Nostradoofus

As the thrill of the chase has returned to Silicon Valley, every VC and hopeful entrepreneur is chasing a new version of the old dream: a winner-take-all web community.

This pursuit, now called Web 2.0, has all the things business school taught you to love: network effects, first-mover advantage, etc. And again, the signals of excess have appeared.

First is an abrupt 50% rise in professional fees among top providers in the Valley. An attorney I know there now charges more than $600 per hour — more than I paid my entire team (14 people, half programmers, all U.S.-based) in 2000, the peak of the bubble.

The second signal is that, in the effort to leave no stone unturned, VCs are examining some pretty crazy community ideas. Take, for example, the idea of community-monitored stock investment ideas.

Huh? Think about this for just two seconds. Successful stock picking means finding an idea and quietly investing ahead of the crowd. A stock picking community would collect ideas from the crowd, and let the crowd vote on them — in short, exactly what the markets already do. No edge to be gained there.

“What is the value per hour of what I’m doing at this moment?”

“Value” doesn’t necessarily mean money. The point is that, beyond financial planning, return on investment is an organizing principle.

When you are able to answer the above question accurately at any time during your workday, you understand time management deeply. You know which parts of your day generate most of the value — often ten, a hundred, even a thousand times the value of your least valuable moments.

I said “accurately,” not “precisely.” Precision doesn’t matter. Nor do the units on your yardstick: they can be dollars, fun, self-improvement — whatever is important.

Armed with this knowledge, changes automatically suggest themselves. If, at that point, you are still busy, it’s generally by choice.

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Mr. Bogle, don’t take this the wrong way. Index funds are a great invention: they are simple, tax efficient, perform well, and push down investment management fees generally. All of these things benefit individual investors.

“Parasite” refers only to the fact that index funds benefit from market efficiency, while providing none.

Index funds track an overall market index by maintaining an appropriately weighted portfolio that mirrors the index. This performs well by riding the rising tide of the general stock market at very low cost.

But imagine if all equity capital were invested through index funds. Then index funds would comprise the entire market. No mechanism would exist for buying stocks below intrinsic value, and selling above intrinsic value. Markets would not be efficient, and stocks would follow a path that bore no relationship to value.

That imaginary situation cannot occur, because in the real world, “value arbitrageurs” always step in to restore market efficiency. But the fact is that index funds are nonmarket entities. Realistically, as index funds take an ever larger fraction of total market capitalization, a market distortion might begin to appear in the form of increased volatility.

Investors extrapolate. Thus, when markets have gone up recently, they pile into index funds, which then automatically buy stocks without regard to price. If this is done in sufficient volume, stock prices generally will rise to historically unusual price/earnings ratios. This creates a self-reinforcing state: rising stocks cause rising index investments, which cause rising stocks.

But individual investors also fear loss more than they desire gain. Thus, when a general market decline begins, redemptions accelerate. If index funds accounted for a large percentage of all stocks, and if price-earnings ratios were at historically high levels, then such a decline/redemption cycle could also be self-reinforcing. “Self-reinforcing decline/redemption cycle” is a very polite way of describing a market crash.

But that can’t happen, the efficient market theorist might argue, because the remaining non-index investors will simply arbitrage all that out, restoring efficient pricing. OK, let’s assume the theorist is right there. In that situation, who makes all the money? Hint: it’s not the index fund investor. Suddenly, they are on the wrong side of the efficiency equation. The arbitrageur makes the money by betting against the blind money going into or out of the market.

Thus it seems two things are true. First, index funds cannot grow past a certain point without ceasing to perform as they have. The change seems likely to emerge not as lower total returns, but rather as much higher volatility.

Second, for index funds to work, a mechanism of market efficiency must exist in the form of managed investments. That role might be small — perhaps only 10% of total market capitalization — but it must exist. And the larger the fraction of total capital under index fund management, the greater and more likely the distortion, and thus the higher the potential returns to traditional managed investments would become.

Thus, in the long run, index funds may actually benefit the few that remain as traditional investment managers.
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Computer-driven stock selection began in the late 1960s, most notably with Ed Thorp’s firm, Convertible Hedge Associates. Thorp applied information theory principles to portfolio allocation, and sought simple convergence plays, e.g. warrants underpriced relative to underlying stock.

The 1970s were a heyday for such strategies. Small but systematic market inefficiencies lurked everywhere. Computers were not widely available, so the few who had access and capability were at an advantage.

By the mid-1990s, most such opportunities had been competed away as understanding became widespread. But the democratization of data and computation was not finished.

By 2000, a small fund could afford fundamental and other data from specialized services like Compustat ($12,000/yr).

By 2002, an individual could obtain reasonably accurate U.S. company and stock data from free services like MSN Money. One could also filter the data set for free, to find all companies fitting a particular profile.

In 2006, these capabilities were spreading to worldwide markets, beginning with London.

It’s reasonable to assume that, very soon, investment managers will have no information advantage in terms of data and screening capability. It will all be instant and free, for everyone.

What’s left? Plenty. As always, strategy — defined as the profit that remains when your competitors execute perfectly — provides the direction.

Financial industry structure always forces a short-term bias. Because clients can pull their money out any time, there is irresistible pressure for investment managers to focus on short-term gain. This is a competitive inflexibility shared by almost the entire investment management industry. As a result, long-term strategies are likely to retain a larger advantage, for longer, than any other strategy.

Short-term bias forces non-fundamental strategies. When a fund manager is under pressure to hang onto clients by delivering an extra 100 basis points this month, he has no time to wait for intrinsic value to be recognized. That can take months or years, and he’ll be fired or out of business by then. So his effort inevitably goes to strategies that attempt non-fundamental strategies, those that try to guess short-term price movements. Individual investors tend to do the same, simply due to impatience. Thus intrinsic value strategies are less competitively exposed.

Index funds are a non-fundamental strategy. Index funds simply buy everything — they do not have the flexibility to stay out. Again, intrinsic value strategies are less competitively exposed.

Non-fundamental strategies are destabilizing in aggregate. Relative-price investment schemes — those that buy or sell based on a stock’s price relative to other stocks — are popular, yet distorting and destabilizing in the aggregate. This definition emphatically does include index funds. Since such “investors” are simply reacting to one another, trends are amplified. This is the reason stock prices are not normally distributed (the “fat tails” distribution problem). It is the source of bubbles and panics, and will always create opportunity for the investor that makes decisions only based on price relative to intrinsic value.

In summary, what’s left is intrinsic value, always intrinsic value. If it says to stay out of the market altogether, then so be it. But that won’t always be true.

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In the past 10 years, we have witnessed two of the four biggest asset bubbles in U.S. history: the Nasdaq in 1997-2000, and the mortgage bubble of 2005 (and counting). (5/3/07 update: a third mega-bubble is now taking shape in private equity.)

Irrational exuberance runs rampant, it seems. Why?

Interestingly, this historical anomaly has occurred at almost exactly the same time that SRI drugs (seratonin reuptake inhibitors, including Prozac, Paxil, etc.) rose to prominence, with millions of prescriptions written. Their express purpose: to make you exuberant, regardless of circumstances.

Not to say SRIs don’t serve a legitimate purpose. But somebody ought to run a regression analysis of Prozac prescriptions against Nasdaq — there’s a story there.

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