I’ve been pondering a new way of explaining market behaviour. Academic Andrew Lo  has already coined the term adaptive markets. This theory of adaptive Markets “shows that the theory of market efficiency isn’t wrong but merely incomplete. When markets are unstable, investors react instinctively, creating inefficiencies for others to exploit.” I thoroughly recommend reading Lo’s book, available HERE.

Robert Shiller has also argued for the importance of narratives as a way of justifying and evolving investor behaviour. In my Citywire US column later this week I also mention another fascinating study  – courtesy of a hat tip to economist Tyler Cowen – (here’s the link,) by Xavier Gabaix and Ralph S.J. Koijen.

As I bserve in my Citywire column, “these economists have very been slightly confused by what it is that actually moves markets and stock prices. Is it then pure random walk, deep fundamnetals such as Robert Shillers CAPE measure or is there another force at work at the level of the aggregate stockmarket. There initial intuition is that institutional behaviour plays a crucial role with managers forced to accept fairly standard risk allocation models.

Their key conclusion is devastating I think – they find that the “the price elasticity of demand of the aggregate stock market is small, and flows in and out of the stock market have large impacts on prices….we find that investing $1 in the stock market increases the market’s aggregate value by about $5. …The mystery of apparently random movements of the stock market, hard to link to fundamentals, is replaced by the more manageable problem of understanding the determinants of flows in inelastic markets. ‘

All of which brings me to one final evolution – that investors turn themselves into  agency, adapting to changing consensus, and then adapting their behaviour as a result. The result is that investors swarm as crowds and these swarms create agency and their own narrative.

In practical terms, investors watch the market build a consensus view and then they react to them. As a crowd they decide that they don’t approach with the market ‘wisdom’ and kick back a la Gamestop, AMC and a long list. Thus private investors emerge as a collective identity.

How might this take shape. The chart below shows the 1 year history for the search term – on Google Trends – of Meme stocks. One notices a periodicity and some obvious upsurges – followed by long patterns of consolidation and quiet. My guess is that we are due another surge, partly because there is a periodicity to crowd behaviour. What might the next surge be related to ? My guess is that the ‘investor crowd’ might react angrily to the growing consensus view that shares are overvalued.

Meme trend data – https://trends.google.com/trends/explore?geo=US&q=meme%20stock

Which nicely brings me to the chart below and a recent report form analysts at Deutsche Bank stateside. This is an effective ‘old school’ summary of why so many investors are deeply worried. The chart below makes the argument simply and figuratively. Shares are looking toppy, not only in a fundamental sense but also technical basis.

Chart – Equities are now at the top of the trend channel in place since the GFC


Equities really are expensive

The fundamentals based challenge for current share prices is ably summarised as follows :

The traditional trailing earnings P/E, the forward P/E on consensus earnings estimates, enterprise value (EV) to EBIT, EBITDA or operating cash flow (OCF), are all in the 99-100th percentile excluding the 1990s tech bubble period. But even including it, they are well into the 90s in percentile terms. EV/FCF is at a 20-year high but the only measure that versus a longer history suggests is not particularly high, though historical data issues in measuring cash flows are significant.

Even at the median individual stock level, valuations are challenging.

“…… the traditional trailing P/E multiple is near a record high and well above Tech bubble peaks, while the multiple on forward consensus estimates is down from its peaks but at levels comparable to Tech bubble peaks. For the median company, EV to EBIT, EBITDA, or OCF are above their Tech bubble peaks.”

What’s the cause of this clear over valuation, and challenging technical situation. According to Deutsche it’s a case of exaggerated narrative anchoring. “ At a fundamental level, we believe the key reason multiples are high is market confusion over where we are in the earnings cycle, in part reflecting the speed and surprise with which the economic recovery has unfolded and the large persistent beats this generated.”

Put simply the market believes the best is still to come but the hard numbers suggest this is wishful thinking.

Cue a possible sell off as those earnings disappoint.

But at that point I would suggest that my first point about investors acting as any angry, pissed off crowd might kick in. Having seen every other sell off followed by an almost immediate rebound, the ‘investor crowd’ – not to be confused with the wonderful IT Crowd – kick back into action. They might argue that in fact the ‘mainstream’ institutions have ‘got it wrong’.

Oh and one last chart from Google Trends. Looks like the Roaring Twenties thesis – which I subscribe to – has gone off the boil. All we need is for a few technological leaps to embolden the meme crowd and I think it could roar back into action !

Why emerging markets EXC China makes most sense exc China

Another excellent piece from Gerry Celaya, Chief Strategist at Tricio, making the point I’ve been making for some time : that emerging markets indices are too broad and much focussed on Greater China.

“ The chart above shows the returns of the MSCI Emerging Markets ex-China index (dark blue) vs. the MSCI Emerging Markets (yellow) and MSCI ACWI (All Country World Index, light blue). Even as US Pres. Biden picked up the phone to reach out to China’s Xi, tensions may remain high between these two. For investors, as China accounts for over 30% of the MSCI EM index, does the removal of this heavyweight change the returns in a material fashion for the ex-China EM index?

At first blush when looking at the squiggly lines on the chart, one would say ‘Not really’. Which should force all of the analysts, fund and wealth managers who insist that China should be part of their holdings to examine their thinking. If the returns of an index with such a big weight is not materially affected when you take that weight out in a new index, what is the point of running the risk of holding that weighting given government actions and policies that pretty much run roughshod over any ESG or SRI considerations? The MSCI EM ex-China index is not really an EM index of course, with over 40% of the holdings in Taiwan and S. Korea. Which continues to raise the point that investors may wish to consider single country or bloc of nations (Africa, Latin America etc.) funds and ETF’s that really put money to work in what they may consider to be emerging markets. “