The Madness of Markets, with Alex Edmans

Many Happy Returns

In this episode of Many Happy Returns, Professor Alex Edmans discusses the inherent irrationality and 'madness' within financial markets. He

Key takeaways

• Alex Edmans' research demonstrates that companies with strong corporate culture and employee satisfaction can significantly outperform the market over long periods.
• The 'limits to arbitrage' are illustrated by Julian Robertson of Tiger Asset Management, who was liquidated for being right about the tech bubble too early.
• Market participants often mistake randomness for skill, a phenomenon described as being 'fooled by randomness.'
• CEO narcissism, evidenced by large signatures or personal use of corporate jets, can be linked to poor company performance and risky decision-making.
• The importance of investment horizon is emphasized; short-term traders may need to ride bubbles, while long-term investors can wait for corrections.

Main topics

• Market inefficiency and human emotion
• Overextrapolation and bubbles
• Corporate culture as an alpha driver

Notable quotes

Even though the people who trade stocks, they're sophisticated, they do this for a living, they are human and humans are affected by emotion.

Conclusion

Investors should focus on their specific objectives and investment hor

Transcript preview

Speaker 1 (0:00) Today's episode is brought to you by Lightyear, the investment platform I use for my stocks and shares ISA. Speaker 1 (0:09) Welcome to Many Happy Returns, where we aim to make you a better investor. Markets are meant to be efficient, yet somehow they keep producing meme stock frenzies, CEO vanity projects, and wild booms and busts. Alex Edmonds, Professor of Finance at London Business School and author of The Madness of Markets, joins us to explain why even the smartest investors lose their heads. Speaker 3 (0:35) We ask how to avoid their mistakes. and whether you can profit from them. All right, let's get into it. So we're here today to discuss the madness of markets. And who better to have on the show than Alex Edmonds. He's Professor of Finance at London Business School and has literally written the Speaker 2 (0:52) book on the madness of markets. Thanks so much for joining us, Alex. Well, thanks so much for the invitation. It's great to be here. Speaker 3 (0:58) So most people are told that markets are basically efficient, aren't they? They price in fundamentals and they're rational, they're dispassionate. Your book seems to say, well, that's not Speaker 2 (1:09) quite right. That's correct, because even though the people who trade stocks, they're sophisticated, they do this for a living, they are human and humans are affected by emotion. So one big emotional driver is overreaction. So you might see some bits of information that seem positive, but we over extrapolate and make much more of it than we should do. And we've seen this throughout history. So there was the tulip bubble many centuries ago, then the internet bubble, biotech bubbles, and now perhaps an AI bubble where these things were di- right. The internet will change the world and AI is the future. But sometimes people get the magnitude wrong and therefore this leads to the market overreacting to what should be moderately good information, but the market thinks it's Speaker 1 (1:54) extremely good. Speaker 2 (1:55) And Speaker 1 (1:56) what do you think it is that drives that mood? Is it just news stories or is it the market itself which drives it? Speaker 2 (2:03) Well behind any irrational behavior there is a grain of truth behind it which is why such behaviors keep recurring. So we hear you snooze, you lose, you need to pay attention to information and to track the market and so people do naturally and for good reason try to pay attention to news. But what we typically do is we over extrapolate and we see this in all areas of life, not just investing, which is why it's so hard to shake. So if you go down to any football stadium this Saturday, if a team has lost three games in a row, then the fans might call for the manager to be fired, even if he's had three or four great seasons beforehand. So what we do there is we will over extrapolate from small trends. Another way to look at it is those small trends could be due to luck. So maybe there was just bad refereeing calls or you hit the woodwork, but we overestimate the effect of skill. Just like if we tossed a coin a hundred times, there might be streaks of three heads or five tails. It doesn't mean that the coin was unbiased. It's just that we got lucky or unlucky. So we translate this into the stock market. It could be that the company has some good news, but the good news could just be nothing to do with the company, but a good economy or some favorable government policies. But if we overreact to this, if we see patterns in what might be more random data, this is the idea of being fooled by randomness by Taleb, then we make too much of particular news items. Is there kind Speaker 3 (3:32) of the opposite effect as well, where there's information that the market is kind of systemically slow to notice? Speaker 2 (3:39) Yes, there is. And this is what makes it so difficult to exploit the madness. Because if markets always overreacted and you think, well, there's a very simple strategy here, which is be contrary. We sell something that's done well recently. We buy something that's done poorly recently. But unfortunately, the market... underreacts to other bits of information. So it typically will overreact to large, flashy news, such as a rebrand towards AI, but something which is more subtle and intangible, the market might ignore. So one of my own papers looks at the effect of corporate culture and employee satisfaction on long-term company returns. Now... Employee satisfaction is highly public. You can look at the list of the 100 best companies to work for in America. You don't need to be an insider trader. But because this doesn't ping on Bloomberg, it's not as flashy as something tangible, the market may ignore it. And what I found was that over a 28-year period, you could have significantly beaten the market just by buying companies with strong corporate cultures. Speaker 1 (4:42) Now, we've had the ESG trend in investing for some time now. And I think in the US, it's very much fallen out of favor. In Europe, probably less so. Do you think that has something to do with what you're saying about intangibles and whether a place is nice to work at, for example? I Speaker 2 (5:02) do think so. And this is interesting because I published my study in 2011. And you might have thought, well, this study alerted investors to the fact that you could buy employee-friendly companies and outperform. So the alpha should have disappeared. But my paper was independently replicated by two other researchers 10 years later, and they found that the alpha was still strong. And this is crazy. So even though the research was alerting investors to the proverbial £50 note on the street, they weren't picking it up. And so why might this be? It could be because of the ESG controversy. So an employee-friendly company may be dismissed by some anti-ESG investors as being woke and fluffy. You're just a company just cares about employee well-being rather than company performance. When my research showed that it's not. splitting a pie between either investors or workers. This is something which grows the pie and actually helps investors in the long term. But because we often have this fixed pie mindset and we often pit either investors or society, some people for ideological reasons might think, I just can't believe that an employee-friendly company is a serious rational um maximizing return company indeed in my first career at morgan stanley you were seen as a good boss if you worked your employees really hard. So once I was told off by my vice president for laughing. And I asked why. And he said, well, if the managing director sees you as too happy, then he will think that I'm a bad vice president for not making you complain enough. Now, obviously, that was a little bit tongue in cheek, but there was some truth behind this, is that in investment banks, you get a good reputation for a manager if you squeeze as much as possible out of your... junior analysts. And Sir Alex Ferguson, he was seen as a great manager of Manchester United. Why? Because he gave players the famous hairdryer treatment if they had underperformed. Speaker 3 (6:59) A lot of that, what you're talking about is kind of a cultural overlay on markets. So people are making maybe irrational decisions rather than just looking at fundamentals. But are there other mistakes which mean that the market can kind of diverge from a fair price? People often talk about limits to arbitrage, don't they? Speaker 2 (7:17) Absolutely, yes. So one reason why people might not exploit seemingly open goals is because of cultural ideological reasons like being anti-ASG. But another, perhaps more rational one, is that it's just too risky to go in the other direction. So let's give an example. In the tech bubble, many investors thought, well, tech was overpriced and so let's move in the other direction. So the rational thing to do. should be not to buy in a bubble, in fact, to short in a bubble. And this is what Julian Robertson did, an extremely legendary investor of Tiger Asset Management, which seeded a lot of the Tiger Cubs, which were very influential funds in their own right. He did the rational thing and he exited from tech. But rational does not always pay because whatever craziness caused tech to be overpriced in the late 1999s. actually widened. It got even madder and the bubble kept inflating so much so that investors in Tiger thought, well, your fund is massively underperforming. All of the other funds which were still into tech were easily outperforming them. And so he was liquidated. His fund had to shut down in March 2000. Then a few months afterwards, the bubble burst and he was right, but he wasn't there to enjoy the victory. So because he'd been liquidated. And so this is what you mean by the limits to arbitrage is, yes, you might think any rational person will move in the opposite direction, but sometimes the smartest money is to ride the bubble, not to burst it. If you think the bubble will keep inflating, then actually you will buy something which is overpriced, thinking it might become even more overpriced in the future. This is what George Soros did in the tech bubble. And I have to admit, this is what I did with SpaceX. So in the SpaceX IPO, I thought, well, there's no way that it could be worth this huge valuation right now. But I know that there's a lot of hype around Elon Musk and space exploration. I subscribed to the IPO, I sold within two or three hours, and it had already been up about 20, 25%. So here, you might be trading not on fundamentals, but on other people's hype. And this is why the madness of markets can persist so much, is smart people often go with the trade rather Speaker 1 (9:35) than the opposite direction. I think Soros describes it as reflexivity, the idea that these things feed on themselves, and it becomes a self-perpetuating thing. Yes, absolutely. Yes, it's Speaker 2 (9:47) self-fulfilling. And John Maynard Keynes also compared the markets to a beauty contest where the goal is not to predict the most beautiful person objectively. but to vote on who everybody else thinks is the most beautiful. So you're trading on other people's opinions. And so there are many assets which might have actually zero fundamental value. The value is what other people ascribe to the asset. So with a house. It has fundamental value. Even if nobody wants to buy the house from you, you can live in it and then you save rent by doing so. But something like cryptocurrency or maybe a non-fungible token there, that is entirely based on what other people ascribe to it. And so if there's Speaker 1 (10:31) a Speaker 2 (10:31) lot of frenzy behind this, and if you think the frenzy might actually get even stronger, it might be rational to do the quote, irrational thing of buying something which is already inflated. Speaker 1 (10:42) But there are some that really wind me up. For example, if you look at Tesla's valuation, you know, it's trading at 100 times forward earnings, where it's almost like a religious cult. You know, if you're one of the people who believe in it, you're willing to pay crazy multiples for something which really shouldn't be valued so highly, at least in my opinion. So do you think these things persist to do with almost a cult-like following for some of the managers, some of the... company directors, which really isn't to do with the fundamentals of the company at all. Yeah, they do persist. And then the big question is, Speaker 2 (11:20) how long will they persist for? And that will decide what the correct trade is. So a lot of these frenzies and hypes and excitement, they do last, but they might not last forever. So let's say you think the hype in Tesla will persist for another three years. Then, even though you think it's overvalued, if your investment horizon is less than three years, you actually want to ride the bubble not to burst it. Why? If you were to move in the other direction, then you might have the Julian Robertson endgame where actually the bubble keeps inflating, you get liquidated because you underperform. But what if you have a really long horizon, maybe a 20-year horizon? Then you might sell now. Why? Maybe you're not selling at the top. Maybe the bubble has got further to go. But if you believe that it will crash at some point, maybe because Musk will find something else to be excited about and might not spend so much time at Tesla. Maybe he might appoint somebody else to be the CEO. Speaker 3 (12:19) Maybe he might buy it out with SpaceX. Speaker 2 (12:21) Well, exactly. There's a lot of crazy things that he might do. Or maybe he gets into a bromance with the next president of the US or another feud. So if we think that this will not last forever, actually move in the opposite direction. And even if you don't call the top exactly right, you're getting the long term trend wrong. And so this is ironic. why an amateur investor like me might be able to beat professionals who are trading every day. Not because we have better information or insight, but we just have a longer runway. We have patience. So I put a lot of my money into the market at the start of 2009. So this was the depths of