Investing in irrational markets

Source: Hock's Viewpoint - By Choong Khuat Hock
http://biz.thestar.com.my/news/story.asp?file=/2010/1/18/business/5475313&sec=business

The financial crisis reflects the fallacy of the ‘efficient market hypothesis’

IT is amazing that economic theories still consider that markets are governed by the “efficient market hypothesis” (EMH), which assumes rational investors, an orderly market and that all available information are known.

The global financial crisis reflects the fallacy of EMH and textbooks should be revised to reflect this.

In reality, markets reflect the nature of its creators and participants – a collection of human beings who would like to think they are rational but are often enough irrational and emotional.

Quantitative models often fail to model the irrationality of human behaviour during extreme times.

Blind reliance on such models was also the reason why Long-Term Capital Management (LTCM, which had Nobel Prize-winning economists) failed as the restructuring of defaulting bonds in Russia in 1998 caused volatilities beyond what was predicted by quant models.

The extremely high leverage utilised by LTCM hastened its demise. Alan Greenspan had to engineer a rescue as the failure of LTCM threatened to damage the markets and market participants.

One way of valuing securities is to use the discounted cash flow model, which is to discount the expected future cash flows to obtain the present value.

However, in many cases, future cash flows are difficult to predict and the discount rate used would fluctuate depending on the prevailing interest rates and the perception of risk which may vary from person to person.

This method is more useful in valuing businesses or securities with predictable cash flows like utility stocks where cash flows are stable and funding costs have been determined. Another popular valuation method is to compare securities with its peers.

Such comparisons are ingrained in the nature of human beings as we can only determine the value or utility of something by comparing it to another. Shall I buy the latest Samsung or Sony LCD TV? How does a BlackBerry compare with an iPhone?

Similarly, if the price-earnings ratio (PER) of a stock is 10 times and the sector PER is 20 times, it may be considered cheap if specific company factors are attractive.

Using sector PER as valuation anchor is fraught with danger as the sector valuation may be unreasonable.

Such comparisons may not reflect the value of potential cash flows from an investment. At the height of the dot.com bubble, valuations were based on price to sales with no consideration placed on cash flow.

The prevailing belief then was that there was a sucker willing to pay a higher price to sales for the business.

The same happened during the debt fueled property bubble in the US when rental yields from property could not cover mortgage payments.

Banks were willing to provide 100% financing to those who could not afford houses based on the assumption that property prices could only go up and mortgage loans could be repackaged into much sought after high yielding subprime securities.

Behavioural finance has many theories to explain why humans are often irrational but the reality is that irrationality is hardwired into our brains.

The brain can be divided into two parts – the hypothalamus, or primal brain, (a few hundred million years old) which directs our instinctive behaviour and the neo-cortex, or new brain, (a few million years old) which facilitates logical deductions, learning from experience, language and complex social interactions.

In times of panic, the hypothalamus takes over and markets tend to overshoot on the downside due to panic selling.

Since these moves are often irrational, the movements tend to be many standard deviations more than what is predicted by a normal distribution curve, creating black swan events.

Faced with an avalanche of incomplete information, humans use heuristics, a simplification process to arrive at a decision based on their past experiences and prejudices.

In arriving at a rule of thumb valuation, anchoring is employed by imputing a fair value to the initial entry level even if the entry level is high.

Therefore, in a rising property market, anchoring may result in the belief that the price appreciation will continue.

A bubble can thus form as the herd is blinded by cognitive dissonance whereby investors pay credence only to views and opinions that reinforce their beliefs. However when the discrepancy between fantasy and reality becomes too large, the bubble bursts.

Investment is hence as much an art as it is science. In the final analysis, it is the cash flow that counts.

The science would be in accurately determining the cash flow but the art lies in determining how much investors are willing to pay for the cash flows.

Identifying periods of over pessimism and optimism would help in determining entry and exit points.

In the end, the advantage lies in accurately predicting beforehand where the herd is heading. Understanding the animal in you and others could indeed be a profitableproposition.

Choong Khuat Hock is head of research at Kumpulan Sentiasa Cemerlang Sdn Bhd.