“The greater fool is someone with the perfect blend of self-delusion and ego to think that he can success where others have failed. This whole country was made by greater fools.”

– The Newsroom

What is The Greater Fool Theory?
The Greater Fool Theory is a theory that states that the price of an object is not determined by its inherent value, but instead by the irrational beliefs and expectations of others in a market. The theory proposes that it is possible to make money by buying a security and selling it in the future at a profit because there will always be a person who is acting as a Greater Fool; someone that is willing to pay a greater price for the security. Following with the logic of the theory, a rational buyer will be willing to purchase a security, even if it is overvalued, because they truly believe that someone else will be foolish enough to buy it at a greater price later.

Are we in a market run by greater fools right now?
A recent Barron’s article said, “Sentiment (in the stock market) is ebullient, to say the least. Investors Intelligence’s polling shows bulls at 63.1 percent of respondents, the highest reading since 1987. That makes 14 weeks in which the number has been over 55 percent — what II dubs the ‘danger zone.’ Bears were down to 16.5 percent, the lowest figure since July 2015. That put the bull-bear spread at 46.6 percentage points, the highest for the current market cycle.” Looking at the amount of positive sentiment in the market right now, even as the bear market continues to mature, we can see that the market is run by greater fools. By some measurements stock valuations haven’t been this overvalued since the 2000 dot-com peak. Investors continue to purchase securities, with either the intention that someone more foolish will come along later to buy their securities for a greater price, or because they actually believe that the securities they are purchasing have great value.
According to the USLegal definition, The Greater Fool Theory, “reaches its height of popularity near the end of a bull market when speculation is high.” I believe that savvy investors are taking advantage of this high sentiment, buying securities and crossing their fingers that the greater fool will come along and buy their securities for an absurdly greater price… until the day that the market realizes stocks are overvalued, and the fools no longer remain.

– Eli Perlmutter

– Edited by Wyatt Swartz

4/18/2017

Commentary on Above Post

I think it is appropriate to give commentary on the above piece written by my associate intern Eli Perlmutter. Overall, I think it is a great piece providing investment theory, education, and current market conditions into one post, but feel there should be additional points made.

1.       Theory is Theory

An intelligent theory is still a theory. When looking at economics, investing, or human behavior theories typically cannot be definitively proven or disproven. Instead they are often arguable from both sides.

2.       Buying & Holding Stocks Over Long-term Periods is Very Rational

There are times where a stock’s price or stock prices are bought up based on irrational beliefs and expectations. We see that happen in the late stages of a bull market. However, buying shares of stock based on expectations can be very rational, in fact all the data suggests that buying and holding a broad range of stocks over long-term periods is about the most rational thing a person can do. When someone buys shares of stock they are buying ownership in a company, and that ownership gives them rights to future earnings and profits the same as if they were buying an ownership stake in their local diner.

3.       It’s Easy to Argue that Stocks are Undervalued

At the start of this week forward P/E for the S&P was 17.23, forward P/E for the EAFE was 14.57 and EM was 12.16 per JP Morgan. Only the S&P is a little above average and it is nowhere near an outrageous level. Foreign developed market stocks appear to be undervalued, and emerging market stocks appear very undervalued. Perhaps Barron’s has very different data calculations or more likely they were grasping for any measurement they could find that created a juicy take. No articles get more readership traction than the ones forecasting collapse.

4.       Above Average Stock Valuations and Sentiment Do Not Imply an Imminent Bear Market

Markets can be at above average valuations for a long time before running out of steam. If we looked at 1996-1999 I think we would likely find a long stretch of above average valuations. Bull markets can continue at above average levels for long periods.

5.       Savvy Investors Do Not Cross Their Fingers as a Strategy

Savvy investors do not cross their fingers and hope. Savvy investors have a plan based on their goals, time horizon and cash flow needs. That plan should be formulated by an understanding of capital markets, and a sound investment process. Savvy investors understand that at times individual stocks or broad ranges of stocks can gain momentum and be bought up based on irrational expectations and greed. Savvy investors know that stock prices are a function of supply and demand, and that in the short-term demand pressures are the more powerful driver.

– Wyatt Swartz

– 4/21/2017