At one time or another, we’ve all had this experience: You’re driving on the highway when, all of a sudden, a maniac goes speeding by, weaving in and out of lanes. Most people have the same reaction when this sort of thing happens: “That guy is crazy,” they think to themselves. “If he doesn’t slow down, someone’s going to get hurt.”
But suppose that an observer responded instead: “That fellow’s speed is perfectly appropriate. Nothing at all wrong with it.” Now you might think it’s the observer who’s the crazy one.
That, in a nutshell, describes the viewpoint of Eugene Fama, an economist who won the Nobel Prize for his work developing a concept known as the Efficient Markets Hypothesis (EMH). If you’re not familiar with it, EMH postulates that stock prices are rational because they reflect all publicly-available information about the underlying company.
Supporters of EMH like to point to the case of the Challenger Space Shuttle, which in 1986 experienced a catastrophic failure shortly after it launched. In that case, investors somehow figured out almost instantaneously which of the companies that had worked on the Challenger was most likely at fault for the disaster and drove its stock down within hours. And after a months-long investigation, investors’ instantaneous judgement was proven correct. To EMH adherents, this is a picture perfect illustration of why, in their view, stock prices, at any given time, accurately reflect the value of a company.
And this is why Fama is skeptical of stock market bubbles. He allows that sometimes investors make mistakes and allow the price of isolated stocks to get out of whack. But Fama rejects the idea that the stock market, broadly speaking, can ever be characterized as too high. That’s because he believes so strongly in informational efficiency and investor rationality.
Now 81, Fama continues to defend this view despite the rise of behavioral finance, which argues that stock prices are driven by human beings, who are only sometimes rational but are, more often than not, very emotional. Fama, in fact, goes as far as to say, “there is no such thing as behavioral finance. Essentially, it’s just a criticism of efficient markets.” Unfortunately, in his rejection of the human element in driving stock prices, Fama is a little bit like the ancients who believed—despite growing evidence—that the Earth was flat.
Who am I to criticize one of the most well known people in finance, a winner of academia’s most prestigious prize? The reason I’m so critical is precisely because of his status in the investment world. It is, I believe, not responsible to be reinforcing the view that stock prices are, at all times, rational and not urging caution when caution is warranted. In Fama’s words, “Almost all investors should regard markets as efficient for their own investment decisions.” He continues with this declarative statement: “If they do that, they will be better off in the long-term.”
In other words, Fama is saying, don’t worry about the price you pay for an investment because it is, by definition, correct. In my view, this is just crazy. Consider a few of the examples we’ve seen just this year:
- Tesla’s shares are, of course, up more than 700% and in a class of their own. But it’s not just Tesla. The P/E ratio on Apple’s stock has risen by 75%, from about 17 to more than 30.
- Bitcoin has tripled in price, despite lacking any tangible basis for valuation.
- Initial public offerings of special purpose acquisition companies (SPACs), also known as “blank check companies,” have quadrupled from last year.
- In a throwback to 1999, barely-profitable technology companies are going public. Since its debut in October, Palantir Technologies (PLTR) has seen its price run up 174%.
In other words, broad segments of the market have become unhinged from reality. And this isn’t a new phenomenon. Individual stocks, and sometimes the entire market, often get carried away. Despite Professor Fama’s assertion that prices are rational, the reality is that markets are often driven by stories, momentum, greed, fear, euphoria—and, among those late to the party, a fear of missing out.
Professor Fama’s view is that, if they even exist, bubbles can only be recognized with the benefit of hindsight. And he derides those who even attempt to spot bubbles: “Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them.”
I’m the first to say that market forecasting is difficult. But I also think that’s a little too glib. When you see things that look like market excesses, I would instead recommend this more balanced approach:
- Stand clear. Fear of missing out is a powerful force, and it’s exacerbated when the media runs stories like the one about Brandon Smith, who became a millionaire by plowing his entire life’s savings into Tesla.
- Stay the course. I don’t recommend jumping on the Tesla bandwagon—but I would be equally careful of going to the other extreme. If today’s market has you worried, avoid the temptation to sell—or to sell everything. Instead, just take the opportunity to judiciously rebalance back to your asset allocation targets.
- Don’t overstay the party. If you did jump on the bandwagon of one of this year’s hot investments and are now sitting on big profits, that’s great. But I wouldn’t do what Brandon Smith is doing, which is to stay 100% invested in Tesla. Instead, I’d develop a framework for selling so that these gains don’t slip through your fingers. You could, for example, sell half of your shares now, then sell more on a fixed schedule—once a month, for example. Or you could tie the size of your sales to the share price, selling more as the price rises. But whatever you do, don’t take Professor Fama’s word as gospel. If a stock price looks too good to be true, it probably is.