Can we quantify the foolishness of the crowd? That’s the question posed by Jeffrey C. Hood in chapter eleven, the final chapter of “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd”.
He wrote, “We have seen that, due to the 'wisdom of the crowd', when a large number of people apply their judgment to a particular estimate or result, and certain criteria are present, the underlying “wisdom” of the crowd will manifest. However, when the collective judgments of the crowd are skewed by irrationality and/or systemic forces, the resulting output from the crowd will not be wisdom, but instead will be a result that is offset from this normal wisdom (the “Foolish Offset”).”
Still, even if we could measure the foolish offset, it could not be a precise measure. That’s an inherent condition since we cannot perfectly measure intrinsic value, which would be the baseline for any deviations due to the foolish offset.
For example, when we estimate the future value of a stock using discounted cash flow (DCF) analysis, we must use best guesses about the growth rate for the next ten years, the terminal growth rate and the discount rate.
So, many of us try to capture intrinsic value as a range, rather than an exact number. Hood went on to discuss Benjamin Graham’s conclusion that an investor only needs to establish whether the value is “adequate” to protect the buyer.
Similarly, Hood believes that any assessment of the foolish offset must, of necessity, be a possible range:
“The current degree of Foolishness or irrationality in the stock market, and more particularly its influence on current stock prices, is not susceptible to quantification, but at best can be assessed as a possible range of values. Throughout modern finance one sees the attempt to quantify parameters, such as risk, value, etc., that are simply not quantifiable. As Charlie Munger (Trades, Portfolio) has said, modern finance seems to suffer from Physics Envy – an envy of the ability in hard sciences such as physics to quantify values with precision.”
What’s more, Hood also expected that the measures of the foolish offset would “almost certainly” be less reliable than measures of intrinsic value. That’s because the foundation of intrinsic value is a set of quantitative criteria, whereas the foundation of the foolish offset is a set of essentially qualitative measures.
Yet, there are some quantitative measures that exist. Hood pointed to the Market Volatility Index, the VIX, from the Chicago Board Options Exchange (now the Cboe Options Exchange (Cboe)). Using options data, the VIX measures the implied volatility of S&P 500 index options, more specifically, what volatility the market expects over the next 30 days.
In popular discussions, the VIX is called the fear index or the fear gauge, because it measures how volatile the market is expected to be. This chart from the CBOE shows the amount of fear and uncertainty in the market since its inception in 1990:
Note the very high spike in the middle-right area of the chart. That occurred in October 2008, which as many will recall was the most worrisome period of the 2008 financial crisis.
The main point is that a measure of fear and uncertainty in the market does exist. Beyond Hood’s book, I would note that, so far as I am aware, no one has married his concept of the foolishness of the market to the VIX index. I’m referring here to the five years since Hood’s book was published.
The author also mentioned the “Fear & Greed Index” at CNN Money. It is based on seven indicators, including stock price momentum, the put/call ratio and the VIX. At the close of trading on November 27, 2019 it had just moved into “Extreme Greed” territory:
Again, I do not know of anyone making a connection between the foolishness of the market and this index. But, Hood observed:
“The Fear & Greed index attempts to indicate the level of fear and/or greed that is currently in the market. It could be that one of these indexes, or perhaps some combination of them, could be used to provide a quantitative value useful in assessing, or perhaps even indicating, the relative amount of fear or greed, and hence a measure of the degree of irrationality, in the marketplace. This topic should probably best be left to some enterprising graduate student in behavioral finance.”
Hood was uncertain about the power of these measures of market irrationality. On the one hand, he believed it might be just a binary result in which we might be able say, “Yes, the crowd is distorting stock prices” or “No, it is not distorting them."
But he also saw the potential of going beyond a binary choice, and eventually being able to say with some certainty that the crowd is distorting the price of individual stocks by this many dollars and cents.
That, of course, brings us back to intrinsic value and the importance of fundamental analysis. If we compare an intrinsic value with a market price, we do have an idea of the foolish offset.
Conclusion
In this final chapter of “Inefficient Market Theory: An Investment Framework Based on the Foolishness of the Crowd”, Jeffrey Hood has given us a tentative look at the potential of quantifying that foolishness.
With the VIX and the CNN Fear & Greed Index, we do have at least binary results for the market as a whole. With the VIX relatively low and the CNN Fear & Greed index at an “Extreme” level, it seems safe to say the market and stock prices are overpriced at the end of November 2019.
In my opinion, both are tantalizing prospects for more sophisticated valuation, but as Hood has noted, it’s probably going to take some serious academic work to realize that goal.
Read more here:Â
- Inefficient Market Theory: Staying Safe in a Market Bubble
- Inefficient Market Theory: Bargains in a Market-Wide Crisis
- Inefficient Market Theory: Berkshire Hathaway and Indexation
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