In 1978, prominent sociologist Mark Granovetter developed a threshold model to explain collective behavior, which may be pertinent to the current euphoria in parts of the equity market. According to his theory, every person has a “threshold,” defined as the number or proportion of peers who they must see act before that person will join in on the action. For example, when one house puts up Halloween decorations, it makes their neighbors more inclined to decorate as well.
In markets, these crowd dynamics can overshoot fundamentals. Finance-focused chat rooms and social media amplify the visibility of peer stock buying, which according to Granovetter’s model, makes it psychologically easier for other retail investors to likewise speculate, sometimes excessively.
This year, lower quality, speculative stocks are soundly outperforming higher quality stocks with stronger fundamentals across markets. For example, the Goldman Sachs Meme Index tracks the performance of the U.S. stocks that are most popular among retail investors, particularly those with high social media visibility. Retail buying has pushed the index up 67% this year, and the index is trading at an incredible, likely unsustainable, 170 times forward earnings.1
In a euphoric market environment, it is important to be even more diligently aware of the securities you own. As crowd dynamics and large equity gains blur the distinction between investing and speculating, investment discipline becomes more valuable, but also more psychologically difficult.
1.The historic S&P earnings multiple is less than 20 times forward earnings. Chart Source: Bloomberg