The public buying frenzy or herding will eventually run out of stream as the Smart Money moves into the opposite side of trades. Many people observe the interesting phenomena that when the major financial networks pound the table on a particular stock or sector, that stock or sector is bounded to suffer a setback soon. The magnitude and persistence of a bubble often depends on the persistence of speculative interests and the risk premium perceived by the smart money in terms of future speculative demand, as well as the float of an asset. Hong, Scheinkman and Xiong (2006) demonstrate the positive link between the float and the propensity for speculative bubble to form. They conjecture:
Investors trade a stock that initially has a limited float because of insider lockup restrictions. The tradeable shares of the stock increase over time as these restrictions expire. We assume that investors have heterogeneous beliefs due to overconfidence and that they are short-sales constrained. As a result, investors pay prices that exceed their own valuation of future dividends because they anticipate finding a buyer who is willing to pay even more in the future. This resale option imparts a bubble component in asset prices.
The effect of a float can be seen in both Chinese stock and real estate markets. Mei, Scheinkman and Xiong (2009) document that the difference between floats of A shares and B shares caused significant price difference between the dual-class shares. A shares (domestic-owned with less floats) exhibit higher trading turnovers and price volatility than their counterpart B-share (foreigner-owned). The price difference decreased with the increase of floats of A shares. Their findings can be extended into the universe of the dual-listed stocks with different floats, such as ADRs vs. the home stocks. A pair-trading strategy can be implemented to take advantage of the different price responses.
As for the current state of Chinese real estate market, a possible bubble is formed due to the willingness of buyers to pay whatever the prices are. Even though the prices exceed their own valuation of fundamental value, they believe that in the future they will always find a buyer willing to pay even more.
Buy-hold Strategy
The most tested long-run strategy has been Buy-and-Hold. The basic truism of investing is to buy the unvalued stocks and sell it when it becomes overvalued. The U.S. market has experienced one of the greatest bull runs during the past 40 years on the back of strong economic growth. The buy-and-hold strategy generates unbeatable returns compared to any other strategies over the long run. Skillful stock pickers, such as Warren Buffett, are richly rewarded. Even some people who buy overvalued stocks as economies grows- the tide lifts their boats as well. Over-valuation is dwarfed by the economic growth.
Many years’of unrivaled success makes the investor community increasing comfortable with the buy-and-hold strategy. Dr. Grossman marks the Buy-and-hold strategy as one of causes of excess risk premium in the current financial system. Instead of selling an asset at the appropriate time, investors hold on to it and fall in love with it. When a large systemic shock comes, they get panicked and sell it at exactly the wrong time.
As we enter into an anemic economic growth period and assets are increasingly prone to speculative attacks, the buy-and-hold approach might no longer be the appropriate strategy. The bursting of the tech bubble and decades of losses for Japanese stocks remind us of the risks in the buy-and-hold strategies. Although the constant rebalance might not be suitable for various reasons, investors need to keep constantly vigilant to the underlying fundamentals and market ecosystem.
Conclusion
Ms. Rana Foroohar wrote on her commentary in the February 1 issue of Newsweek,
The greatest lesson of this downturn is that we shouldn’t rely on one tidy idea to encompass a world of human complexity.
From George Soros' reflexivity to fusion investing, many portfolio managers have been incorporating behavioral theory into their strategies throughout the years. The herding indicator proposed by Lillo etc (2008) can be constructed to gauge the degree of herding in the market. Sentiment indicators, net order flow and autocorrelation in daily trading volume can be easily integrated into daily decision making process. For more sophisticated traders, many models such as game theory, complexity theory and other social sciences are available to construct a tradable strategy and mitigate risk. For example, Sorrentte and Zhou (2004) proposed a log-periodic power law model to predict the ending of a bubble.
The stock market and various asset classes rebounded after the financial meltdown. It is arguable whether or not we are in a liquidity-fueled mini bubble. There are certainly distinct fads in the recent post-crisis market. Many market participants flock into certain areas like gold, certain commodities and emerging markets.
It is difficult to be precise where we are in the pattern of bubble. The Pragmatic Capitalist posted “Where are We in the Bubble Process” on Seeking Alpha this month. If what he predicts it is true, it is prudent for investors to adopt a stop-loss/start-gain policy. The past market cycle should teach us to stay on guard when the market relentlessly points in one direction.
Sources
Barber and Odean (2008), “All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors”, Review of Financial Studies 2008
Hong, Scheinkman and Xiong (2008), “Advisors and Asset Prices: A Model of the Origins of Bubbles”, Journal of Financial Economics, 89, 2008.
Hong, Scheinkman and Xiong (2006), “Asset Float and Speculative Bubbles”, Journal of Finance, June 2006.
Lee, O’Brian, and Sivaramakrishnan (2008), “An Analysis of Financial Analysts’ Optimism in Long-term Growth Forecasts”, Journal of Behavioral Finance. 2008
Lillo, Moro, Vaglica and Mantegna (2008) “Specialization and herding behavior of trading firms in a financial market”, New Journal of Physics 2008
Mei, Scheinkman and Xiong (2009) “Speculative Trading and Stock Prices: Evidence from Chinese A-B Share Premia,” Annals of Economics and Finance, 10-2, 2009.
Olsen(1996), "Implications Of Herding Behavior" Financial Analysts Journal 1996
Prechter (2001), “Unconscious Herding Behavior as the Psychological Basis of Financial Market Trends and Patterns”, The Journal of Psychology and Financial Markets 2001
Scheinkman and Xiong (2003), Overconfidence and Speculative Bubbles, Journal of Political Economy, December, 2003
Sornette and Zhou (2004), “Predictability of large future changes in major financial indices”, arXiv:cond-mat 2004
Yu and Kim (2009) “Analysis of Business Week hot-growth stocks: Momentum and Fundamental Investment Approaches”, Journal of Asset Management 2009
Yung and Liu (2009), “Implications of Futures Trading Volume: Hedgers vs Speculators”, Journal of Asset Management 2009
Disclosure: No position
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