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Stockpicking as a Keynsian beauty contest
April 13, 2014 4:59 pm by Ellen Kelleher
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John Maynard Keynes once compared the exercise of picking stocks to a beauty contest. The relative attractions of both stocks and catwalk models are subjective, he argued, but to a degree, their value is determined by their popularity with the audience.
Here, Andrew Bell, chief executive of the investment trust Witan, offers an analysis of how Keynsian theories apply to today’s markets. Here’s an extract from his blog.
The process of abstraction can go on and on, as the selection moves further away from making your own judgments of beauty towards an assessment of popular fashion or psychology. In the process, your face would lose its sun tan.
This process of buying what you think others want instead of making your own assessment can explain some of the changes in fashion in stock markets that occur even where the news does not change dramatically. At its most extreme, markets can be drawn into a self-fuelling momentum-driven rally where confidence grows that a particular sector will continue to be in favour, thereby justifying new investments at improbably high valuations.
The outstanding example in recent times was the dot-com mania at the turn of the century, when the NASDAQ index of US technology stocks rose from 1500 to 5000 in the 18 months ending March 2000 only to fall back to 1500 in the next 18 months. 10 years later, the index is still only half its peak level. Japanese equities, which were all the rage in 1989 as Japanese companies and management science seemed set to take over the world, are 74% lower 20 years on, as two decades of disappointing economic growth pricked the valuation bubble that collective enthusiasm had inflated in Tokyo (remember the reports that the land on which the Imperial Palace was built was worth more than the State of California?).
Something similar, though less outlandish, has been afoot in the markets’ behaviour over the past year, when there have been rapidly changing preferences between defensive “blue chip” stocks and those with more cyclical characteristics. A group of 4 “fallen angel” stocks that fell into the FTSE Smallcap index in March 2009 (because of fears that their debts would overwhelm them) proceeded to more than double in April, their performance alone adding 15% to the value of the Smallcap index. Many managers who performed strongly during 2008’s falling markets, by holding investments with predictable earnings, were left behind the 2009 rally, when enthusiasm for cyclical recovery plays (which were lowly valued a year ago) rebounded.
Unlike Keynes’ beauty contest, there is a reality check in investment markets. Beauty may be subjective but cash is countable.
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