Update: Bubbles and Crashes

I published the article below in late 2008 which turned out to be the depths of the severe bear market that began the prior year. The research cited how money flows can tend to exacerbate market trends thereby creating opportunities for investors willing to invest against the flow. The research concluded by stating that stocks should greatly outperform bonds and commodities post-2008 and that is indeed what has happened.

It's worth noting that the strongest money flows in the years immediately after the bear market (2009-2012) were into bond (fixed income) funds as investors took a risk averse stance with stocks. After the research summary below, I discuss the implications for this research given what we're seeing in the financial markets in 2021.


Every so often, academia produces some interesting research which leads to investing insights or confirms some important principles investors lose sight of.  What follows is a summary of some powerful research from the London School of Economics.

Until now, "irrational exuberance" has been the usual explanation for stock market bubbles and their aftermath. A new paper from the London School of Economics provides a rational explanation for the damaging volatility of stocks, bonds, currencies and commodities.  Two economists at the London School of Economics have now come up with a new theory that explains momentum on the basis of rational, rather than irrational responses. They are Professor Dimitri Vayanos and Dr Paul Woolley, director and chairman, respectively, of the Paul Woolley Centre for the study of Capital Market Dysfunctionality at the LSE.

Conventional wisdom has always held that competition among investors will drive the prices of financial securities to reflect the best estimate of their worth in light of all information.  Otherwise, rational investors would profit by stepping in to correct the mispricing. This principle also became enshrined in academic theory with the "efficient market hypothesis".

"This view of financial markets has remained largely unaltered despite the accumulating evidence of price distortions in the form of systematic mispricings, periodic bubbles and crashes, and levels of volatility vastly greater than the underlying dividend streams.  Much of the volatility arises from the trends that develop in prices over periods of, say, three months to three years.  Such trending is usually termed momentum when the bubble is inflating and reversal when prices return to normal," says Dr Woolley.

So far the only explanations of momentum have come from economists of the appropriately named behavioral school.  They attribute momentum to psychological biases on the part of some investors, hence the term "irrational exuberance."

Their paper's principal departure from conventional analysis of asset pricing is to understand better what happens when investors delegate responsibility for investing to professional agents, such as money managers, mutual funds or hedge funds.  The key to their analysis is that the end-investor does not know whether poor performance against the benchmark index is due to a manager's prudent avoidance of overpriced stocks or incompetence.  If the investor decides to fire the manager, the underperforming stocks will be sold, thus driving the price down further. And if the investor also decides to hire a recently successful manager, the stocks that have lately been rising will be pushed up more, thereby compounding the momentum effects. 

Here's an example from the late 1990s bull market ending and the early 2000s bear market.  Technology stocks were all the rage in the late 1990s and value stocks were out of favor.  These tendencies were exacerbated by investors pulling money from value managers whose comparative performance at the time looked poor and directing that money to hot shot managers, whose relative performance was strong and were piling into tech stocks. When the tech bubble broke in the early 2000s, of course, those stocks got clobbered while value stocks did well. 

Delegation to full-time managers, coupled with hiring and firing based on short-term results, contributes to momentum effects arising from the client's lack of knowledge about the manager's true skills.  End-investors and managers, alike, are acting rationally in their own self-interest, but the act of delegation and lack of complete information for the investor is the simple, but powerful, driver of momentum. This, in turn, generates outcomes that damage economic growth and welfare.

Dr. Woolley added:  "Once the stable door is opened to the prediction of market inefficiency in a rational expectations framework, the implications are endless for both the theory and practice of finance. The policy implications of this research are far-reaching; if governments fail to address this dysfunctionality of capital markets we will see a repetition of booms and crashes in the coming decades, possibly on an even greater scale."

If you think about what happened during the recent bull market which ended in 2007, commodities and oil were hot and investors handed more money over to managers who profited from that sectors' run-up. That bubble burst and with the severe bear market that began in late 2007, investors have been fleeing stocks and piling into bonds. When this reverses, at it will surely will, stocks should greatly outperform bonds (and commodities) in the years ahead. 

Here in June of 2021, we can look back over the past year as the stock market has staged a furious and relentless comeback in the aftermath of the Feb-March 2020 meltdown that quickly lopped about 35 percent off of stock prices. During the last half of 2020, funds flowed into bond funds and out of stock funds. This, of course, was not a good decision by those investors selling generally depressed stocks to buy generally inflated bonds. Late last year and into early 2021 saw a large amount of money flowing into risky assets/vehicles such as SPACs, cryptocurrencies, and thematic stock funds focused on high growth companies.