Hoary Fools: Profiting From Predictable Investor Sentiment
By Jesse Czelusta (from the October 2006 issue of Index Rx)
Seven years ago, we sold the very first issue of Index Rx by touting our plan as an "idea whose time has come." We were wrong. Our idea was actually seven years ahead of its time.
Or 285 years behind.
According to a paper* in the world's leading journal of economics, the idea of profiting from "predictable investor sentiment" was successfully implemented as far back as 1720. In "Riding the South Sea Bubble," eminent economic historians Peter Temin (of the Massachusetts Institute of Technology) and Hans-Joachim Voth (of the University of Pompeu Fabra) tell a story that will sound eerily familiar to Index Rx subscribers. Their tale goes something like this:
In England in early 1720, the South Sea Company launched a novel scheme that would send its shares to dizzy heights. The Company's plan was simple--to issue and exchange its own shares for theretofore illiquid forms of government debt that traded at substantial discounts. This gave holders of government debts a means of liquidating their holdings, the British Government a way to reduce its debt payments, and the South Sea Company a thriving business where none had existed. This Ponzi-esque scheme led to one of the most infamous episodes in financial history--the so-called "South Sea Bubble."
The Company's shares soared over the course of that summer. Citizens, nobles, businessmen, and government officials scrambled to purchase South Sea stock. Were investors aware that a bubble was forming? Most previous evidence would suggest that they were not. Temin and Voth reference "numerous accounts of frenzy and mania, of deluded maids and pensioners investing their hard-earned pennies;" and also of "eighteenth-century…equivalents of modern-day analysts, working hard to convince investors that there was only one direction for shares: up."
Analysts being what they are, it is no surprise that South Sea shares were plummeting to the ground along with the autumn leaves.
Yet there were many who seemed well aware that a bubble was present. The instructions of the Duchess of Rutland to her broker are indicative: "'bye as much as theat will bye today, and sell it out agane next week, for tho I have no oppinion of the South Sea to contineue in it I am almost certine thus to mack sum litell advantage.'"
Enter Temin and Voth's main character. Throughout the course of the South Sea episode, one well-informed investor managed to consistently beat the market by investing in the overvalued stock of the South Sea Company. Hoare's Bank, "a fledgling West End London banker, knew that a bubble was in progress and nonetheless invested in the stock." The partners of the bank netted a handsome return in the process, earning more during the bubble then they had in the previous two decades combined.
An efficient markets theorist might argue that such an outcome is possible, even expected, given that probability distributions are as likely as dogs to have tails. By definition, someone will always beat the market, and someone else will always lose to the market. People get lucky or unlucky. Yet Hoare's own ledgers point to a more intriguing explanation. Using a new data set provided courtesy of Henry Hoare, a living descendant of the original bank owners, Temin and Voth show that frequent and repeated profitable decisions of Hoare's Bank were by no means the result of chance.
Instead, Hoare's was using its knowledge of investor sentiment to "ride the bubble."
Hoare's knew that South Sea shares were overvalued. The amount of South Sea stock that the company required as collateral for a given loan amount rose dramatically along with the share price. Hoare's was well aware that the stock was headed for a fall.
And yet the bank itself continued to actively trade South Sea shares. On average, the stock rose substantially in the periods following Hoare's purchases and fell during the periods following Hoare's sales. The bottom line was a hefty pile of British pounds in the pockets of Hoare's partners.
Thus, it seems that this little London bank was poking holes in efficient markets theory more than two and one-half centuries before the theory was even born. "Sophisticated investors understood shares to be overvalued and (yet) expectations of 'greater fools' buying later were key for the success of firms like Hoare's."
So perhaps the editors of this humble publication are neither as crazy nor as revolutionary as our critics might argue. It seems that we have merely been following in the steps of those who have profitably gone before.
During the tech bubble of the late 1990's, both of the editors of Index Rx were relatively certain that the entire stock market was overvalued and headed for a downturn. Yet we continued to invest in shares. Why?
Because we know that our opinion doesn't move stock prices. Our goal is merely to do what everyone else does before most of them do it. Using our proprietary pattern spotting models, we've been doing this successfully for the last seven years. Like that of Hoare's, our strategy "did not avoid all of the sharp declines, nor did it always reap the full benefit of large price increases." But the market has eaten so much of our dust in the past seven years (see page 5) that I can hear Wall Street's hacking cough all the way from here in California.
And how did Hoare's do it? I recently had the opportunity to ask Professor Voth this very question. His answer, though disappointing, was rather quaint and charming. His best guess is that the partners of Hoare's, given their central location amidst the back alleys of London's financial district, were somehow able to track the tides of investor sentiment by looking to the foot traffic outside their windows.
Dynamic Indexing is not exactly a window looking out upon footsteps in the mud and blood of today's financial markets. Then again, in a metaphorical sense, that's precisely what it is.
Regardless of why predictable investor sentiment exists, here's a tip that will serve as well over the next seven years as it has over the past seven: Follow the age-old lead of Hoare's by following our portfolios' prescriptions. You are "'almost certine thus to mack sum litell advantage.'"
(Only seven years old and what hoary fools we are!)
*Temin, Peter and Joachim Voth. 2005. "'Riding the South Sea Bubble," American Economic Review, vol. 95.