The Greater Fool and the Persistence of Irrationality

This is going to be a bit nerdy, but hopefully it’s insightful. Probably the biggest difference I have seen between economic theory and reality is the lengthening of lags across the economy and markets.

What do I mean by that? I mean if theory predicts it might take one year for higher interest rates to hurt the economy, now it might take three. Similarly, if an asset bubble might previously take three years to deflate, now it takes five to ten.

Why is this? I don’t think anyone knows, though I will share some theories later on. First, let me present the evidence.

The Persistence of Irrationality

The tech and housing bubbles both persisted longer than most probably remember.

The tech bubble was pretty apparent in 97 (arguably 96) and the housing craziness went back to 04 (arguably 03). So these both took three to five years to crash.

They felt like forever at the time, but they were just the beginning of this longer tail of irrationality.

The Fed first went to zero interest rates in late 2008. This should have caused inflation by 2010 or 2011. For sure, we’d have a big problem by 2013 or 2015. How could we not?

Well, we didn’t. The lag ended up being twelve years and, even then, required an obscene amount of money printing in response to a 100 year event (Covid) to finally unlock inflation.

Where else have we seen these large lags? Asset valuations.

Even Covid only temporarily paused the widening gap between growth and value stocks. Nothing seems to interrupt the recurring outperformance of US stocks vs. rest of world.

Pour one out for your friendly value or international investor. They are at fifteen years of underperformance and counting. Surely, this will mean revert at some point.

Means That Don’t Revert

But that argument could have been made two years ago, three, four, five…if you bet on mean reversion, it was a career killer.

That doesn’t mean it will never happen, but it takes something stronger to shake things loose.

The private equity bubble never relents. Even as debt costs have finally risen, valuation multiples keep rising.

This makes no mathematical sense. As borrowing costs rise, the return to the equity portion is diminished. Multiples need to go down, not up. But the irrationality persists. It will probably take significant credit losses to wake people up.

Insurance Lags

How about in insurance? Well, the late 90s casualty troubles emerged by 2002, so a five year lag. What about this time? It took ten years to admit litigation funding was a problem!

I mean, it’s not like people weren’t talking about it at the time. I remember badgering companies to pull back on casualty at the time. Plenty of people were concerned about what was going on with litigation funding.

But insurers were able to hide it for ten whole years this time! By the way, that is bad for the long term viability of the insurance business.

When interest rates or stock prices stay irrational for too long, at least you can sell and capture your undeserved gains and sheepishly walk away.

When you write year after year of bad casualty business without admitting is was underpriced, you may find you have arrived at technical (if not actual) insolvency. Insurers need faster, not slower feedback loops!

Next, look at how long it took the cat market to admit their returns were too low in light of higher cats. They let themselves get abused by buyers for years while the lags got longer.

The Need For Larger Shocks

What I have learned over the past couple of decades is it now takes larger exogenous events to reverse extreme persistence.

Covid is a prime example. If it weren’t for Covid, the Fed would probably still be justifying zero interest rates.

Cat rates didn’t respond to all the earthquakes of 2011 or Sandy or the three 2017 hurricanes. No, it took punch to the face after punch to the face after punch to the face to finally get reinsurer’s attention.

As mentioned, private equity likely won’t stop until there are shocking credit losses. Similar to insurance, slow feedback is not healthy here.

The leverage means shocks lead to bankruptcy and, with valuations so high, the pain will be devastating. Note, the same risk exists with the unchecked growth in private credit.

I can’t tell you what will be enough to cause investors to finally shift from US to international stocks but, when it does, it’s going to be crushing.

But Why Has This Happened?

So I’ve hopefully laid out a convincing case that lags have gotten longer and it takes bigger tail events to shock the system back to normal.

But why is this happening? I won’t suggest I have all the answers, but I have hypotheses.

Before offering them, I’d suggest an eager economist could devote a career to researching this topic. It’s hugely important and, I would even argue that a robust theory is Nobel worthy.

So what are some possible explanations?

Too Much Information

One candidate is better access to information. While you would think more information would lead to better decisions, it arguably does the opposite.

There is a signal to noise problem. It is harder to tell fact from fiction because of the overwhelming amount of data.

Think about social media. Has more access to information led to people being more or less likely to have an opinion based on facts or nonsense?

Unfortunately, most people have a hard time telling the difference. It can be difficult, for a non-expert, to know what to believe when people on both sides of an issue sound so convincing.

This obviously isn’t confined to social media. Most news media is now partisan in one direction or the other.

Therefore, when a false narrative takes root, it can be very difficult to debunk it. This allows bubbles, especially ones based on seductive narratives, to continue longer than they should.

People need to be shocked to their senses to change their opinion which tends to require overwhelming evidence.

From a trading perspective, more information leads to more trading. Therefore, a lower level of confidence is needed to initiate an investment which leads to a greater risk of error.

This leads to the second theory…

Too Much Liquidity

Similar to better information, better liquidity sounds like a good thing. However, it can lead to suboptimal decision making.

As noted, it can lead to more trading of lower quality ideas. By the way, this isn’t just about securities. It also applies to “trading” businesses (insurance agent rollups!) or the ease of creating new businesses (“AI” startups) or debt creation (private credit relative to banks).

It also allows less sophisticated investors to participate because there is no cost to trade and it is easy to enter and exit.

Efficient market theory assumes assets prices reflect all available information. But not all investors are knowledgeable!

If unsophisticated investors make up too much of the market, it can cause prices to deviate from an “efficient” price. A well known example of this was the meme stock craze.

Once investors (or consumers) start getting rewarded for irrational behavior, there can be a compounding effect that perpetuates the mispricing.

When markets were less liquid, you had to be more thoughtful before committing capital because it wasn’t easy to get out if you made a mistake.

It also made it easier to correct a bubble. Smaller shocks would cause people to sell because the risk of potentially worse news in the future was too much to bear.

For example, the reason the mortgage bubble ended wasn’t that people refused to buy homes anymore because they were too expensive.

Rather, it was because housing related speculation in CDOs and other derivatives was a far less liquid market. Once liquidity dried up, the pricing of these assets crashed which, in turn, led to the decline in actual housing prices.

Since then, markets have become progressively more liquid, so there is even less need to bail at the first sign of bad news. This had led to a major change in behavior.

Greater Fool Theory

This leads to what I view as the biggest change in market behavior.

It is easier to make money by creating irrational prices and selling before they deflate than to invest based on fundamental analysis of the “proper” value.

In other words, the best way to profit is to assume there is always a greater fool that will come along.

And in today’s world of manipulable information and ample liquidity, it isn’t hard to find a greater fool.

There is no penalty to buying something that is crazy overvalued as long as a) it gets more overvalued in the short term and b) you sell before it stops being overvalued.

This applies not just to stocks, but to houses or private equity valuations or anything else you can flip.

(While less applicable in an operating role, it still applies when there is a time horizon issue. If I’m an underwriter worried about how my GL book will look in five or ten years, I will leave for another carrier before losses emerge. In this case, you assume your employer is the greater fool).

This is what allows prices to remain irrational for so long. Something has to come along to convince people there will no longer be a greater fool.

It’s similar to the famous Chuck Prince quote from the housing crisis of needing to dance while the music was playing. The difference now is the song is American Pie (8:37) rather than Blackbird (2:18).

Ramifications

You may be wondering how much this really affects you. If you are not participating in greater fool behavior, do you need to worry about this?

I’m afraid you do. When prices are detached from reality, it leads to inefficient capital allocation.

Deserving companies that may not have exciting narratives don’t get funded while worthless companies are able to raise a lot of capital.

Think about how much money was destroyed throwing dollars at useless insuretechs that could have gone to established insurers.

Instead of that capital being used to provide underpriced insurance, it could have gone to established insurers who might have sought profitable growth, which could have reduced some of the price increases we’ve seen across the industry in recent years.

Now, imagine how much capital has been destroyed in other sectors besides insurance.

All those inefficient decisions lower GDP growth, job creation, etc. So yes, it does affect you.

I don’t have easy solutions, but the first part of fixing a problem is to understand it.

We need to find ways to make it easier to verify correct information vs. misinformation and, arguably, things like free stock trading should go away.

There are probably other contributing factors I haven’t identified as well. But whatever the causes, there needs to be more focus (both in the private sector and from public policy) on how we can encourage more efficient allocation of capital.