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APR. 01, 2022

A Rush of Blood to the Head

By now, you must have seen several videos and read comments on Will Smith slapping Chris Rock at the Academy Awards night last Sunday. Commentators have been discussing the reasons, some justify him, but everyone agrees, Will Smith overreacted. His overreaction might lead to adverse consequences, such as being expelled from the Academy.

The commentary surrounding the episode made me think of overreaction in financial markets. Overreaction is quite common in financial markets, which might lead to adverse consequences for the investors and the real economy.

How does overreaction arise? The father of modern macroeconomics, John Maynard Keynes, argued that “day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even absurd, influence on the market.” These words were written in 1936 but might as well be found in a freshly printed economic newspaper.

The change in value of a stock or an index can lead to misconceptions about its fundamental value, a misconception that can self-reinforce as more investors follow the crowd and trade in the same direction. Don’t forget that overreaction can increase the prices above the fundamentals, such as in a bubble, or make them spiral down in the case of a crash. The abnormal upwards or downwards movement of the price can be amplified by how most financial markets work. There are two main types of orders: market orders, where investors send an order for immediate execution at the best available price; and limit orders, where investors declare their willingness to buy or sell a stock at a price they decide. The latter type builds up the so-called market liquidity necessary for the orderly functioning of a stock market. When an overreaction hits, many investors submit market orders, and the fewer investors who submit limit orders demand a price farther away from the fundamental value, thus amplifying the price swings.

Is there a way to contain the overreaction and maybe profit from it? In finance, these two aspects go hand in hand under the name of arbitrage. In case of bubbles and crashes, a plausible strategy to make a profit is contrarian trading: buy the losers, sell the winners, pretty much what they are doing in the movie “The Big Short”. Although on paper, these strategies yield annualized returns as high as 30% in case of negative overreaction and 15% in case of positive overreaction; these profits are very slim after taking trading costs into account, as market liquidity is much lower in the presence of bubbles and crashes.

Another aspect to consider when dealing with contrarian strategies is funding: Julian Robertson, the manager of the hedge fund Tiger, had a contrarian strategy in place during the dot-com bubble. Although the strategy was right on paper, the significant losses accumulated while the bubble inflated enraged his investors, who pulled away the money. Robertson was forced to liquidate the fund at the beginning of March, just a week before the massive crash that would have proven him right.

His own words give the best analysis of what overreaction means: "In an irrational market, where earnings and price considerations take a back seat to mouse clicks and momentum, such logic, as we have learned, does not count for much."

We thank you for your continued support.

The FAM team