Play the Man, Not the Puck
Why did stock prices move so wildly in December? Why have they bounced back so sharply in January?
Explaining the historic movements of stock prices is difficult, as any financial journalist will tell you. Identifying and predicting the causes of future stock movements is even more difficult. Perhaps the only thing we can assert about markets with any confidence is that they are volatile, chaotic, and unpredictable.
But while markets might be unpredictable and ever changing, human behavior is often predictable. And since investors are—for the most part—human, it is perhaps a better strategy for those who wish to understand and beat the market to become students of investor psychology. The best course of action is, to quote an old hockey axiom, “play the man, not the puck.”
The new and exciting field of behavioral finance is constantly revealing new insights into how human nature shapes markets. One of the pioneers of the field, Andrei Shleifer, recently published a new book, A Crisis of Beliefs, that uses the financial crisis of 2008 to explore how human psychology interacts with markets. We discussed his research in our previous mailer on extrapolation bias, and this week we dive deeper into this important new book.
Shleifer argues that the seeds of crises are always planted in good economic times. During good times, investors become complacent, extrapolating from the recent past into the distant future and neglecting to focus on downside risk. Credit spreads decline, new debt issuance increases, lending standards fall, and investment and output soar. Shleifer argues that investors form a mental model of how markets work that simultaneously extrapolates good news and neglects tail risk.
Figure 1: Neglect of Risk & Extrapolation of Good News
Source: A Crisis of Beliefs
This excessive optimism and neglect of tail risk leads to excess lending. This excess lending leads to increasingly illiquid wealth. Then, when bad news reminds investors of the tail risk they’d neglected in the good times, they rush to sell their over-leveraged and illiquid positions, causing fire sales and crises.
What should investors take away from this research?
In good times, avoid investments that have clear signs of neglected risk, excessive lending, and increasing illiquidity. We believe private equity is one of today’s market’s greatest correlated mistakes.
Investors share a remarkable consensus optimism about private equity. Over 90% believe private equity will outperform public markets.
Figure 2: Neglected Risk in Private Equity
Source: Preqin
Private equity firms are borrowing ever more on the basis of that bullish thesis. The Federal Reserve warned about lending above 6x net debt/EBITDA after the last crisis, but today the majority of private equity deals are done with higher leverage levels.
Figure 3: Excess Lending in Private Equity
Source: Pitchbook
The leveraged equities private equity firms create through leveraged buyouts are increasingly illiquid. The majority of PE portfolio companies are now held more than 5 years – the most illiquid the asset class has ever been.
Figure 4: Illiquidity in Private Equity
Source: Hamilton Lane
All Shleifer’s ingredients of a crisis exist in private equity today. All that’s needed to reawaken investors and cause a panic is an event that reminds investors of the tail risk in these portfolios, say one large private equity fund blowing up.
Investors would be wise to be cautious in this overheated market and seek out areas where consensus, leverage, and illiquidity do not create such a toxic brew. The more attractive parts of the market should be ones where pessimism is high and there are willing sellers.
Shleifer uses survey data to prove his point. When credit spreads are low, expected future spreads are too low, and when the spread is high, the expected future spread is too high. The below chart shows historical spreads and forecast errors from investor surveys.
Figure 5: Predictable Errors in Forecasts of Credit Spreads
Source: A Crisis of Beliefs
Investors tend to err by being excessively optimistic in good times about assets with strong historic returns (e.g. private equity) and too bearish after recent frightening events (e.g. December's market sell-off). To earn excess return and avoid these predictable errors, investors need to take risks other investors do not want to take, to play the man, not the puck.