Are markets in a bubble because traders live in one?
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The writer was a partner at hedge fund Canyon Capital
Recent equity price falls are raising concerns that the US stock market, propped up by a herd of bulls detached from economic reality, has been in a bubble.
The definition of a bubble — a cut-off world isolated from diverse interaction or plurality of views — reminded me of the market professionals I encountered in 20 years as a hedge fund investor. I met exactly one other female partner. Most investment teams look like male Ivy League rowing crews. If the stock market is in a bubble, it is because traders live in one.
Financial bubbles are not new. The 1637 tulip mania, when prices of the bulb newly introduced in Holland soared and collapsed, is an early example. But they have cropped up regularly ever since. An unrealistic view of growth of the industrial sector in the 1920s preceded the 1929 US stock market crash, and of internet usage in the 2000s inflated the dotcom bubble. Deregulation, high leverage, low interest rates and excess cash may also contribute.
But one factor is common: call it mob behaviour, groupthink, or Fomo — depending on how cool you want to sound to your children. A price bubble is the same bad decision made by a herd.
A study published in 2014 by the National Academy of Sciences concludes that “bubbles are affected by ethnic homogeneity in the market and can be thwarted by diversity”. It makes sense. Financial markets are supposed to self-correct, so for bubbles to occur, pricing mistakes must be widely shared.
What more fertile ground for such miscalculations than a homogeneous group, where participants are prone to accept their peers’ decisions and unlikely to question their behaviour? Animal spirits at work.
Outsiders are not only rare, but often disregarded. While in a meeting where everyone else was male, I once corrected a participant who had erroneously valued an interest rate option as worthless. It wasn’t worthless, I said, merely out of the money. “You are a woman, I am a man,” he said. “Let's not debate.”
I considered pointing out that this was an option-pricing model that won two white men a Nobel Prize. But I was expected to let it go. So I did, even though I was leading the meeting.
As a senior portfolio manager, I still found that when I forcefully disagreed, I was dismissed as “too emotional”. On the night Donald Trump won the 2016 US presidential election, an analyst asked if I would “break down in pieces if Hillary lost”. He later said it was “a joke”.
Change requires impetus and incentives. Today, many industry recruiters are going about it the wrong way. A headhunter at Long Ridge Partners put it like this: “Most funds want to go out and hire the best talent. They don't care if it's a man or a woman.” Doesn’t he watch sports? It isn’t the best talent that wins; it’s the best team. A great baseball team doesn’t have nine hitters. The retail sector currently presents an outsized opportunity for distressed investing. An investment team that does not reflect the customer base will struggle to evaluate these businesses.
Unless clients demand diversity from their investment teams, there is no incentive to change. There is a precedent. Starting around 2017, State Street and BlackRock began insisting on board diversity for the public companies in which they invested. They threatened to vote against slates made up only of men. The last all male board in the S&P 500 added a woman in 2019. Institutional clients should demand the same from hedge funds and investment managers.
Generating uncorrelated returns, or “alpha”, requires differentiating yourself from the herd. Surely that is easier for a diverse group of people to do. The alternative is a community sealed in a bubble, woefully unprepared to recognise irrational exuberance.