Sunday, December 20, 2009

A Giant Ponzi Scheme

In business school, we learn that the price of equity in the market represents a measure of the long-term value that is available to the buyer of the equity, through the underlying companies' earnings. While investing and losing money in this same market, we gradually understand that that is not necessarily the case; often, in shallow markets such as India, it is quite possibly the exception. We realize that investors are not long-term buyers, and that they are usually more interested in making gains from capital appreciation (i.e. a rise in equity price) than from dividend payouts. In other words, the value no longer comes from a future growth in earnings, but rather, what price future investors can be coaxed into paying.

And this is where the similarities arise vis-à-vis Ponzi schemes. What such schemers do is that they publicize their fund, and collect cash from duped investors. The returns that these investors earn are primarily generated from the cash collected from subsequent investors. Publishing these great returns often leads to greater hoards of investors rushing to put their monies into the fund till, ultimately, a few investors are left holding the bill, as it were. By this time, the schemer has usually set sail on the high seas, with his ill-begotten earnings. I do not need to draw out the lines of correspondence; those of us who've participated in the equity markets over the past couple of years know them only too well.

Just like all Ponzi schemes always progress towards the same degenerative conclusion, the markets also go through periodic corrective cycles, such as the one we've just witnessed. While one would feel that the many market crises and sudden upswings and downswings would have sounded the death knell for the numerous efficient market hypotheses (the price is always right), one also realizes that people are not always ready to renounce whatever captures their imagination. Unfortunately for them, just like the amount of calamity insurance sold doesn't increase or decrease the probability of their occurrence, the market will remain irrational with scant acknowledgment of believers and atheists.

A number of studies have discussed this apparent disjoint between theory and empirical evidence. When Robert Shiller conducted a survey of investors who witnessed the 1987 market crash in the US, a large proportion of them said that their actions on that Black Monday were triggered by newspaper articles they'd read about price drops the previous week. Mind you, very few of them even mentioned a change in fundamentals as the problem, which is what proponents of the efficient market theory would suggest. Of course, people have pointed at many problems in hindsight, but one shouldn't always give credence to such artificial causality (retrospective bias is another interesting problem that warrants a discussion, but maybe at another time).

So where do efficient market hypotheses go wrong? In my opinion, in today's day and age, their assumption of a billion independent investors is the main stumbling block. With the incredibly ease of information transmission that one witnesses today, it becomes that much simpler for rumors / incorrect information to spread. It also becomes easier to capture market sentiment, which individual investors usually rush to emulate. So, investors are not necessarily independent; rather, they are inter-dependent. Such an increase in correlation between individual investors' sentiments and trades means that one can no longer assume that no single investor affects price abnormally.

The pervasive nature of market sentiment is what led to rises in equity prices with only cursory correspondence to underlying fundamentals. And all the investors who failed to exit while ahead were left with shares that had suddenly lost a non-negligible proportion of their value.

The market, every now and again, gives up its stubborn affection for unreal prices without warning. Unfortunately, not every rational one-step-ahead-of-the-rest investor can wait out this period, to obtain the profits that are surely his to be had – while guts may or may not be lacking, liquidity is limited. As I once heard a seasoned trader say (and no doubt he'd heard this somewhere else), "The markets can remain insane longer than you can remain solvent."

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