Chas Craig, BridgeTower Media Newswires
Regular readers of this column know behavioral finance topics feature prominently because learning about cognitive errors and emotional biases, eliminating them where possible and structuring processes designed to neuter them where they are not, can be an investment edge.
In this space we have previously discussed the decline of rationality and the anatomy of a bubble. Given those earlier takeaways, it seems plausible to expect more frequent bubbles than was historically normal. This doesn’t have to mean systemic bubbles (e.g., the dot-com and housing bubbles), but could manifest itself in more mini, rolling bubbles (e.g., meme stocks, joke crypto currencies and SPACs). By mini I mean small in terms of their systemic impact, not the magnitude of the price versus value dislocation.
The 9th edition of Fundamentals of Investments: Valuation and Management was used as the textbook in the Investments course I had the privilege of teaching last semester at OSU-Tulsa. Although the text predates meme stock mania, Chapter 8 entitled “Behavioral Finance and the Psychology of Investing” is especially relevant to the topic.
The authors pointed out that “Noise Trader Risk,” also known as sentiment-based risk, poses limits to arbitrage. The text noted the following:
• A noise trader is defined as someone whose trades are not based on information or financially meaningful analysis.
• Noise traders could act “together” to worsen mispricing.
• Noise trader risk is important because the worsening of a mispricing could force the arbitrageur to liquidate early (and sustain steep losses).
• If noise trader risk exists, then this is another source of risk beyond systematic (i.e., overall market) risk and unsystematic (i.e., firm-specific) risk.
• When firm-specific risk, noise trader risk, or implementation costs are present, a mispricing may persist because arbitrage is too risky or too costly.
Previously, I would have rolled my eyes at the noise trader concept as being too small (or at least redundant of other behavioral finance topics) to be of any real practical relevance. This was a conclusion that did not age well, as a wolf pack of retail investors formed in an online chatroom led by someone calling himself the “Roaring Kitty” took the stock prices of companies (most famously GameStop Corp. and AMC Entertainment Holdings Inc.) to unbelievable heights in what must be the greatest and most successful short squeeze of all time.
In terms of the academic and practical implications, if we could not before, we can now definitely say that noise trader risk does exist, and it can be dramatic from time to time. As a result, a large mispricing that should be quickly arbitraged away can persist for long periods. For example, as I told my students, I viewed the meme stocks collectively as the largest price versus value dislocation I had ever seen. However, given the wolf pack, shorting the stocks was too risky a proposition. At least one previously well-regarded hedge fund manager saw his track record effectively ruined by the whole ordeal. Additionally, most financial academic research hinges on earning returns for risk assumed. Since noise trader risk is now clearly additive to systematic and unsystematic risk, it could open an interesting new field of research.
It’s worth noting that, to date, the retail wolf pack, many of whom refer to themselves as “Apes,” have focused on buying stocks to execute short squeezes. I suppose they could also go the other way too. It’s not far-fetched to envision a scenario where disenchanted primates (e.g., AMC has basically round-tripped its meme frenzy gains) collude to actively bet against the very same fragile companies they pumped last year.
—————
Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).
