Why We Keep Blowing Bubbles
ONE of the most mysterious market phenomena is momentum - the tendency for fast-rising stocks to keep going up. How come such an obvious market anomaly is not arbitraged away?
I have referred in previous columns to the work of Paul Woolley and Dimitri Vayanos of the London School of Economics on this issue, and they have a new piece in the latest issue of Central Banking Journal. Their idea is that the anomaly is the result of investors using agents (professional fund managers) to manage their money. They choose those managers on the basis of past performance. That past performance will inevitably result from good/lucky stock selection. So when they fire one poorly-performing fund manager and select an outperforming one, the inevitable result will be that cash will flow into the stocks owned by the outperforming managers (the previous winners) and out of the ones selected by the poor performers (the previous losers). The classic example was in the late 1990s when money was taken away from value managers and given to growth managers who were buying technology stocks.
This process helps to explain asset bubbles. Eventually, prices depart so far from fair value that a shock occurs and the process reverses - often quite quickly, as fund managers stampede out of once favoured stocks. The evidence suggests that momentum works over periods of up to two years but reversal effects predominate after that.
For me, the theory, while telling part of the story, misses the key factor of credit expansion which Charles Kindleberger outlines in his classic Manias, Panics and Crashes. There were no asset bubbles during the Bretton Woods era but there have been many in the period of rapid credit growth since.
In the second part of their essay, Woolley and Vayanos deal with another interesting theme - the expanded role of finance in the modern economy. They argue that
the scale of financial activity and the intensity of secondary trading indicate that financial markets are in a state of what might be described as expanding disequilibrium. The social costs of dysfunctional finance show up in various ways: the misallocation of resources across the economy, especially to finance itself, the periodic crises, the costs of bailouts and regulation and so on.
I am not sure about the "evidence" they cite for this phenomenon - namely that investment returns in the current century have been much lower than they were in the 1980s and 1990s. That is surely the result of starting valuations - investing in the early 1980s when initial yields were very high guaranteed good long-term returns, while investing in 2000 when yields were very low guaranteed bad returns.
But they are on the button with their analysis of how the finance sector prospers through this turmoil. They write that
Agents have learned that financial markets do not function like goods markets, and that the usual laws of competition do not apply under asymmetric information. Moral hazard, complexity and opacity all help them capture rents. They also benefit from mispricing, volatility and the proliferation of products. The costs and fees of intermediation go hand in hand with pricing inefficiencies in contributing to the erosion of the returns on savings.
To change all this, Woolley and Vayanos call on investors to adopt a manifesto including a focus on value investing, low tuirnover and the avoidance of structured products and high-charging alternative investment funds. I suspect that call may fall on deaf ears; with future returns on conventional investments likely to be low, and with pension funds struggling to meet their commitments, the lure of alternative investing is only likely to grow.