In the market conditions we are in rational valuation of things has not been useful. This is not me saying “We’re in a different time and this isn’t important anymore” - What I am saying is the divergence between rational pricing and market pricing is so wide that to rely on rational pricing metrics can let you down.
The idea that markets should make sense if from the Efficient Market Hypothesis (EMH). From my view, it’s impossible to believe the EMH is at work in markets of my lifetime. It sounds like it should. Some people I think are too into that and they think it’s the Efficient Market Fact - a hypothesis is not a fact. It’s a starting point.
Hy·poth·esis
A supposition or proposed explanation made on the basis of limited evidence as a starting point for further investigation:
During our lifetime we’ve not seen efficient markets. The idea that because the markets are so big and because all of the info that can be known about markets is known to the markets everyone will act in their own self-interest and do the most logical thing based on all the data is not a thing.
The hypothesis proposes people will “Act as if” they have all the info and are making the best decisions and the average of this will produce the correct price.
It’s not happening.
All of this stuff is likely very important to where prices ultimately end up but where prices end up and the route they take there are two different things. If we’re looking at markets to make trading decisions we have to deal with what the market is doing now and what the market is doing now will very seldom be inline with the EMH.
So as far as I am concerned the EMH is out the window. There are smarter people who’s done work to discredit the EHM so I won’t go into any of that. I’ll just say from my simple mind I am looking at markets and they do not look like they make sense in the context of EMH.
There probably is a time and place for it but there’s certain extremely bad times to bet on it. Recent years have been the worst of times to bet on it. I do fully expect it will be worst just before it’s best - but I have no idea how much worse it can get. I still don’t understand how BTC got over $10. I really don’t get it. But it certainly did!
If you take the premise we’re in a bubble you have to accept the EMH has no part in it. The bidding nature of the market mean people who do not care about the EMH in any way are going to be liable to be willing to pay a price far higher than you’d estimate reasonable. Even people who know better know they can flip it the “Greater fool”.
What anything is worth is not important in markets from the perspective of someone engaging them to make money. The only thing that matters is what someone will pay for it during the time you hold it and how this can hurt or help you.
Valuations are the Passenger
If this is the top the headline of this and timestamp will look funny in the future but I’m not necessary calling for much higher valuations - my point is I don’t see them useful in either forecasting a bull or bear. Valuations being high imply bear but reality of bubbles says valuations can be higher.
Valuations are not the driver. They’re the passenger. Where valuations are is not dictating where the car is. Valuations are going where the car goes. The car is the bubble. It will recklessly scream on or it will crash. One of these is highly likely. Valuations will have a story to tell after, but they’re along for the ride.
All that matters is the driver. And the driver is momentum. In these market conditions, momentum is right. “The trend is your friend until it bends”. While markets are making higher highs and higher lows the bias is to buy with stops under the lows and if markets make lower lows the bias is to short rips.
The Pitfalls of EMH for Bulls and Bears
The pitfalls for bears are obvious. You’ll see things as too high and they’ll double. In 2021 my little cousin gave me £50 to buy assorted cryptos for him. I thought he was going to lose it and decided to keep it, give it back after the dump and try to wise him up a bit. I essentially took a short. I’d have had to pay him.
I ran down close to 300% on that. In the end I’d give him his £50 back but I took massive percentage drawdown by having essentially short with no stop. This was a small thing, but bears can run into this same thing in much more serious situation.
On the bull side, I expect the casualties to be the passive investors. Those who believe markets will generally uptrend and there’s no point trying to do any sort of risk analysis or protection - because the EMH says so. I think that’s going to end very badly for them. The question is when it will end.
I think there maybe are certain market conditions where the EMH matters, but it’s absolutely not during times of rampant speculation. In rampant speculation momentum is king. Being able to bet on momentum while covering your downside for sharp shifts in momentum is the only viable strategy.
The Extraordinary Popular Delusion
Valuations should matter but the idea people can act as if they do not and benefit from this endlessly is an extraordinary popular delusion. The madness of crowds.
It is not new. We should accept it this happens in markets.
Extraordinary Popular Delusions and the Madness of Crowds is an early study of crowd psychology by Scottish journalist Charles Mackay, first published in 1841 under the title Memoirs of Extraordinary Popular Delusions
The first three chapters deal with:
The Mississippi Scheme
The South Sea Bubble
The Tulip Mania
For 100s of years people have been willing to do irrational things in bubbles.
This is so well established that it is actually irrational to have rational expectations of a bubble. The only way in which some attachment to rationally helps you is keeping you mindful of downside risk as a bull. As a bear, the real outcome is usually going to greatly exceed the expected outcome.
It’s only sane to think about it like this. When you look at all the great minds with masses of resources available to them who underestimated bubbles. Some of the most exceptional people in market history have felt the sting of thinking something had to end too soon before it did.
These are not dumb people. They’re not be putting themselves into that situation if it was as simple as working out the fair value for things and betting against them when it got overvalued. Many great people have went entirely bust being short things that would eventually drop over 70% (Sometimes zero).
The Over and Undershoot
If you subscribe to us being in a bug bubble you have to take the premise that valuations are going to overshoot their fair value on both sides now. How much above fair value they can go is extremely hard to determine. There’s a bit more chance with how much below fair value they can go, but still it will be lower than makes sense.
The driver is going to be momentum. With momentum it’s viable to see things trading at many multiples of what they are worth and possible to see things trading at under 50% of their intrinsic value. Momentum will drive valuations. They will not drive momentum. This should be expected until the bubble is fully resolved.
Once markets have excessively overshot at the high (Which might be now and it might be 100% higher - who cares, follow momentum) and then made a bust to overshoot the low, there will be far less players in the market. It will be mostly people who are serious about the market.
At that point, knowing what things are worth will be an advantage. Probably not before. If you’re an opportunity seeker ready to follow momentum, these are great times. Spectacular market conditions for speculating in. If you want them to make sense, they’re liable to be very frustrating.
What things are worth is not as important in a market as what people are willing to pay for them. That’s the fact. I do not make the rules. The only sane things to do in such conditions is do nothing at all until it’s all over or to bet on momentum and protect the downside.
It is not wise to try to be clever.