The Big Market Delusion

By LARRY SWEDROE

“Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper. To trace the history of the most prominent of these delusions is the object of the present pages. Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”
– Charles MacKay, “Extraordinary Popular Delusions and the Madness of Crowds“, 1841

Psychologists have long known that individuals allow themselves to be influenced by the herd mentality, or the “madness of crowds,” as Charles MacKay described it back in the 1840s. The herd mentality may be defined as a desire to be like others, to be part of the “action” or “scene.” This mentality manifests itself in the fashion world where, like the length of a skirt or the width of a tie, fashions seem to come into and go out of favour with no apparent reason. In his book “The Works of Henry Fielding,” the English novelist and playwright put it this way: “Fashion is the great governor of this world; it presides not only in matters of dress and amusement, but in law, physics, politics, religion, and all other things of the gravest kind; indeed, the wisest of men would be puzzled to give any better reason why particular forms in all these have been at certain times universally received, and at other times universally rejected, than that they were in or out of fashion.”

Unfortunately, when it comes to investing, perfectly rational people can be influenced by a herd mentality. The potential for large financial rewards plays on the human emotions of greed and envy as well as the fear of missing out (FOMO). In investing, as in fashion, fluctuations in attitudes often spread widely without any apparent logic. But whereas changing the length of a skirt or width of a tie won’t affect your net worth in any appreciable manner, allowing your investment decisions to be influenced by the madness of crowds can have a devastating impact on your financial statement—as investors in WeWork recently learned.

Investing, especially in speculative assets, has become much more of a social activity over the past 20 years. The dramatic growth of investment clubs and the proliferation of internet chat boards is supporting evidence. Today, investors often spend many of their nonworking hours online, reading, discussing, or simply gossiping about their investments. Of course, they discuss their successes with far greater frequency than they do their losses—contrary to the cliché that misery loves company. How can investment “fashions,” or the madness of crowds, be destructive to your financial health? Let’s see.

Influenced by the herd, investors start betting huge sums on investments they know little or nothing about (perhaps can’t even spell) or would not even have previously considered. If a particular madness lasts long enough, even conservative investors may abandon long-held beliefs—feeling they have missed out on what the crowd deems “easy money” or a sure thing. They forget basic principles such as risk and reward and the value of diversification. This is the “Uncle Jim syndrome”—“If Uncle Jim can make all that money owning Google, Amazon, Netflix and Tesla, why can’t I? I’m at least as smart as he is.”

While it doesn’t happen often, perhaps once every generation or so (just long enough for people to forget the last bubble and for a new generation of “suckers” to come of investment age), bubbles seem to appear with regularity. We are all familiar with the dot-com debacle, but that bubble was not unique. For example, in the 1960s we had a “tronics” bubble, when any stock with “tronics” as a suffix soared to heights never imagined. There have been enough manias that several wonderful books have been written on the subject. To avoid repeating mistakes of the past, consider reading Robert Shiller’s “Irrational Exuberance,” Edward Chancellor’s “Devil Take the Hindmost,” and Charles MacKay’s “Extraordinary Popular Delusions and the Madness of Crowds.” MacKay’s book is particularly noteworthy as it was written in 1841—proving that while fashions change, human behaviour doesn’t.

Since fashions affect social behaviour, is it not logical to believe that they affect investment behaviour as well? In his book, Shiller makes the strong case that mass psychology may at times be the dominant cause of stock price movements. While the market is very rational over the long term, for short periods it can become quite irrational. The madness of crowds takes over and a new “conventional wisdom” is quickly formed. MacKay put it this way: “Every age has its peculiar folly: some scheme, project, or fantasy into which it plunges, spurred on by the love of gain, the necessity of excitement, or the force of imitation.” Sir Isaac Newton was reported to have said about the investment mania of his day, the South Seas Company, “I can calculate the motions of heavenly bodies, but not the madness of people.”

Shiller argued that “Anyone taken as an individual is tolerably sensible and reasonable—as a member of a crowd, he at once becomes a blockhead.” In mass, blockheads can play a major role in the stock market. What are known as positive feedback loops lead to self-fulfilling prophecies—in the short term. Buying attracts more buying, and prices go up simply because they are going up. Buoyed by rising prices, investors become more confident, enticing more money into the market—helping to explain the well-documented momentum factor. Like a Ponzi scheme, the strategy works until it doesn’t. Herding can create bubbles and, unfortunately, the devastating impact that results from the bursting of those bubbles.

Bradford Cornell and Aswath Damodaran contribute to our understanding of how manias (excessive valuations) develop with their December 2019 paper “The Big Market Delusion: Valuation and Investment Implications.” They began by noting: “There is nothing more exciting for a nascent business than the perceived presence of a big market for its products and services, and the allure is easy to understand. In the minds of entrepreneurs in these markets, big markets offer the promise of easily scalable revenues, which if coupled with profitability, can translate into large profits and high valuations.” They cited Uber as an example, noting that its market value exploded because it was billed not as a global ridesharing company but as a logistics company with the potential to capture a share of a gigantic market, which could easily be worth tens of billions of dollars.

They then examined how the “big market promise” affects business formation and financing. Their focus is on the role that enthusiasm about the prospects for dramatic growth leads to collective overpricing of companies in big markets. The overpricing can persist because of limits to arbitrage, the high costs and fear of unlimited losses from shorting, and the risk that an overly optimistic acquirer might step in and buy a new company and work to prevent sophisticated investors from correcting mispricings, allowing them to persist and bubbles to develop. Eventually, the divergence between price and value, reflecting a more realistic assessment of the earnings that the big market can deliver, eventually leads to a correction.

The delusion

Cornell and Damodaran noted that for a business to succeed in a big market, “a whole host of other pieces have to fall into place.”

The company must be able to capture a reasonable share of that big market, a task that can be made difficult if the market is splintered, localised or intensely competitive.
The company has to be able to generate profits in that big market and create value from that growth, also a function of the firm’s competitive advantages and market pricing constraints.
Once profitable, the company has to be able to keep new entrants out.

Thus, they concluded: “It is therefore dangerous to base an argument for investing in a company and assigning it high value based on enthusiasm for the size of the market that it serves, but that danger does not seem [to] stop analysts and investors from doing so.” A problem is that many entrepreneurs also see the same opportunity. And they are just as overconfident that they will be the ones to succeed. In addition, they each find a venture capitalist who is just as overconfident and thus willing to provide funding. While 75 percent of all new businesses fail within the first five years, a study of about 3,000 entrepreneurs found that 81 percent believed that their chance of success was at least 70 percent, and a third of the sample felt that success was guaranteed. The result is that “the market will become more crowded and competitive over time with new entrants being drawn in because of the perceived growth potential associated with the big market. Thus, while revenue growth in the aggregate may confirm that the market is big, the revenue growth at firms collectively will fall below expectations and operating margins will be lower than expected because each of the individual firms overestimated its own prospects.”

Eventually, some or many of the participants would recognise the gap between reality and expectations, and entrants would fold and aggregate pricing drop. However, Cornell and Damodaran noted that “despite the shortfall in the aggregate, there will be a few big winners and these big winners will fuel the cycle of enthusiasm for the next big market.” They hypothesised that the size of the gap between perception and reality is determined by four factors:

The Degree of Overconfidence: The greater the overconfidence exhibited by entrepreneurs and investors in their own products and investment abilities, the greater will be the overpricing. While both groups are predisposed to overconfidence, that overconfidence tends to increase with success in the market—the longer a market boom lasts in a business space, the larger the overpricing will tend to become.
The size of the market: As the target market gets bigger, it is more likely to attract added entrants, and the collective overpricing will increase.
Uncertainty: The more uncertainty there is about business models and the ability to convert them into revenues, the more overconfidence will skew the numbers, leading to greater overpricing in the market.
Winner-take-all markets: The overpricing will be greater in markets where there are global networking benefits (i.e., growth feeds on itself) and winners can walk away with dominant market shares.

Cornell and Damodaran presented three case studies to support their thesis: one where the process has almost fully played out (dot-com retail from the 1990s), one where it has been unfolding for a while, online advertising (think Facebook and Google), and a third, the cannabis market, where it is just beginning.

They related the cycle of the dot-com retailers by noting that the Bloomberg U.S. Internet Index was initiated on December 31, 1998, with 100 young internet companies. It rose 250 percent the following year, reaching a peak market capitalisation of $2.9 trillion in early 2000. By November 2000, the Bloomberg index had lost about 70 percent. By 2003, the index had lost 93 percent of its value, and Bloomberg stopped computing it. Of the dozens of publicly traded retail companies in existence in March 2000, more than two-thirds failed. Even those that survived, like Amazon, faced carnage, losing 90 percent of their value and flirting with the possibility of shutting down.

Cornell and Damodaran then provided detailed analysis on the online advertising industry and related how the same pattern followed. They noted that there “are signs that the market has moderated since 2015, with the number of companies shrinking, as some were acquired, some failed, and a few consolidated.” They cited the case of Twitter, whose stock is down almost 40 percent from November 2015 because of the perception that its pathways to profitability are rocky.

The third case analysed the cannabis industry, another big market opportunity with lots of cannabis users who are willing to spend large dollars on the product. Add to that the favourable changes in legislation. In October 2018, the excitement over the big market opportunity was so great that one company, Tilray, had a market cap of $13 billion when its sales were just $28 million. Others had similar multiples, with the collective market cap approaching $50 billion.

Cornell and Damodaran noted that, as is typically the case with big market stories, “for each company, the high market capitalisation relative to any measure of fundamental value was justified using the same rationale, namely that the cannabis market was big, allowing for huge potential growth. While that argument has some basis, the fundamental valuation question is whether the collective market, at least as it existed in October 2018 was large enough to sustain the collective market capitalisation of all the existing companies and expected entrants.”

One year later, “the assumptions regarding growth and profitability were being universally scaled back, business models were being questioned, and investors were reassessing the pricing of these companies.” The result was a loss of 50 percent in market cap, with Tilray dropping by more than 80 percent.

Warning

Cornell and Damodaran warn investors that these cases are not unusual. They cited as other current examples artificial intelligence, meatless meat, office leasing, rental housing, ridesharing, fintech (financial technology) and video streaming—“all these new markets that are predicted to ‘huge’ by the new companies entering these spaces. Furthermore, investors are bidding up prices dramatically based on the alleged potential of these new markets.” They warn investors to watch for these patterns:

Big market stories: In every big market delusion, the shared feature is that markets are huge.
Blindness to competition: When the big market delusion is in force, entrepreneurs, managers and investors generally downplay existing competition, failing to factor in the reality that growth will have to be shared with both existing and potential new entrants.
All about growth: When enthusiasm about growth is at its peak, companies focus on growth, often putting business models aside or even ignoring them completely.
Disconnect from fundamentals: If you combine a focus on growth as the basis for pricing with an absence of concern at these companies about business models, you get pricing that is disconnected from the fundamentals.

While there are similarities, Cornell and Damodaran noted that “there are also differences in how these markets correct. For instance, the dot com bubble hit a wall in March 2000 and burst in a few months, as public markets corrected first, followed by private markets. The online advertising run-up has moderated much more gradually over a few years, and if that trend continues, the correction in this market may be smooth enough that investors will not call it a correction. With cannabis stocks, the rise and fall were both precipitous, with the stocks tripling over a few months and losing that rise in the next few months. In all three cases, the most difficult variable to pinpoint is what caused the correction to occur at the time that it did.”

Summary

Cornell and Damodaran concluded: “The big market delusion is driven by bias in the selection of people who become entrepreneurs and venture capitalists. Overconfident in their own abilities, entrepreneurs and venture capitalists are naturally drawn to big markets which offer companies the possibility of huge valuations if they can effectively exploit them. And there are always examples of a few immense successes, like Amazon, to fuel the fire.” These factors lead to the big market delusion, they continued, “in too many new companies being founded to take advantage of big markets, each company being overpriced by its cluster of founders and venture capitalists. This overconfidence then feeds into public markets, where investors get their cues on price and relevant metrics from private market investors, leading to inflated values in those markets. This results in eventual corrections as the evidence accumulates that growth has to be shared and profitability may be difficult to achieve in a competitive environment.”

Overconfidence is an all-too-human trait. In fact, Nobel Prize-winning economist Daniel Kahneman called overconfidence “the most significant of the cognitive biases.” Given the odds against creating a successful business (about 4:1), one could argue that to even be an entrepreneur, or a venture capitalist for that matter, you have to be overconfident! And overconfidence seems to be the explanation for the big market delusion. Forewarned is forearmed.