How to avoid becoming roadkill in the bubble - Morphic Asset Management

How to avoid becoming roadkill in the bubble

“A bubble is just a bull market you’re not in”

Eddy Elfenbein


Whilst funny, and to a certain extent true (Sydney housing anyone?), if the stockmarket recovers swiftly from the coronavirus induced swoon (if it doesn’t, this is a moot point), and keeps going at speed it went at last year some thought needs to turn to the last phase of a bull market morphing into a bubble. Often overused, bubbles do exist and bubbles are different to bull markets.

Let me turn to one of my favourite books of last year.

Like many readers, I try to use the Christmas holidays as a period to read the books I said I’d get around to but never seem to over the course of the year. Top of the list was “The Man who Solved the Market”, a story of Jim Simons, the chain-smoking mathematician and his secretive hedge fund, Renaissance Technologies.

Most readers would have heard of Warren Buffett and the awe in which he is held by fundamental investors. Well, Simons’ returns dwarf those returns with 66 per cent per annum before fees for over 30 years, and his fund has made over $100 billion of profits for investors.

Yet very few knew much about Renaissance and how the quant fund ran money because Simons shunned publicity.

The Australian Financial Review‘s Jonathan Shapiro has written already on the book and Simons’ story, so I’m not going to focus on that, except to say it’s remarkable that for all the brains and brilliance the fund’s initial returns were poor for so long that it came within weeks of closing. Even the very best struggle at times.

What I’d like to focus on is what I learnt from the book. You see, I thought their success was due to accessing better stock data faster and quicker than other investors can and processing that. The answer is actually both simpler and more complex.

What they have written into computer code is how investors react and behave in each market, from soybeans to equities.

They have coded how you behave and know, on average, what you will do next. You, the reader and investor, are the source of their profit.

If this all sounds Orwellian, think of this phrase on market efficiency: “markets are 100 per cent efficient, the inefficiency is the humans that make up the market”. Because our brains are hardwired relics of jungles of Africa, humans respond in predictable patterns to news.

Economics has come to recognise this, with the Nobel Prize going to Daniel Kahneman for his pioneering work in behavioural finance. It’s now accepted that there is “loss aversion”, “bounded rationality” and numerous other insights into how we think, making humans irrational in their behaviour.

Bringing the two threads together – bubbles and Simons – how can we test my theory on solving you? Look at his funds returns in bubble years. They are off the charts. Renaissance made 136 per cent in 2007 on the way up in the bubble and then 152 per cent in 2008 on the way down after the bubble popped.

They also made 128 per cent in the dotcom bubble of 2000.

Apart from being ridiculously good returns, it’s remarkable because it’s generally accepted that investing in bubbles is hard, because fundamentals go out the window.

But what all bubbles have in common (up to now) is humans trading against humans: be it Bitcoin, US tech stocks or tulips. And humans experience greed, FOMO, fear and depression the same, thus making them predictable for a machine.

Now none of this helps tell me whether this year becomes a bubble year or not, but it does provide some guidance on how to frame your year. Quite simply, you don’t fight bubbles with fundamental reasoning. It just doesn’t work.

More generally there are other ways to avoid becoming the food that feeds the Renaissance machine. Write down your investment thesis and set your buy and sell rules in advance, so as to stop your inner chimp taking charge. Even market professionals find it hard to overcome those impulses and often override themselves.

Or as one market strategist says “the problem with bubbles is they force you to look stupid either before they pop or after they pop”.

This article was written by Morphic’s joint-CIO Chad Slater in a column for the AFR and you can find a pdf version here.

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