Is Technology Making Us Too Bullish on Stocks?
It’s getting harder and harder to imagine how a momentum-driven bull market can last much longer if almost everyone thinks the markets are overvalued.
US equities have now swelled to nearly 60% of the MSCI World Index, around twice their representation 25 years ago.
Research Affiliates calculates a near record high Shiller P/E of 47-times cyclically adjusted earnings for US small-cap stocks and 27 times for US large caps — valuations that imply future expected shareholder returns of around zero. The picture is a little more sanguine elsewhere: A Brexiting United Kingdom has a Shiller P/E of just 12 times, Germany and France are at 15 times, while in emerging markets, China trades at 11 times and India at 18 times.
But a burst bubble in the United States — caused, let us imagine, by the long expansion of the US Federal Reserve’s balance sheet — suddenly exploding into inflation and currency debasement would endanger highly correlated markets everywhere.
Just in time for the market surge, a novel paper, “The Shiller CAPE Ratio: A New Look,” by Jeremy Siegel, was published recently in the Financial Analysts Journal® and summarized by CFA Digest. Siegel maintains that new US accounting standards adopted since 1993 have led to the overstatement of declining earnings in recessions and generated an artificially high cyclically adjusted P/E ratio.
So those investors gauging the elevation of the US markets with CAPE ratios might actually be too conservative. Yet Siegel, the so-called “Wizard of Wharton,” was similarly optimistic in an interview just before the dot-com bubble burst in 2000.
Is Social Media Turning Us into Stock Market Pollyannas?
Perhaps one reason panglossian market conditions can persist in the age of Twitter and Instagram is that omnipresent social media allow us to edit out anything that vaguely threatens our preferred mindset about stocks, even if such a willfully pollyanna-ish approach conflicts with inconvenient facts.
A new study evaluating Twitter, “Investor Attention on the Social Web,” from the Journal of Behavioral Finance, analyzed the StockTwits trading community on the social media platform. The researchers observed different categories of investors’ attention in real time to determine what drove that attention. They found no single regulatory mechanism or timescale and concluded that much depends on the skill and experience of the individual investor.
This finding is contrary to the tenets of the efficient market hypothesis (EMH), which assumes prompt and uniform attention to all available information. Distractions among investors include the all-too-human search for validation and social proof to confirm their rectitude. The authors conclude that stocks with higher volatility and momentum better capture investor attention.
Price-sensitive information can appear first in social and news media before impacting stocks. One study, “Wisdom of Crowds: The Value of Stock Opinions Transmitted through Social Media,” from the Review of Financial Studies, conducted textual analysis of articles on Seeking Alpha, a popular investor forum. It found that opinions transmitted through social media can actually predict stock returns and earnings surprises.
Similarly, further research confirms that “Media Makes Momentum.” Excess profits accrue to investors in firms with higher levels of newspaper coverage
Investment bubbles are typically assumed to feature individual investors and uninformed momentum trading. But the reality is more nuanced, according to another study, “Are Individual or Institutional Investors the Agents of Bubbles?” Using a study of South Korean markets, the study’s authors found trading by institutional investors, particularly foreign institutional investors, tends to be trend driven.
Conversely, individual investors appear to trade in a contrarian manner. Interestingly, the authors note that the actions of ubiquitous global hedge funds can easily distort local market valuations and quickly swamp local short-selling capacity.
More Dubious Networks
Other examples of dysfunctional networking abound. “Social Interaction at Work,” from the Journal of Financial Economics, suggests that people who work together often invest together. Using a large sample of Norwegian investors, the study finds co-workers invest in similar industries, which tend to underperform, and invest more like their colleagues as their tenure with their employer lengthens. The study is a salutary reminder of the dangers of crowding and the difficulty of exiting overcrowded trades as well as the virtues of keeping social and investment matters separate.
Empirical investor networks (EINs) lie between public media and private information sharing. EINs encompass private conversations, social networking, and blogging. A study of EINs found that comparatively centralized operators have a market advantage over those on the fringes of the EIN: Well-integrated members trade earlier and more successfully than their peripheral counterparts. Perhaps democratization in investing has reached its limits after all.
Conquering Distraction and Quantifying Noise
Distractions caused by vision-narrowing apps and dysfunctional networks can be a menace to investors trying to navigate uncertainty, but solutions are available. Exponentially increasing digital information is driven by the fear of missing out or being out of contact and carries a personal and professional cost, according to psychologist Larry Rosen and technologist Alexandra Samuel. Writing in Harvard Business Review, they propose that solutions to the heavy burden of overstimulation and exhaustion can be found in a psychological approach coupled with better use of technology — by controlling and moderating exposure to social media while also using technology itself to control overuse and prioritize, categorize, and sort new information.
Last but not least, stock market noise and uncertainty is embedded in all valuations, and we can certainly attempt to measure and quantify it. The IPO of Facebook offers an excellent opportunity for a case study of how uncertainty can be quantified. Aswath Damodaran discusses the valuation of the Facebook IPO and identifies three groups of uncertainties, each requiring a different response.
To help readers navigate and stay current on the latest related research, we have compiled a range of informative materials from CFA Digest and other CFA Institute publications.
- “Are Individual or Institutional Investors the Agents of Bubbles?”: Bubbles in financial markets are generally believed to be driven by the actions of uninformed individual investors. But the authors’ detailed study of trading activity in the South Korean equity market suggests that trading by institutional investors, particularly foreign institutional investors, tends to be trend driven. Individual investors, however, appear to trade in a contrary manner.
- “The Shiller CAPE Ratio: A New Look”: Jeremy Siegel argues that the use of GAAP earnings, which includes mark-to-market requirements, artificially inflates the cyclically adjusted price/earnings ratio (CAPE ratio), which leads to lower forecasts of real stock returns.
- “Living with Noise: Valuation in the Face of Uncertainty”: Uncertainty is embedded in all valuations, although the degree varies among companies and countries and across time. Uncertainty in valuation can be categorized into three groups: estimation versus economic, micro versus macro, and discrete versus continuous. Each type of uncertainty needs a different response. Thankfully, tools are available that investors and analysts can use to deal better with uncertainty in valuations.
- “Tracking Social Media: The Mood of the Market”: Such social media platforms as Twitter and Facebook generate huge amounts of contemporaneous information. The author discusses how this information can be analyzed but raises questions about its ability to explain investment returns.
- “Wisdom of Crowds: The Value of Stock Opinions Transmitted through Social Media”: To determine the value of stock opinions transmitted through social media, the authors conduct textual analysis of articles published on Seeking Alpha, a popular social media platform for investors. They also evaluate the perspective of readers via comments written in response to the articles. Their findings indicate that investor opinions transmitted through social media can predict future stock returns and earnings surprises.
- “Investor Attention on the Social Web”: By developing and testing a process to examine practitioners’ conduct in the surfeit of information on social media, the authors evaluate how today’s investors focus their attention.
- “Social Interaction at Work”: Positive correlations between the stock market investment decisions of individuals who work together can be identified. These decisions tend to result in stock purchases in companies within the same industry and, more generally, do not lead to improved investment outcomes.
- “Conquering Digital Distraction”: The flood of digital information exacts a professional and personal cost. The authors offer differing perspectives on how to manage it.
- “Investor Networks in the Stock Market”: In exploring the role of empirical investor networks in information diffusion, the authors find strong support for the existence of stable and relatively diffuse structures on the Istanbul Stock Exchange. Within these structures, more central members trade earlier and more successfully. The finding is consistent with an information-sharing network.
- “Media Makes Momentum”: The momentum effect is stronger among firms with higher levels of newspaper media coverage. Excess profits attributed to excess media coverage are found among firms exhibiting higher levels of valuation uncertainty, among firms with a media tone consistent with their formation period return profile, and among firms headquartered in US states ranked as being more individualistic.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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