Most people would agree that the rational investor is a rare creature in financial markets these days. Be that as it may, it's worth reflecting upon whether you fall into the opposite camp, what are known as "noise traders," people who misconstrue the potential for future returns.
Put simply, noise traders are those who buy high and sell low, as Milton Friedman observed.
It turns out, though, things are more complicated than Friedman put it. Some wild bets on stocks are highly risky but they can pay off, according to voluminous economics research. Noise traders as a group can survive and thrive, and they can even dominate markets. But it's also true that individual traders with incredibly unreasonable expectations can go broke. The dividing line seems to be just how wildly unrealistic the bets are.
High valuations on tech darlings and recent IPOs such as Zoom Video Communications (ZM) - Get Report , Tufin Software Technology (TUFN) - Get Report and PagerDuty (PD) - Get Report suggests a good chunk of the new highs in the market are just the result of speculative excess by noise traders. Whether that momentum can last may be a function of how realistic the extreme optimism of noise traders is.
Who are noise traders? As opposed to rational investors, noise traders tend to gamble that one or another factors having nothing to do with a company's asset value will move a stock's price up or down in short order. The belief is usually informed by a vague notion that whatever the price of a stock is now, it surely is over- or under-valuing the true worth of the company (speaking unscientifically, it seems there are more bullish noise traders than bearish ones, but the phenomenon could also apply to those betting something must come down in price sharply).
Noise traders tend to fixate on the shares of companies that are young, hard to value and sometimes thinly traded. Some or all of those attributes characterize many of the newer tech stocks out there, including Zoom, Slack and PagerDuty.
The theoretical foundations of the phenomenon of noise traders goes back decades. Economist Robert Shiller started writing in the 1970s about excessive swings in the market tied to fads and fashion -- something that has come to be known as behavioral finance and market psychology.
The Friedman view of things was that such fads would always be defeated over time by rational markets.
But researchers who built upon Shiller's insights said that's not necessarily the case: noise traders can in fact dominate. Economists J. Bradford De Long, Andrei Schleifer, Lawrence Summers and Robert Waldmann showed theoretically that by taking on excessive risk, noise traders can gobble up more wealth than rational investors as a result of the excess returns on speculative bets.
"Noise traders as a group can not only earn higher returns than do rational investors but also can survive and dominate the market in terms of wealth in the long run," they wrote.
One reason noise traders come to dominate is because arbitragers, who should restore balance by betting against noise traders' excesses, have a limited appetite for risk, and they can be chased out of the market by the continued success of noise traders bidding up prices. Hence, the market loses the important counter-balancing force to return prices to a proper level.
So are today's investors in tech stocks seeing the future potential of companies, or are they simply noise traders? Zoom and Tufin and PagerDuty aren't profitable, but all three have seen amazing returns since their debuts in April. Tufin is up 55%, Zoom is up about 53% while PagerDuty is up over 26%. All three have done much better than some other recent IPOs, including Slack (WORK) - Get Report , the workplace messaging software maker. Although up on Monday on some bullish analyst notes, Slack is down about 10% since its June 20 debut. Uber (UBER) - Get Report and Lyft (LYFT) - Get Report , the ride-sharing services, have also traded down.
The swift momentum upward by Zoom, Tufin and PagerDuty in the past three months is accompanied by little in the way of fundamental upward revision of their financial prospects. Yet all three now trade for exorbitant premiums. Zoom fetches 34 times the $754 million it revenue it may earn over the next fiscal year. Similarly but not quite as extreme, PagerDuty fetches 17 times next year's estimated $209 million. Finally, Tufin trades for a less demanding seven times next year's projected $133 million, though that is still pricey relative to other tech names.
These valuations are not entirely out of keeping with a generally white-hot market for cloud software companies. Okta (OKTA) - Get Report , the maker of software that authenticates corporate users to enterprise computer systems, is still losing money and trades for 21 times its projected $717 million next year. Okta shares are up 81% this year. Meanwhile, that estimate for next year's revenue has only risen by about 7% this year.
It's hard to say when noise traders' expectations get out of hand, as valuation always involves some uncertain factors for such young companies. But given the sharp move up in the shares of young companies such as Zoom and Okta, the bets are not only speculative, but approaching the grossly speculative side of things. And that could spell trouble for noise traders.
Tiernan Ray neither trades nor owns shares of any companies mentioned in this article.