By Tim Courtney, Chief Investment Officer
When people get together as a crowd, it can be a good or bad thing. One crowd could be a group of people working toward a common productive goal, like a company. Another crowd could turn into an unruly mob that causes chaos. In markets, we can find examples of both types of crowds.
In the mid-1800s, Scottish journalist Charles Mackay published a book on the behavior of crowds and their effect on financial markets throughout history. The book popularized the expression “madness of crowds”. Unfortunately for markets, the madness of crowds is still a force that moves prices. The madness of crowds played out during the Japan stock market bubble of the late 1980s, the dot com craze of 2000, and the great financial crisis of 2008. Most recently, market prices soared in several stocks near bankruptcy, such as GameStop and AMC quadrupling in price in 2021.1 Many speculative assets and unprofitable companies generated eye-popping returns due, in part, to the fear of missing out and crowds speculating rather than investing.
However, rising interest rates and higher inflation are having an effect of washing out much of the speculation that had built up in markets over the last several years. Eventually, the madness of crowds that meaningfully moves prices (to both highs and lows) over shorter periods of time begins to give way to reality, and prices move back closer to their true worth.
While madness can drive markets for a time, there is wisdom in crowds too. Remember the game show Who Wants to be a Millionaire where a contestant can consult the audience for an answer they don’t know themselves? The audience was usually right, and even when the audience was divided, there was certainly someone in the crowd who knew the correct answer.
In 2021, there was, on average $775 billion worth of stock traded globally each day.2 Those are just stock trades. Across stocks, bonds, options, currencies, commodities, and other assets there is an unbelievable amount of information that works its way through markets and into prices. Well before the Federal Reserve began raising rates, the bond market had already priced the expected increases into markets³. It’s one of the reasons why it is nearly impossible to (legally) act on a single piece of information quickly enough – since other people almost certainly have that same piece of information.
That doesn’t mean markets are always right, but it does mean that it is difficult to know exactly when prices are wrong. Both the wisdom and madness of crowds are working through markets. Celebrated investor Benjamin Graham, who taught at Columbia and had many students such as Warren Buffet go on to become well-known investors themselves, coined a phrase to describe this tension in markets. He said in the short term the market is a voting machine, where the majority rules, right or wrong. In the long run, the market is a weighing machine, where the true value of assets is established – some prices confirmed, and others found wanting.
In the market today, there is a lot of information making its way into prices – from war, to rate hikes, inflation, elections, etc. As this happens, we want to own productive assets that produce the goods and services we all need. We want to own those assets at a reasonable price. And above all, we want to own assets that will stand the test of the weighing machine. If you have any questions about your portfolio assets, please contact your Exencial advisor.
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