The news that Robin Hood is looking to IPO has helped to divert attention from the rumblings against investment democratisation. In both the US and the UK there’s a growing chorus of ‘experts’ who reckon that democratisation of finance is a BAD thing and that investors can’t be trusted. The Times has run a few stories on this basis today and as usual there’s a blending of two very different ‘problems’. The first is that there is a problem with high leverage and what I call ‘betting against the house’ products. These include the hopeless pursuit of profits in FX trading as well as options based accounts and spread betting. These are, as the numbers remind us, essentially futile exercises in wealth destruction for private investors as the odds are stacked against you, and most lose. Lots and lots in some cases.

But this is NOT the same activity as ordinary speculative investing, using online brokerage accounts where supposedly reckless young people are staking all their money on fractional shares in say tech stocks. This is not leveraged activity and involves a speculative mindset which is different than a gambling mindset – although ‘experts’ love to conflate the two. The moral panic/rot sets in when the experts start to worry about where these foolish young people acquire their information -at which point evil social media rears its ugly head.

The link to the Times article is here: https://www.thetimes.co.uk/article/young-novice-investors-get-risk-warning-z3hgfqz2t

My favourite expert comment is from Interactive Investor who call for better education in schools (and no doubt apple pie and more flying unicorns while we are at it). “It’s horrifying that some young investors are being steered by TikTok, not teachers or parents, on important issues that will affect their financial futures far more than which GCSE options they pick. Depending on your gut feelings is a terrible strategy for investing if you actually want your money to grow meaningfully over the long term.”

I am not sure where to start with this moral panic/nonsense and I will ignore the observation that gut feeling is entirely worthless (tell that to hedge funds).

Maybe a dose of honesty is needed. Care to guess where most of my older generation of speculative investors get our ideas from? Bulletin boards and comment boards. These equally online locations are clearly not the apogee of mindless evil like TikTok but come on, they are not exactly the ivory towers of modern finance theory either. Virtually everyone who I know that invests and is over the age of 40 has

1. Always had a speculative side portfolio where they lose money on a regular basis
2. Has a terrible track record of making monumental errors in their investing strategy when they were young, but then realised the error of their ways and learnt from their mistakes
3. Spends stupid amounts of time listening to crazy ideas from friends, golf club buddies, Jim Cramer and bulletin boards

I would go even further and observe that many young investors I talk to have very cleverly switched their investments from crazy over valued tech stuff towards cyclical, value stocks – in fact many of my son’s friends are quietly busy buying oil stocks, or Microsoft or airlines. This is what the over paid analysts on Wall Street call a cyclical rotation but practised on a humble basis – “those tech stocks look overbought but these cyclical stocks look cheap”.

So, when the regulators start to look in detail at this space, I would like to humbly suggest that they don’t start with nobbling apps which democratise investment but give a good kicking first to the binary bet/FX brigade and then move on to the wealth managers who quietly ply their trade charging extra ordinary sums of money. I have a few candidates in mind and many of them are stock market darlings but their small (actually not so small!) numbers don’t look at terrifying as the 70% + of investors who lose money spread betting. Nevertheless the long term impact of these small numbers is no less disastrous. My Citywire column this week helpfully points to a few candidates who might warrant some attention by the busy body regulators: you can read it here. https://citywire.co.uk/funds-insider/news/david-stevenson-sjps-high-fund-fees-will-eat-your-returns/a1484836?ref=citywire-money-opinion-list

Earnings aren’t important? Discuss

And while we’re in a contrarian mood I must applaud Nicholas Rabener at FactorResearch for a cracking paper who’s latest paper in the CFA Institute’s journal is well worth reading. You can read it here: https://blogs.cfainstitute.org/investor/2021/03/22/myth-busting-earnings-dont-matter-much-for-stock-returns/?mc_cid=24bf44e8a7&mc_eid=d8376c4e49

Those experts I was talking about earlier like to stick to the conventional wisdom (taught in all good schools where they teach about investing), which is that there is a close connection between earnings growth and share price appreciation. If a company grows profits, the market will reward it. I’ve always that was largely – though not exclusively – rubbish, as it was much more obvious to this cynical observer that behaviour, greed and speculation are more powerful indicators of stockmarket flows than earnings data.

As Rabener reminds us, plenty of academics have also deconstructed this link including the likes Elroy Dimson, and Jay R. Ritter, both of which  “ demonstrated that the relationship between economic growth and stock returns was weak, if not negative, almost everywhere. They studied developed and emerging markets across the entire 20th century and provide evidence that is difficult to refute. Their results suggest that the connection so often made between economic developments and stock market movements by stock analysts, fund managers, and the financial media is largely erroneous.”

Nicholas has chosen to focus on earnings driving stock returns – his results are obvious. “The correlation between US stock market returns and earnings growth was essentially zero over the last century. We tested this hypothesis by focusing on earnings growth for the next 12 months and assume investors are perfect forecasters of the earnings of US stocks. Returns were only negative in the worst decile of forward earnings growth percentiles. Otherwise, whether the earnings growth rate was positive or negative had little bearing on stock returns”.

The graphic below nicely contextualises this insight.

And if earnings are of questionable value, what about measures such as the PE ratio? Over to Rabener again. “ The average P/E ratio was indifferent to the expected earnings growth rate over the next 12 months. Indeed, the higher forward growth resulted in P/E multiples slightly below the average”.

So, what gives? If its not classic rational behaviour driving stock prices, what is?

“The simple explanation is that investors are irrational and stock markets are not perfect discounting machines. Animal spirits matter as much if not more than fundamentals. The tech bubble of the late 1990s and early 2000s is a great example of this. Many high-flying companies of that era like Pets.com or Webvan had negative earnings but soaring stock prices.” Let’s not talk about Robin Hood IPOs and Bitcoin, shall we !!

If we follow this logic, then I think we can absolve those reckless youngsters I mentioned earlier of any blame in their speculative endeavours – they are in fact engaging in the best education money can buy. They’re learning from their mistakes, but also realising that the single most powerful factor driving stock market returns is not ruthless, clever rationality but momentum which is itself a by-product of simple (and not so simple) behaviour based mental shortcuts.