been around for a long time. In a line generally attributed to Graham, as often cited by his disciple Warren Buffett, “In the short term the market is a voting machine; in the long term it’s a weighing machine.” Money can be made by exploiting others’ mistakes, but over time you should just strap in and follow the companies that perform the best.
See more: Market Valuation: Expensive CAPE Or Cheap PEG?
And John Maynard Keynes (allegedly) provided an aphorism, also as long ago as the 1930s, to explain why profiting from others’ irrationality, while tempting, is dangerous: “Markets can stay irrational longer than you can stay solvent.”
All of this literature has co-existed with the growth of a massive industry devoted to ignoring it. The efficient markets hypothesis, which holds that share prices will at all times incorporate all known information, and move in a “random walk”from news story to news story, is written into the assumptions that guide most investment models. There’s acceptance that human imperfection guarantees that this walk will not be truly random, but an edifice of algorithms, arbitrage models and indexes now exists to identify those errors, profit from them, and in the process help ensure that the market returns to its true path as a weigher of fundamentals, not a voting exercise.
So it doesn’t at first seem that there’s any great need for a new book called The Madness of Markets. But it turns out that Alex Edmans, the London Business School professor who has just published a book with that title, has indeed found fertile territory. Over the last few decades, ever increasing computer firepower has allowed academics to find and categorize ever more anomalies; Edmans’ book is a dazzling summation of all that evidence. It adds up to a stunning indictment of human weaknesses, with numbers attached. And he’s presented it as a how-to manual for investors to try to make money from others’ mistakes (even if Keynes’ warning will always be relevant).
The Madness
The Madness of Markets marshals the literature to produce a litany of human weaknesses. The cumulative effect is to make you wonder if anyone has any brain cells at all, and should even be allowed to try buying and selling stocks.
Edmans has contributed much to the literature himself, notably by proving that international soccer has a predictable and asymmetric effect on global markets. In the biggest soccer-playing countries, the period of a World Cup tends to be marked by poor returns as attention is diverted to the football pitch. This reflects in negativity only; dispiriting exits are followed by abnormally bad days on the market, but there is no countervailing irrational rally on days when the home country actually wins the tournament. Meanwhile, the degree of cloud cover over a financial center will limit returns; gray days are bad for animal spirits and gains are consistently lower, and this can be documented and quantified. Both of these studies, concerning variables that should surely not have any impact on companies’ fundamental value, work as rare “clean” tests that markets can be moved by pure shifts in the mood, divorced from financial and economic effects.
If the list of stupid investor behavior is long and dispiriting, the roll call of bad CEO behaviors, the ways they give themselves away, and how to profit from them, is nothing short of breathtaking. Reasons to bet against a company include:
- Its annual general meetings are held a long way from home, and particularly if it’s at a distance from any first-tier airport (one US company went so far as to hold its AGM in Lahore, Pakistan — it wasn’t a buy).
- The language changes in its statement of risks (any change at all will indicate that something worrying is afoot).
- Questions are taken only from analysts with a Strong Buy rating (excluding such companies can make you 19% in extra returns per year; it’s common across a range of international markets, and the bottom line is that who a CEO chooses to hear from matters more than what they say).
- The CEO speaks in an anxious tone (which can now be measured by computers using something called Layered Voice Analysis).
- Letters to shareholders are full of cause-and-effect language (like “because,” “therefore,” or “as a result”), as this shows that they’re on the defensive and have something they need to explain away.
- Corporate jet fleets; they demonstrate that the board is permissive of excess, and companies that allow corporate jets underperform those that make their execs fly commercial by 4% per year.
- Making stock-financed friendly mergers — these are generally an admission that their shares are overpriced, and shorting them while going long on companies that make cash tender offers gains 17% per year.
And so on, and so on. There are 300 pages of this, they’re very entertaining. They’re also an indictment of how capitalists somehow allow these things to take place in plain sight — even if the market does pass judgment in the end.
ESG
Edmans is also known as one of the first academics to demonstrate the possibilities of ESG (Environmental, Social and Governance) investing, and his material on this subject is fascinating. It’s somewhat of an indictment of the current polarized world where people on all sides of the argument can only view issues through a political or cultural lens, and miss the opportunities to make money staring them in the face.
His paper, published more than a decade ago, showed that the stock market persistently underpriced corporate intangibles, based on the performance of companies in Fortune’s annual list of the 100 Best Companies to Work For. Generally, companies that keep their employees happy will retain them for longer, avoiding costly churn, and motivate them to work harder. This is not necessarily that surprising, but the size of the effect was impressive. From 1984 to 2011, such companies outperformed the rest by an annual 2.3% to 3.8% per year — a massive effect when compounded for so long. Subsequent research shows that the effect has continued.
There are many other examples. Companies with good governance that are responsive to shareholders, and popular with employees and customers, are generally doing something right. That can be expected to show up in the share price eventually. Identifying and buying them is wholly in line with the traditional tenets of capitalism — you’re looking for a way to make money that others might not have spotted.
The problem with ESG, for Edmans, is that it combines several factors. Environmental investing — aiming for companies with low carbon emissions — may be good policy for the future of the planet. It cannot be shown to generate returns. As the whole concept has been subsumed in the culture wars and fallen under ferocious political attack, so plenty of good ideas have been unnecessarily abandoned in the process. Edmans explains:
Without government moves to impose a cost on companies for their emissions, he argues, there’s no reason to assume that environmental investing will generate returns — and the many ESG investors have not shifted corporate behavior. Unfortunately, it rests on politicians, not on capitalists aiming to do well by doing good, to deal with pollution. Still, the political madness of the moment means that the many intangibles that the ESG movement has discovered can deliver enduring returns are going ignored.
A degree of madness and irrationality in investing appears to be a human constant. So is political division, although that’s currently been taken to extremes. For now, the mania to find the most profitable investments has collided with over-hyped claims and backlash around attempts to identify good companies. That creates opportunities for those who can keep their heads.
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