An appealing thing about financial markets is that, chaotic as they appear, they can be almost fully explained by one elegant theory.
The theory goes as follows: The price of securities reflects all publicly available information, and returns are a compensation for risk.
This theory — the efficient markets hypothesis, or EMH — makes sense of almost everything. It explains why stock markets return most than bond markets over the long run, why stocks are more volatile than bonds which are more volatile than bills, why even hitherto-successful investors are no better than anyone else at picking stocks, and why ordinary punters can expect to match the investing performance of seasoned pros.
The doyen of the EMH is Eugene Fama, a professor at the University of Chicago. He first posited it in 1970.
Then, as often happens with simple elegant theories of the world, people started noticing anomalies. Certain categories of stocks seemed to reliably return more than others in a way unexplained by the EMH. What was that about?
Undeterred, Fama reformulated his theory. Along with his co-author Kenneth French, he came up with an asset pricing model that took account of two new factors: size (the company’s market cap) and value (that is, the share price relative to underlying book value). These were chosen because cheap companies and small companies were the most important categories of stocks that had been shown to outperform the market.
Augmented thusly, the EMH was back in business. And its underlying intuition hadn’t changed. Fama and French were still saying market returns were tied to risk. They had just expanded the conception of risk.
Small, fragile companies are riskier than big solid ones, so they return more. Cheap companies are cheap for a reason — they have crashed into the ditch, and need to resolve their problems. They are riskier, said Fama, which is why they return more.
The continuum of risk and return, Fama said, runs from government bonds to corporate bonds to stocks to value and growth stocks. One theory to rule them all.
There was one problem, though. There was a pesky category of stock that seemed to outperform the market on a regular basis — that was much harder to shoehorn into Fama’s grand theory of risk and return.
The category — or factor, as they call it — is momentum. The momentum factor is the tendency of stocks to keep doing what they’re doing. If they’re rising they’ll keep rising, if they’re falling they’ll keep falling.
Stocks, bonds, currencies, and even sports betting has been shown to exhibit momentum. And momentum is one of the strongest, if not the strongest, anomaly that’s been found in the literature.
The following chart shows how the momentum factor has done in recent years. Since 2020, it has trounced the S&P.
Momentum is hard to square with efficient markets. It's not obviously anything to do with risk.
The best explanation would appear to be that people are just a bit stupid. They overreact to good news, and are slow to incorporate new information. It's an explanation that will be intuitive to anyone who's spent any time around humans.
I've been reminded of all this stuff by the goings-on in the crypto world. Crypto is a puzzle for financial economists. According to the standard models, securities are meant to be valued based on their claims on future cash flows. But crypto doesn't have any cash flows.
Cryptos are very risky in that their price drops suddenly, and they have very high returns (recent crash notwithstanding), but you can't tell a coherent story about why they're risky, as with value stocks or small caps. They're risky because they exhibit risky characteristics and that's that.
It's clear enough crypto doesn't fit the EMH framework. Fama himself is skeptical of it.
But what about the momentum factor? Momentum, the unloved stepchild of financial economics, seems to have something to say about how cryptos behave in real life.
Momentum predicts that stuff that is rising will continue to rise, and stuff that is falling will continue to fall. There you have it! That's your theory of crypto.
It's happened three times now. Take bitcoin. Once every three years or so, Bitcoin starts to take off, and then the momentum builds. It hits a peak. Then there's a reversal. In a short space of time, most of the gains are given back. Three years later it happens again.
In 2013 bitcoin rose 1,000 per cent, then fell 60 per cent. In 2017 it rose 2,000, then fell 80 per cent. Between 2020 and the start of this year it rose 570 per cent, and has since fallen 70 per cent.
Another point is that the momentum factor is at its strongest when markets are going up. When growth stocks are doing well, momentum does well too. When growth's opposite, value, is doing well, momentum doesn't do well. I mention this because we've been in a historic growth market in recent years.
It's not a fancy theory, I'll grant you. But it does fit the facts. Cryptos go up when they're going up and they go down when they're going down. In this respect, they're like stocks and bonds and everything else, except more so. Crypto is unmoored from any rational model based on something like the risk to the present value of expected future cash flows. So the momentum factor is left to run riot.
It's investing as pure emotion.