Market Tops Form "At The Margin"

Yesterday, Federal Reserve Chairman Ben Bernanke likened monetary policy to landing a jet on an aircraft carrier which reminded ConvergEx's Nick Colas of a few choice 'Top Gun' quotes...  "Son, your ego is writing checks your body can’t cash" seems most appropriate. But Colas' review of a recent academic paper on the social dynamics of how long people applaud - and why they stop - is perhaps useful in comprehending the market's reaction.  The funny thing about the work is that the distribution of ‘Clapping duration’ looks pretty much exactly like the P/E ratio of the U.S. equity market going back to the 1800s.  Why do people start and stop their applause or buy into a stock market?  It all happens "at the margin" in both cases, and just a few people putting their hands in their pockets is enough to get the rest to stopWe still can’t get “Highway to the Danger Zone” out of our head.

Via ConvergEx's Nick Colas:

One of the most entertaining features of the 1980s is that the entire decade is neatly summed up by just 2 movies: “Top Gun” and “Wall Street”.  The first glamorized the defense industry, one of the big industrial winners of the day, and the other codified the public’s perception of modern finance.  Who can forget “Greed is good” or Maverick buzzing the tower?  Good times…

I had an 80s flashback today when Federal Reserve Chairman Ben Bernanke likened the challenges of managing monetary policy to landing a jet on an aircraft carrier.  Now, the Chairman bears very little resemblance to Tom Cruise, to be sure.  But in my mind’s eye there was Dr. Bernanke in a flight suit trash talking his fellow naval aviators in the ready room.  The thought didn’t really get as far as figuring out who might play the doomed “Goose” character, but I suppose the current chatter about San Francisco President Janet Yellen taking the reins next year makes her the logical choice.  Since her job isn’t as dangerous as the #2 on an F-18, I expect she will be fine.

As tempting as it would be – and consistent with the spirit of these notes  - to find some similarities between dog fighting and monetary policy, that’s not where we are going today.  If you need to take a moment and put on Kenny Loggins’ “Highway to the Danger Zone”, I understand.

I recently read a novel study by some European researchers about how long people applaud.  They taped a variety of audiences at college lectures and then parsed out when and how long individuals gave the requisite round of clapping after a lecture.  The goal of the work was to understand how “Social” issues – the manner in which individuals response to the actions of others – change human behavior and how long an impact they might have.  This is a hot topic at the moment, given the valuations given to social networking companies.  If there are discernible clues to how people join groups and how long they stay, leveraging these observations would be the veritable pot of gold at the end of the rainbow.

What struck me about the study, however, was distribution graph of how often the population being studied actually clapped.  There is a link to the study at the end of this note, but here is a brief description:

  • The distribution of claps is a typical “Bell curve, anchored at zero (no clapping) on the left and with a longish tail on the right.  A few people clap a lot, evidently.
  • The average number of times someone claps at a lecture was about 10.  The fat part of the distribution is 5-15 claps.
  • No one clap-count had more than 10% of the observations.  It is unusual for people to clap exactly the same amount repeatedly, which also makes sense.

The bit that surprised me was that the clap-count graph looks pretty much like the typical market P/E ratio histogram we’re all used to seeing.

Yes, there are plenty of ways to value the stock market, but the Price/Earnings ratio is still the most widely quoted.  The relevant data from this graph is:

  • The most common P/E ratio based on current earnings is 14 times.
  • The “Chunky middle” of the distribution is 12-18 times (remember this data goes back to 1871).
  • There are a handful of long-tail high multiple periods (north of 30) and a few (10 years) at or below a 10 P/E.

Now, there are plenty of naturally occurring data sets which exhibit the same kind of sloppy “Normal” distributions, but this comparison makes some intuitive sense to me.  Stock valuation is essentially a form of ‘Approval’ that investors are confidence in the fundamental underpinnings of the equity market.  And, of course, clapping is a sign of approval from an audience about a just-witnessed performance.  Consider that the U.S. stock market currently trades for 15x current year earnings, and you’ve got a pretty typical level of “Approval” that fundamentals are reasonably robust.   At least as strong as the average of the last 130 years or so.  Not bad.

So what gets a group of people to stop clapping, and are there any lessons for those of us who look at capital markets?  Here is what the researchers found on this point:

  • Applause starts with just a few people in an audience and gathers steam.  The end of the clapping starts in much the same way, with a few participants putting their hands down.  It’s not like everyone stops at the same time, followed by eerie silence.
  • Humans are social animals, and once people see that others in the crowd have stopped applauding, they quickly cease as well.
  • You don’t need to be near a just-stopped-clapping person to be aware that the number of people applauding has diminished.  Just hearing the level of noise created diminish slightly is enough to get the rest of the group to stop quickly.

Put in Wall Street parlance, applause happens “At the margin” with a few people starting up and others joining in.  The analogy to capital markets activity is clear.  Bottoms form when investors begin to value potential investments more highly than the previous day or week or month.  The resultant price action entices others to “Join in” and the perceived value of the assets in question rise further.  One set of hands clapping becomes many, then all...

The reverse process is how markets form tops.  When everyone is clapping there’s no one left to add to the noise.  Then someone stops, and someone else sees that.  They stop.  The noise begins to fade, just a little at first.  But as it becomes perceptible to everyone, human nature kicks in.  Who wants to be the last guy or gal clapping?  Everyone will stare… The applause stops quickly at that point.

In the end, this is a simple analysis, but one which speaks to capital markets as essentially large “Social networks”, and that is an intuitively appealing construct.  Attention and engagement ebb and flow based on macro confidence, micro financial results, and other fundamental inputs.  Valuation becomes an analysis of whether more or fewer investors will be clapping next month or next quarter.  But one thing is for sure – you want to be among the first people to clap and quit when the noise is the loudest.

Getting that bit right is the hard part.