Home >Opinion >Columns >How stock market gurus are stoking a bubble

Stock markets have been on fire, lately. Monday’s dip was more than made up for by Tuesday’s up move. The price-to-earnings (PE) ratio of the Sensex, India’s premier stock market index, during the current financial year has stood at 31.6, higher than any year before. This basically means that investors have been paying 31.60 as a price for every rupee of earnings of the 30 stocks that form the BSE Sensex.

The PE-ratio level this fiscal year has been higher than it was in June 2000, when the dotcom bubble peaked at a ratio of 29.4. It is also higher than the stock market bubble of 2007, which peaked in December that year at a PE ratio of 26.9. Given this, we could well categorize the current rise in stock prices as a bubble.

The interesting thing is that the PE ratio of the Sensex has been rising since 2012-13, when it was at 17.1. It has followed a largely upward trend since then, just going down marginally from 2017-18 to 2018-19, when it fell from 23.8 to 23.7.

What this tells us is that over the past eight years and more, the prices of Sensex stocks in particular and shares in general have risen faster than company earnings. Typically, when prices go up, it is an indication of the expectation of future earnings of companies going up. But when stock prices go up for more than eight years without their earnings catching up, it is safe to say that conventional wisdom has broken down.

In fact, a bulk of this jump in the PE ratio has happened between 2018-19 and now. Multiple reasons have been offered to explain this phenomenon, including the observation that low interest rates on regular savings have forced people to invest in stocks in search of higher returns and thus driven up prices.

But one reason that has not been adequately examined is the rise of the social media over the last few years. This has led to the collective decision-making of investors going wrong.

As James Surowiecki writes in The Wisdom of Crowds: “Bubbles… are textbook examples of collective decision making gone wrong. In a bubble, all of the conditions that make groups intelligent—independence, diversity, private judgment—disappear."

Before explaining when investors lose their independence, let’s try and understand a situation in which crowds act rationally and independently through the example of an experiment carried out in 1906 by the British polymath Francis Galton.

In that experiment, Galton wanted individuals to guess the dressed weight of an ox. As William J. Bernstein writes in The Delusion of Crowds: Why People Go Mad in Groups: “Approximately eight hundred participants purchased tickets for an ox-weighing contest at sixpence each, with prizes awarded for the most accurate guesses of the weight of the dressed animal, that is, minus its head and internal organs."

The average guess of the participants was 1,197 pounds. This was almost the same as the actual dressed weight of 1,198 pounds. This was possibly because the contestants acted independently. As Bernstein writes: “Contestants had to fill out an entry card with their address so that the winners could be notified, and since the result would not become known until the ox was later butchered, this would have discouraged the contestants from congregating before completing their card."

This dynamic of independent, diverse and private judgement breaks down during a stock market bubble. In a sense, whenever and wherever there is a bubble, investors tend to act like sheep and follow in the direction they are led, like a herd. Typically, they listen to gurus who tell them that things are only going to get better.

In the past, the messages of these gurus only got as far as the mainstream media—first newspapers and magazines, and later TV and the internet. Also, given the limited space available in dailies and magazines and limited time on TV, only the bigger gurus came through. But with social media all pervasive now, stock market gurus have managed to get around this limitation. They can get their message across through YouTube, Telegram, Instagram and so on. Hence, the market for gurus has expanded and there are many more of them now, many exclusively online.

The stickiness and success of such ‘advisors’ depends on the stock calls they make and whether these help their followers make money or not. The thing is that at a time where everything has gone up over a period of time, it is very easy to mistake dumb luck for sheer competence. This dynamic has benefitted these gurus. Even on many social-media chat groups without gurus, investors keep assuring one another that stock prices will continue to go up. In that sense, social media has not just brought stock gurus and investors closer, it has also brought investors closer too. This proliferation of advice has only helped the herd mentality seen in stock markets grow stronger still, which has led to a situation where, as Surowiecki puts it, prices are rising “because people expect them to keep rising".

There is easy money that can be earned from the comfort of a home, and nobody wants it to end—neither the gurus, nor the investors. The trouble is that whenever a bubble starts to run out of air, a similar dynamic will play out, but in the reverse direction.

Vivek Kaul is the author of ‘Bad Money’.

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