The Invisible Hand Will Sink These Markets
publication date: Feb 26, 2021
author/source: Brian Nelson, CFA
Image: Nan Fry
By Brian Nelson, CFA
Adam Smith’s “Invisible Hand” is often thought to be a blessing by the capitalists of the world. The free-market economy will find the right answer, they may say. Self-interest and greed will inevitably push humankind to new horizons and achieve levels of greatness no person before thought possible. What fools we are to believe.
Irrational behavior around shares of GameStop (GME) continued Friday, February 26, with the company trading in a huge range of $86.00-$142.90 on the session. We re-released our 16-page report on the stock and peg a fair value estimate of just $4 per share, with the high end of the fair value estimate range of $7. A Bank of America analyst reiterated a $10 price target. GameStop shares closed at ~$102.
There’s clearly no reasonable basis for owning GameStop’s stock at current price levels, in our view, and there certainly was no reasonable basis when the stock was trading as high as $483 per share earlier this year. An equity capital raise by management would result in a fair value estimate increase (perhaps a material one depending on how many new shares the market can stomach), but the takeaway is the same:
These markets are nuts. The iceberg is coming, and we’re still going full steam ahead.
The Securities and Exchange Commission (SEC) noted February 26 that “as part of its continuing effort to respond to potential attempts to exploit investors during the recent market volatility,” it had suspended trading in 15 more stocks—all “because of questionable trading and social media activity.” We applaud the SEC for its swift action, though much more is needed, and it may be too little too late.
Unlike the dot-com bubble roughly two decades ago, the fervor of the price-agnostic trading frenzy of 2021 has an aura of permanence to it. This “craziness” is here to stay. Where during the dot-com bubble, sell-side analysts were in a race to set the highest price target, regardless of their underlying opinion of the firm, there was a solution to the problem. Get rid of the bad apples. But today, we have a fraction of the sell-side analysts we used to; they’ve been out of a job for some time now.
Fired – in favor of underperforming statistical quant work or the fantasies of artificial intelligence and machine learning. More than 60% of trading in the marketplace is now driven by indexing, algorithms and quant traders chasing momentum or following trends--or moving stocks higher or lower based on simple P/B or P/E ratios. The quants know statistics, but of finance they know little.
Moreover, there are trillions in indexed products, and their overseers believe we still operate in an environment like that of even a few decades ago—when sell-side analysts were pulling seven-figure salaries because the invisible hand rewarded price discovery. We are not operating in such an environment. The price setters have almost all left. Shown the door, even.
The best finance schools aren’t teaching how to responsibly evaluate the fundamentals of a company and haven’t been doing so for decades. Heck, they think they’ve “solved the market” with backtests and “made up” factors. They are teaching coding or indoctrinating students to believe that any share price is as good as the next (GameStop at $450, for example – what a deal! – yes, sarcasm), or that the market simply knows best. Maybe years ago, the market was once a decent price-setting mechanism, but today, it is most certainly not.
GameStop is just one of at least a few dozen rather large stocks whose share prices make no sense--and I’m not talking about Tesla (TSLA). There's actually some reasonable basis to Tesla’s valuation. It’s not just the two dozen or so companies that the SEC suspended trading today either. This nonsense is everywhere. Do we really believe that a $7 trillion asset manager like Vanguard, or the trillions in indexed products today that pay little attention to intrinsic value are not also distorting market prices?
Pretty straightforward, no? But some of the brightest minds on the Street today may say in disbelief: “Full Steam Ahead!” Of course, some of them are just stubborn. They’ve been singing the same tune for decades, finding different ways to say the same thing over and over again, and they can’t change it now. They’d be wrong, and their egos couldn’t take it for one second. The invisible hand is yet still working overtime.
Elon Musk tweets out a Clubhouse app and a completely different company with the ticker CMGR soars. The same situation happened to another company called Signal Advance (SIGL) over another one of Musk’s tweets. Yet another instance like this but without a Musk tweet occurred with confusion of ZOOM last year. There’s no fix to this, and these are just the distortions we see clear as day.
You can’t convince a die-hard index aficionado that’s hauling in $20 million a year on a book of business that he’s built based on the faulty efficient market hypothesis and underperforming modern portfolio theory to all of sudden care about the greater good of society. What did Upton Sinclair say: "It is difficult to get a man to understand something when his salary depends upon his not understanding it.”
Nobody cares that these markets are going straight to the bottom of the ocean like the Titanic, no more than uninformed nations can heed the warning of climate change before it's too late. We’re headed for disaster one way or another. The incentives have been in place for a long time. “Sell index funds. Look – random factors can explain these returns.” Most of what’s coming out of finance today is nonsense, padding the wrong pockets.
How many people celebrate when they get the fair value of a company, correct? Where’s that on the news? Pay a man twice as much to not do individual due diligence on stocks, and just mechanically rebalance assets every six months or so and not give a damn about the health of the marketplace, what do you expect? You don’t think Jack Bogle is hailed as a hero by advisors for saving individual investors money, do you? Jack hasn’t saved the prudent stock picker a plug nickel.
Adam Smith’s invisible hand of active management used to result in the optimization of price discovery, where participants would do their very best work to buy and sell to “uncover” the best market price, creating a positive externality for all investors--even those quants and indexers that are now polluting the system. Today’s invisible hand is leading us off a cliff. Incentives are in place to continue to discourage price discovery, and to no surprise, we’re seeing just a glimpse of it.
Iceberg ahead, and very few see it. Sure, there are perma-bears that have been bearish for the past two decades that are right twice a day like a clock, but we’ve been bullish. The ship is damaged, the markets are going to sink, and it’s not the “little guy’s” fault. The distortions in the financial markets are clear when viewed through the lens of a $6 billion company GameStop, but they are no less evident than implicit distortions caused by a bunch of index funds piling into the same name at once.
We didn’t hand out Nobel prizes just for Long-Term Capital Management to blow up. We didn’t hand out Nobel prizes for EMH just to witness what’s happening in the markets with stocks like GameStop doing what they’re doing. We didn’t hand out Nobel prizes to provide excuses for why modern portfolio theory in the form of the 60/40 stock/bond portfolio has failed investors for the past 30 years relative to a monkey throwing darts at the WSJ pages.
Why are we handing out Nobel prizes -- and why doesn't Warren Buffett have one? You get the type of academic work you incentivize, and incentives are out of whack. I’ve said jokingly that finance for the past 60 years can easily be summed up by two developments: 1) Oh, you can’t do stock analysis? Well, here’s indexing. 2) Oh, you can’t beat the S&P 500? Well, here’s some quant jargon.
Indexing and quant jargon are doing far more damage than a few traders on social media. Believe you me. These markets are not well, and the invisible hand is guiding through a fog of misinformation to disaster. Markets have bounced right off the high end of our fair value estimate range on the S&P 500, and we’ve raised cash. The violins are playing on the Titanic. The “unsinkable” ship we call the price discovery mechanism of the markets can sink. Let us not be fools to think otherwise.
There will be an epilogue to Value Trap, and you and I both know that I don't want to write it. Let's keep playing the violin for now.
Tickerized for GME, CMGR, SIGL, TSLA, ZM, ZOOM
Temporarily Suspended Trading: Bebida Beverage Co. (BBDA); Blue Sphere Corporation (BLSP); Ehouse Global Inc. (EHOS); Eventure Interactive Inc. (EVTI); Eyes on the Go Inc. (AXCG); Green Energy Enterprises Inc. (GYOG); Helix Wind Corp. (HLXW); International Power Group Ltd. (IPWG); Marani Brands Inc. (MRIB); MediaTechnics Corp. (MEDT); Net Talk.com Inc. (NTLK); Patten Energy Solutions Group Inc. (PTTN); PTA Holdings Inc. (PTAH); Universal Apparel & Textile Company (DKGR); and Wisdom Homes of America Inc. (WOFA), Bangi Inc. (BNGI); Sylios Corp. (UNGS); Marathon Group Corp. (PDPR); Affinity Beverage Group Inc. (ABVG); All Grade Mining Inc. (HYII); and SpectraScience Inc. (SCIE)
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Brian Nelson owns shares in SPY, SCHG, QQQ, and IWM. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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