Why ‘quacks’ and bubbles can so easily proliferate in financial markets


There are some valuations, like that of megacap technology stocks, that are breathtakingly high compared with historical levels and are hard for some to justify. There are other valuations, like that of recently bankrupt companies, or of a company that shares a name but is otherwise unrelated to a popular service, that defy any grounding in reality whatsoever.

So why are they appearing so often? Part of the answer lies in the incredibly accommodative conditions that central banks are providing — with zero interest rates and huge portfolios of government bonds — that make risk taking so rewarding on a relative basis.

But a new paper provides another explanation. It was co-written by Jean-Phillippe Bouchard, the chairman of French quantitative investment firm Capital Fund Management as well as a prolific researcher in both physics and finance.

The paper asks a simple question. Many aspects of our lives rely on the so-called wisdom of crowds — markets, of course, but also juries and parliaments. So why would anyone bother to engage in information seeking instead of free riding the majority opinion?

Without going into the model the researchers created, the short answer is to get an audience and prestige. “It leads to a kind of division of labor equilibrium: as they do not benefit from the wisdom of crowds effect, individual learners achieve lower accuracy, which is offset by the reward they get from being listened to. Such reward may be prestige, influence, or more concretely university positions, consulting fees, copyright, etc.,” they say. Studies have shown that people with atypical opinions were viewed as more likable, courageous and admirable.

That isn’t always good news. Financial markets are, as anyone can see, difficult to predict. Bouchard agrees with the famous economist Fischer Black, creator of the options pricing model that bears his name, who stated that an efficient market is one which the price is within a factor of two of its value. (That is, the price is either less than twice or more than half its true worth.)

“This is a situation where ‘quacks’ easily proliferate, since it is hard to distinguish them from genuine experts,” the researchers say. “In this case, the aggregation mechanism by which financial markets are supposed to reveal the ‘true’ fundamental price of firms may completely break down. Furthermore, a prevalence of followers that trade chronologically after informed traders can give rise to bubbles that further decouple market prices from ground truth.”

The buzz

The U.S. House of Representatives is expected to vote to impeach President Donald Trump for a second time after Vice President Mike Pence wrote to House Speaker Nancy Pelosi to say he would not invoke the 25th Amendment.

The U.S. coronavirus situation continues to be bleak — the 7-day averages of new cases and hospitalizations are at records, with 4,056 deaths on Tuesday alone, according to the COVID tracking project. The U.S. had administered the first vaccination to 9.33 million people, according to the Centers for Disease Control and Prevention, with the Trump administration due to issue new guidelines to expand vaccine eligibility to everyone over 65 years old.

Federal officials have been told pharmaceutical company Johnson & Johnson
might not be able to catch up to vaccine-production goals until the end of April, according to the New York Times. Australian scientists have cast doubt on the ability for the vaccine made by drug company AstraZeneca
and the University of Oxford to achieve herd immunity.

It’s a busy day on the U.S. economics calendar, with the release of consumer prices for December, the Beige Book, the federal budget statement for December, and speeches from Federal Reserve Gov. Lael Brainard, Vice Chair Richard Clarida, St. Louis Fed President James Bullard and Philadelphia Fed President Patrick Harker.

Builder KB Home
beat earnings expectations and reported a 42% increase in orders.

Installment-payment company Affirm is due to start trading, after it priced its initial public offering at $49 per share, raising $1.2 billion.

The markets

Markets are looking sluggish so far. U.S. stock futures

were a touch weaker, while gold futures
rose. The yield on the 10-year Treasury
was 1.12%.

The chart

Maybe fundamentals matter at least a little bit. Steven Bell, portfolio manager and chief economist for BMO Global Asset Management, in a presentation pointed out that the best-performing indexes had the best earnings growth, relative to expectations. More broadly, he expects stocks to outperform bonds and cash as the vaccinations get rolled out, and he expects U.S. equities to outperform.

Random reads

Sales of penny-farthings — those Victorian-era bikes with the giant wheels — have surged during the pandemic.

A dog collar made by a South Korean company claims it can discern a canine’s mood.

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