During his recent interview with Capitalisn’t, Jim Chanos describes a phenomenon observed in bull markets where investors, despite knowing the risks, are drawn to fraudulent, aggressive, and questionable companies for extended periods. This “irrational exuberance” is attributed to two factors:
- Systematic risk: This refers to the inherent uncertainty of the market, which investors accept to participate
- Idiosyncratic risk: This refers to the specific risk associated with individual companies, which can be significant for fraudulent or unreliable ones
The longer the bull market lasts, the more intense and speculative behavior becomes. People become less skeptical and more willing to overlook red flags, leading to increased involvement in scams and hypes. This ultimately contributes to the unsustainable nature of bull markets.
Here’s an excerpt from the interview:
Chanos: We’re trying to isolate the idiosyncratic risk of a short portfolio and take out the systematic risk, which is that markets go up over time.
All things being equal, on a simple basis, that should be your alpha. The problem is that alpha has a beta, in that the alpha contracts and expands with the level of speculation.
People will flock to the fraudulent companies, the aggressive companies, the companies with crazy accounting and silly business plans, no matter what you might think they’re worth, for reasonably long periods of time.
It is what it is. It’s part of the game. And so, you can take the systematic risk, but the idiosyncratic risk can still be reasonably large. The waves of speculation in the frauds and the scams and the hypes have a cycle all their own.
The longer the expansion and the longer the bull market, the more intense the speculation at the end of it is. People’s sense of disbelief gets eroded, and their skepticism gets eroded the longer things go on.
They begin to realize that traditional metrics of value don’t count. It would have kept me from making all this money that my next-door neighbor made. And so, you begin to believe things that are too good to be true at the end of cycles.
I look at NFTs in 2021. For months on end, people were bragging about their digital apes being worth $500,000, $600,000, millions of dollars. And why? Because someone else was willing to pay it. It was patently absurd and led to tears, but you couldn’t tell anyone that at the time.
Of course, as it relates to frauds, again, people’s willingness to believe things that are too good to be true and look closely when everything is working, and everything is making you money, gets eroded in a bull market, whereas people are far more skeptical and far more parsimonious with their capital when they’ve lost money.
You can listen to the entire discussion here:
For all the latest news and podcasts, join our free newsletter here.
Don’t forget to check out our FREE Large Cap 1000 – Stock Screener, here at The Acquirer’s Multiple:
