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  • donaldmattersdorff

"The Wisdom of Crowds"


When COVID hit in early 2020, the stock market plunged. Newspapers filled with stories about the shutdown of travel, hospitality and restaurants, and how the pandemic would usher in the biggest recession since 2008/2009. Many investors pushed the "Sell" button.

Before COVID, the market reached 29,000 (on the Dow). It plunged to 19,000 on all of the worrying news, but after the briefest of pauses, reversed and soon passed 29,000 again, before moving on to the current level of almost 34,000.

Several factors explain this. Millions of information workers continued to work from their laptops at home. Aside from the inconvenience of having our dog bark during Zoom meetings, we barely noticed that something was wrong. Add to this, the stupendous fiscal and monetary stimuli which poured in from different sources in government, and the world never looked better for a lot of companies, especially including Amazon, Apple, Zoom, Google, Netflix, etc., - the tech firms which helped us cope from home. I've mentioned this before, but Peloton, the stationary bike company, had two bumper years and a strong stock in spite of appalling business fundamentals. Peloton also helped us cope from home.

Today we see that the stimuli were too strong - that they set the stage for our current problems with inflation and rising interest rates - and that COVID was a less serious problem, economically speaking, than we at first imagined. We didn't understand what was going on at the time. I certainly did not. But very quickly, the stock market did, and it reacted appropriately. How did that happen?

I sometimes refer to the "madness of crowds" in my emails. Madness happens when a stock or a trend becomes so popular that it climbs with a self-sustaining momentum of its own, independent of business reality. A stock goes viral, we might say today, often resulting in a crash when the bubble pops. The phrase "madness of crowds" comes from Charles Mackay's book, published in 1841, "Extraordinary Popular Delusions and the Madness of Crowds", which chronicled several such manias, including my favorite, the Dutch tulip bulb bubble.

But here we have an example of "the wisdom of crowds", an occasion when, even if we don't understand what's going on as individuals, collectively we do. The "wisdom of crowds" theory says that even if crowds sometimes go crazy, often they predict very accurately, building one of the strongest cases for the benefits of free markets in our economy.

Did you know that if you show a jar full of pennies to 100 people, and ask them to guess the number of pennies in the jar, their individual guesses will be all over the place, but their average guess will be within 1% or 2% of the correct answer every time? Isn't that amazing? It's hard to see how it happens. The crowd collectively knows something which none of the participants know individually. The individual guesses, no matter how wildly off the mark, hone the accuracy of the collective guess. Francis Galton first noticed this in about 1900, when he observed that fair-goers, when asked to guess the weight of an ox, could not do so, but that their average guess always came close.

On most days, this describes the stock market also. Millions of people enter the marketplace every day. They stay for the briefest instant to buy or sell, and do not pause to explain their actions. Some think the market will go down. Others buy because they expect it to go up. A significant number hold neither view. They have received an inheritance which they would like to invest, or they need cash to buy a car. The reasons to buy or sell vary almost with every single participant.

All of that buying and selling results in a stock price which vibrates up and down, sometimes just a little, sometimes a lot. In any given moment, we can think of the current price as an "average" of the combined actions of buyers and sellers, and the wisdom of crowds theory applies. Who can say what price is fair? A share of stock represents a small slice of an organization in continuous motion, with new products, thousands of employees, hundreds of competitors and, often, many millions of customers. You have to see the future of this very complex picture more accurately than others to anticipate the movement of a stock. Good luck doing that consistently. But collectively, the crowd seems to know. Shares only occasionally go wildly out of whack, which makes outguessing the market so difficult.

Today, I think that I see something like this going on. After briefly touching 36,000 in December of 2021, the market has declined, as of this writing, to 34,000. Not exactly a major crash, wouldn't you agree? Prognostications of inflation, recession - sometimes both together - have covered the headlines for almost two years. I myself have written about it. Rates have risen sharply and we had the biggest bank scare in recent memory.

But the economy never got the memo. Consumers did not pull in their wings. New technologies like artificial intelligence popped up. Unemployment remains very low. New Hampshire, which I follow more closely than most states, right now has the lowest unemployment rate in its history. Oregon, where I live, is close. No doubt about it - the economy remains strong, and so does the stock market. The many forecasts of doom and gloom have so far not panned out.

So which is it? Are markets irrational, and prone to bouts of mania and madness? Or are they wise and far-seeing beyond the ability of an individual? The answer, I think, is both.

In his book, "The Wisdom of Crowds" (2004), which coined the phrase, and from which I learned a lot, James Surowiecki outlines the conditions under which crowds choose wisely. He mentions:

· A Diversity of opinion among individuals

· Independence from the influence of others

· Decentralization of sources

· Aggregation - a method, such as a marketplace, to pool individual opinions into a collective result. (Elections accomplish this in politics.)

· Trust in the system.

When these conditions exist, markets operate very well. When they do not exist, the wisdom of the marketplace falls into doubt, and properly so. Then we see extraordinary manias and panics and the madness of crowds at work. But in normal, calm, everyday markets, be careful calling out major mispricings. You will likely be disappointed.

I find this thought exercise useful when looking at investments. New fears, not well understood, such as COVID, push the market down. Most of the criteria mentioned above are absent. That's the time to look for opportunities. The banking scare in March, which blew in out of nowhere, had the same effect.

Electric vehicle stocks, including Tesla, look like a mania to me. Tesla is just a car company, which will more and more resemble an average one, with more and stronger competition, as time passes. Amid inflation, Tesla has lowered prices twice this year. It did not do so from altruism. Competition forced its hand. Tesla will increasingly come under scrutiny from many different directions, with independent voices expressing doubt, such that we can predict that the bubble in the stock price is over.

In closing, and as an aside, I must point out that I think social media diminishes wisdom, both for crowds and for individuals, for the reason that it so facilitates groupthink and herd behavior. I will leave that discussion for another day. I myself plan to post this essay on my website and on social media, so I guess I can't complain.

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