In Part 1 of this series, I set the stage for a discussion of behavioral finance and game theory as they pertain to how market participants behave. In Part 2, I expand upon some of ways that individuals and institutions behave in ways that can be explored from this perspective.
Giving People What They Want
One of the most striking features of the capital markets of the recent year or two has been the ‘Las Vegas’ feeling to much of the action in the markets. There has been tremendous excitement around IPOs of companies including Zynga (ZNGA), Groupon (GRPN), and most notably Facebook (FB). The hoopla around the Facebook IPO, in particular, is without precedent. Why do the financial media and corporate management work together to create this frenzy? The answer is simple: people buy it. If investors ignored the carnival atmosphere around these firms, we wouldn’t see this kind of media. If people say that they want to invest in solid well-run profitable firms, but clearly signal that what they are actually buying is shares in IPOs of companies with enormous dreams but untested business models, we know what Wall Street will provide. If investors seem to be seeking investments that behave like lottery tickets, it is perfectly rational for venture capitalists to fund such companies and to rapidly take them public. I view the marketing of Facebook’s IPO as perfectly executed to exploit behavioral biases. I am not a conspiracy theorist, but even the trading delay on the day of the IPO helped to bring the frenzy to own shares to a fever pitch. The Facebook IPO and others like it suggest that Wall Street is very effectively playing a game that many investors do not really understand. Continue reading →
Watching the market this year has been like observing an exercise in game theory and behavioral finance, and the two fields are closely related. Game theory is the study of how a rational person makes decisions in uncertain situations. As the name suggests, game theory was developed with the intent of developing optimal strategies in games in which chance or the decisions of an opponent play a role in your outcome. Game theory focuses on how rational players can make the best decisions to maximize their satisfaction. Behavioral finance adds the nuance that, in real life, people do not necessarily have all available information and, even if they do, they often make decisions that are inconsistent with those made by a perfectly-rational and fully-informed decision maker. Continue reading →
Today, the yields on ten-year Treasury bonds are at a fifty-year low, and no period prior to the last few years reflects yields that even come close. From 1962 to 2005, the lowest the 10-year Treasury bond yield ever got to was just below 4%, more than twice the current yield.
The chart below shows how unusual our current environment is. The vertical axis is the yield from 10-year Treasury Bonds and the horizontal axis is time and we are looking at a period from 1962 to present. From 1980 to today, we have seen the yield of 10-year Treasury bonds go from about 12% per year to below 2%. The 10-year Treasury yield is considered a benchmark measure of bond yield and interest rates. The Fed funds rate and the 10-year bond yield are very closely tied to one another. For another illustration of how interest rates, the Fed funds rate and 10-year bond yield are related, see here. Continue reading →
The stocks of companies that produce and distribute alcoholic beverages have dramatically out-performed the broader market both in recent years. There are many factors that can lead to the relative out-performance of one sector. Surprisingly, however, so-called ‘sin stocks,’ including those of companies that produce and distribute alcohol, have a long history of delivering high returns to investors. Sin stocks tend to fall into the ‘value’ category, but even after accounting for the well-known value premium, a 2005 study, titled The Price of Sin: Effects of Social Norms on Markets, found that ‘sin stocks’ provide additional returns that cannot be explained by the value premium alone. The study finds that this out-performance is both substantial and statistically significant. The Folio Investing Wine, Beer, and Spirits Folio demonstrates that this out-performance has persisted in recent years, too. Continue reading →
A new article in Knowledge@Wharton highlights a body of research that suggests that the universe of public companies is very different than in the past. There are, for example, 44% fewer publicly-listed companies on U.S. exchanges than there were only fifteen years ago. The Wharton article is a review of a range of work, including both experts who believe that we are seeing a decline in the role and significance of public firms and those who conclude that we are seeing a natural part of the business cycle. In the late 90’s, it seemed as though every small company, with or without a proven product of earnings, was rushing to cash in on IPO fever. Many of these companies subsequently failed. Today, after a decade of weak market performance and with individual investors increasingly skeptical of the stock market, it is not surprising that fewer firms are going public. The Wharton article also cites increased oversight and regulation of public companies as encouraging firms to remain private. Continue reading →
The market rally of the past twelve months may appear somewhat baffling in light of the fact that individual investors have been pulling money out of the market. The S&P 500 is up 22.5% in the last year, while September marks the 17th consecutive month during which investors took money out of equity mutual funds. The outflows from equity mutual funds are not simply due to investors moving from mutual funds to ETFs. A recent analysis by Bianco Research demonstrates that including ETF flows does not change the results. Continue reading →
Real Estate Investment Trusts (REITs) are companies that own and, typically, manage real estate investments to generate income. REITs may also invest in mortgage securities (these are called mortgage REITs or mREITs). REITs may specialize in specific types of properties. The Folio Investing Retail REIT Folio holds equal-weight allocations to the largest publicly-listed REITs that own and manage shopping centers, outlet malls, and urban retail property. Retail stores lease space from the REITs and the leases are the primary source of income. Continue reading →
Guest post by Contributing Editor, Robert P. Seawright, Chief Investment and Information Officer for Madison Avenue Securities.
Tom Stoppard’s Rosencrantz and Guildenstern are Dead presents Shakespeare’s Hamlet from the bewildered point of view of two of the Bard’s bit players, the comically indistinguishable nobodies who become headliners in Stoppard’s play. The play opens before our heroes have even joined the action in Shakespeare’s epic. They have been “sent for” and are marking time by flipping coins and getting heads each time (the opening clip from the movie version is shown above). Guildenstern keeps tossing coins and Rosencrantz keeps pocketing them. Significantly, Guildenstern is less concerned with his losses than in puzzling out what the defiance of the odds says about chance and fate. “A weaker man might be moved to re-examine his faith, if in nothing else at least in the law of probability.” Continue reading →
Bob Huebscher just published an outstanding article on the sustained high level of unemployment in the United States. The question that he seeks to address is whether we are in the recovery phase of a major recession or we are actually in the midst of a long-term shift in the economy. The article calls these two possible explanations ‘cyclical’ and ‘structural.’ It is worth understanding the key factors that have resulted in the current persistent unemployment levels in order to put the recent modest reduction in unemployment into context. Are we seeing signs of the long-awaited recovery that will bring us back to full employment or is the recent growth in employment simply variability around a long-term shift in the U.S. economy in which unemployment will remain well-above historical levels? Continue reading →
The telecommunications industry is evolving quickly. Recent data suggests, for example, that half of all adults in the United States have a tablet or smartphone. There are many countries that have an average of more than one cell phone line per person. In the developing economies, cell phones have allowed much broader access to voice and data services than would have been possible if the traditional fixed-line infrastructure needed to be built. Ten years ago, Nigeria had only 100,000 phone lines. Today, Nigeria has 100 Million cell phone accounts. The ways that people use telecommunications are also expanding. For people with little or no access to banking, mobile money services can provide the essential roles of banking. The continued convergence of banking with telecommunications has substantial implications for both. Continue reading →