Stock trading is easy and the madness of crowds

written by Peter Sainsbury

“Money won is twice as sweet as money earned.”
Fast Eddie Felson (Paul Newman) in The Colour of Money

During the first few months of 2020 the share price of a small Chinese company listed in the US rose 1,800%. No one really knew what the company did, or even whether they were still operating. The company had failed to provide any public disclosures since listing on the stock-market five years earlier.

The company was called Zoom Technologies and had the ticker symbol ZOOM. Unfortunately for those investors who bought into the rapid advance, Zoom Technologies has nothing to do with Zoom Communications, the video conferencing service that everyone has been using to hold meetings and virtual drinking sessions since lockdown. Concerned that investors might be getting confused, the US Securities and Exchange Commission promptly suspended trading in the shares for a brief period. Well done that lucky investor that realised their mistake (or the mistakes made by others) before the shares were halted.

This wasn’t the first time that investors have gotten stung by a case of mistaken identity. Less than twelve months earlier Zoom Communications listed on the stock-market. Zoom Technologies was again at the centre of investor confusion, surging from less than $0.01 per share to almost $6 in the space of a month. Knowing that investors get duped so easily, perhaps it’s ‘rational’ to seek out companies which have a name or ticker like actual companies with genuinely stratospheric share price returns.

Efficient Market Hypothesis

In theory, none of this should happen. At least that’s what many economists would have you believe. The Efficient Markets Hypothesis (EMH) suggests that markets cannot be beaten since all relevant information is automatically incorporated into the price. According to the economist Eugene Fama who came up with the idea:

“An ‘efficient’ market is defined as a market where there are large numbers of rational, profit ‘maximisers’ actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.”

Fama also identified three distinct strengths of efficiency in a market: strong-form (all private and public information is rapidly incorporated into the price, and so any trade can only ever be a pure gamble), semi-strong-form (there is no edge from trading on the basis publicly available information since the price already incorporates it) and finally weak-form (technical analysis, i.e. past prices are useless in predicting future prices).

The theory was popularised by Burton Malkiel in his 1973 book, A Random Walk Down Wall Street. According to the author the price of a stock or any other asset resembles a drunkard’s walk – meandering, erratic and unpredictable. Malkiel made the conclusion that since it was impossible for a money manager to predict unpredictable markets then it was better for investors to put their money in diversified, passive funds.

Bankrupt stocks

Zoom Technologies wasn’t the only example of crazy asset price movements during the corona crash.

Car hire company Hertz filed for Chapter 11 bankruptcy protection in May 2020 sending its share price in a tailspin. But after dropping 80% the shares surged more than 800% over the next two weeks. Alas it wasn’t to last. As the share price fell back from the peak Hertz issued a prospectus offering even more shares for sale, a highly unusual move for a company in Chapter 11. Canny investors would have spotted that the prospectus used the word “worthless” several times! The bubble in Hertz stock rapidly deflated almost as quickly as it blew up, declining by 70% to where it has remained depressed for the rest of the summer

US oil and gas producer, Chesapeake is yet another example. Oil prices in the America dropped to a record low of almost negative $38 per barrel in April and have since rebounded almost $80 per barrel to positive $40 per barrel. Teetering on the brink of collapse, the rebound in oil prices did little to improve the company’s fortunes. Many investors though took a different view. Betting on a rebound, the share price of Chesapeake surged 400% in early June before dropping back. Despite numerous warnings of impending bankruptcy, the coronavirus was the last straw for the shale-oil pioneer. Weighed down by billions of dollars of debt it filed for bankruptcy in late June.

On the face of it, buying shares in companies that are close to the edge or have just declared bankruptcy appears to be completely bonkers. Many investors made the bet that there might be enough recovery over the coming weeks and months for them to come out of Chapter 11, or that government intervention might come in and save them - akin to what happened to the auto sector after the Great Financial Crisis (GFC).

Even at the best of times the outcome of bankruptcies is highly uncertain. Add in a global pandemic and recession and uncertainty goes to a whole new level. What normally happens when a company goes into bankruptcy proceedings is that they may decide to cancel all the existing stock, rendering it worthless. Alternatively, the business may survive but new equity is issued meaning that existing investors equity stake becomes highly diluted.

Remember that stocks are an option on the future value of a firm. The risks of losing all your money might be close to 100% but if the upside is enormous it’s not completely irrational to bet on it. And so, it’s important to know who is with you, as once the tide turns it can leave you perched on the beach without your swimming trunks.

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The return of the day traders

“The main purpose of the stock market is to make fools of as many men as possible.”
Bernard Baruch

Sports cancelled. Nothing to bet on. Only Belarusian football to keep sports gamblers entertained.

Younger people have typically been worst hit by the economic fallout from lockdowns. With a lot more time on their hands, nothing to bet on and a need to supplement their income, speculating on the direction of the stock-market has been a useful, if not always profitable distraction. Stimulus cheques from the US government and furlough schemes elsewhere have further fuelled new investors interest in the stock-market.

Brokerage firms like Robinhood and others allow investors to buy fractions of a share, catering for the newbie investor with far less cash to kill. Instead of having to shell out more than $3,000 for a single Amazon share or over $1,000 for a share of Tesla, young and inexperienced investors eager to ride the technology boom have been able to buy much smaller slices. According to Deloitte almost half of North American men aged 25-34 who watch sports also bet on sports at least once per week. Around 80% of Robinhood traders are the same age with a similar percentage thought to be men.

Of course, there’s nothing wrong with young people developing an interest in investing. In fact, it should be encouraged, especially if it develops into a lifelong habit of saving and investing for the future. But the problems occur if inexperienced investors get introduced and addicted to ‘financial weapons of mass destruction’ such as options. Many have been wrongfooted by market volatility, suffering big losses when the market moves against them.

But with nothing to bet on, stocks have appeared to be a sure bet. Barstool Sports founder Dave Portnoy has been one of the most flamboyant characters of the lockdown, pivoting away from promoting sports betting to championing the stock-market. Before lockdown Portnoy had only bought one stock in his lifetime. With gambling on sports on hold during lockdown he turned his content creation skills to the stock-market.

At the start and close of every trading day he livestreams his thoughts on what to buy next. In one clip he rummages into a Scrabble bag pulling out an ‘R’ and a ‘T’ and then pumps $200k into the first company that came up, not knowing a single thing about it.

Dave Portnoy portrays his mission as sticking it up the establishment, “I’m sure Warren Buffett is a great guy, but when it comes to stocks, he’s washed up. I’m the captain now.” But with stocks only ever going up, he can do no wrong.

The greater fool

“If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring.”
George Soros

Many decades ago investors believed they were pitting their wits against professional traders dressed in bright yellow jackets, barking calls from the side of a trading pit. Watch the financial news on CNBC and you’d be forgiven for thinking this is still the case, in fact the old New York Stock Exchange floor is now just a TV studio.

Nowadays new or even experienced investors might believe that they are winning (or losing money) from other humans punching orders into a computer or thumbing them into an app. You are more likely going to be up against a bank of computers, the only audible sound being a gentle hum. Although estimates vary its thought that well over two-thirds of all trading on the US equity market is quantitatively driven by computers, automatically punching orders into the market.

Some of these automated strategies look to piggyback on the momentum in the market. If enough retail investors jump on a stock, even one that’s declared bankruptcy the sheer volume of orders can set-off a feedback loop which then draws in more retail investors.

Warren Buffet may be old, and he may have missed the rebound in airline stocks since the mid-March, but that doesn’t (as Dave Portnoy suggests) makes him “washed-up”. In a letter penned to his shareholders in 1987 he said, “If you’ve been in the [poker] game 30 minutes and you don’t know who the patsy is, you’re the patsy.”

With gamified apps making it easier than ever to play the market it’s easy to lose sight of who exactly is on the other side of the trade. One factor that new retail investors have overlooked is that nothing is ever free. And that also goes for commission ‘free’ stock trading. The brokerage firms route their order flow through high-frequency trading firms that can then profit from the bid-ask spread. They make so much money from it - especially for financial products like options - that they’re willing to pay big bucks to firms like Robinhood. The more that they can encourage you to trade, the more Citadel and others are willing to pay.

You see, it can be rational to buy bankrupt, overvalued companies that are going the way of the dinosaurs, as long as you think there is a good chance of finding someone willing to pay a higher price. The greater fool theory as it’s known, is the idea that during a period of sharply rising prices an investor can make money by buying overvalued assets and selling them for a profit later, since it will always be possible to find another investor willing to pay a higher price.

Until it doesn’t. Because at some point there are no more fools left to buy.

Split ends

In early August Tesla boss Elon Musk announced a 5-1 stock-split, taking effect from the end of August. This means that an investor who wants to buy a stake in the electric car company will be able to do so by purchasing a share one-fifth of the size as before, and existing shareholders will get 4 additional shares for the 1 they already have.

Everyone knows that slicing a pizza into smaller and smaller pieces doesn't increase the size of the pizza. The decision to slice Tesla’s equity up into narrower slices makes no difference to its ability to manufacture electric cars or build a better battery. However, just like Robinhood enabling investors to buy fractions of a share, stock-splits make a company more marketable to smaller investors. Before the split was announced, Tesla’s share price had more than tripled since mid-March making it expensive for retail investors to own.

The semi-strong form of the EMH suggests that no investor should be able to take advantage of the stock-split announcement since it will be instantaneously reflected in the share price. Taking account of pre-announcement speculation Tesla’s share price surged almost 20% in less than 48 hours on the news with investors continuing to push the price higher, even though all the information should have already been built into the price.

Elon Musk Stock Split

The wisdom of the crowd?

The EMH is based on the concept of the wisdom of crowds, i.e. that most individuals are poor at judging the value of an asset, but the collective decisions of a large collection of individuals is more likely to be accurate.

The first person to formally recognise the wisdom of the crowd was Francis Galton. At a livestock show in 1906 fairgoers were given the opportunity to guess the weight of an ox. The person with the closest guess winning a prize. Although over 750 people participated in the competition no single person guessed the weight of the ox. But when Galton took the average of all the guesses it turned out to be the exact weight – 1,198 pounds.

The experiment has been repeated many times subsequently with sweets in a jar replacing pounds of bull among other things. But the most amazing demonstration of the wisdom of crowds occurred after one of the most tragic of events. On 11.39 am on Tuesday 28th January 1986, the Space Shuttle Challenger took off from the Kennedy Space Centre. Millions of people around the world tuned in to watch the launch live. Seventy-three seconds later though Challenger exploded.

Weeks passed and investigators combed the wreckage of the flight data for clues. Eventually the focus of the investigation was narrowed down to the O-rings, large rubber seals around the joints of the booster rocket. A report was published 5 months later outlining the investigation. It was bad news for Morton Thiokol, one of the four companies involved with building the rocket.

How long did the stock-market take to punish the company? Amazingly the markets had mercilessly downgraded Morton Thiokol’s stock within 13 minutes, not 13 minutes after the publication of the report, but 13 minutes after the disaster.

13 minutes after the explosion the New York Stock Exchange halted trading in Morton Thiokol after it slumped 6% on volumes 17-times normal. When it resumed trading the stock fell further, ending the day down 12%. The other three companies also saw their share price decline, but significantly less and with much lower volumes.

Intraday Stock Price Movements by Motton Thiokol Following the Challenger Disaster

James Surowiecki argues in his book, The Wisdom of Crowds that “diversity and independence are important because the best collective decisions are the product of disagreement and contest, not consensus or compromise.” Unfortunately, diversity and independence are the most likely conditions of the wisdom of crowds to fail.

Following every stock recommendation from Portnoy’s Scrabble bag, buying the most popular stocks on Robinhood or scouring the subreddit r/WallStreetBets for tips is about as far away from the principles of the wisdom of the crowd as you can find.

As Charles Mackay tells in the book Extraordinary Popular Delusions and the Madness of Crowds, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.”

Reading this article, you would be forgiven for thinking that most investors are completely stupid. They invest in the wrong company with a similar sounding name or ticker. They invest in companies whose very own management describe as being “worthless”. They forget to wonder if they are the patsy - the greatest fool.

The crowd can be wise though, and that wisdom often appears in the most unusual of places.

Gone With The Wind

In early June HBO Max took the decision to temporarily remove the film Gone With The Wind from the US streaming service. Set during and after the American Civil War the film has long been attacked for its depiction of slavery.

After the news broke that HBO Max were removing the ability to stream the film, demand for the DVD and Blu-ray versions surged as fans rushed to secure their own copy of the film. Overnight the film shot to the top of the Amazon movies and TV bestseller list.

The price of the 75th Anniversary Edition Blu-ray sold by third-party sellers on Amazon rose four-fold. In late May the film cost around $10 but then began to gradually creep up as buyers sensed that the film might be restricted. It then surged to over £30 on news of the ban, before eventually rising to $40 by the end of June. As availability evaporated, some sellers even offered to sell the Blu-ray at the astronomical price of $334.01.

Gone with the wind price chart

Gone with the wind price chart

Collectables are an alternative investment that traditionally includes items like art, wine, and postage stamps. But it can include anything that is in short supply and that groups of people value highly. Fans of Gone With The Wind collect memorabilia relating to their favourite film and would have snapped up limited supplies if they felt they couldn’t watch their favourite film by streaming it. Other collectable speculators would have spotted the opportunity to buy DVD’s and Blu-ray’s at low prices in the hope of off-loading them for a higher price.

MTG ‘racist’ cards

In an earlier article I highlighted the Magic: the Gathering (MTG) trading card game as an alternative asset, one that has its own booms and busts depending on the demand for and scarcity of particular cards. MTG cards are traded in the same way as other collectables. If investors anticipate that demand for certain cards will outweigh supply, then they can profit from holding the ‘asset’ in anticipation of higher prices.

In mid-2020 the supply for some of the rarest MTG cards became even more acute. In the same way that the global civil rights activism that occurred in the aftermath of George Floyd’s death prompted HBO to temporarily ban the streaming of Gone With The Wind, MTG’s parent company took the decision to review racist references on its cards banning several different cards.

One particular card ‘Reparations’ escaped the ban, yet speculation that it could be next on the list of cards to be banned led to wild price speculation. From a low of €1 during May and June the price tripled during July before then spiking to €8 by the end of the month. An 800% return for any card holder that cashed out.

Prices slumped by over 75% within a week – much like the price volatility recently observed in the stock-market. But then in the first couple weeks of August prices began to rise again, more than doubling as speculation over a possible ban gathered force.Prices slumped by over 75% within a week – much like the price volatility recently observed in the stock-market. But then in the first couple weeks of August prices began to rise again, more than doubling as speculation over a possible ban gathered force.

Reparations price chart

Reparations price chart MTG

source: cardmarket

Play the players

Poker is a game where you can still win, even if you have a poor hand. For it's not about the cards you are dealt, but how you understand and take advantage of the other players at the table. The same principle applies to investing whether it be bankrupt or similar sounding companies on the stock-market or controversial collectable asset markets.

The crowd can be wise, but they can also be mad. The trick in betting and investing is to spot the transition taking place, take advantage of it but then jump off before sounder minds reassert themselves. Remember the words of Warren Buffet’s partner, Charlie Munger, “It’s not supposed to be easy. Anyone who finds it easy is stupid.”

Peter Sainsbury

Peter Sainsbury

Peter Sainsbury is the author of The Winning Formula: Betting on F1, Commodities: 50 Things You Really Need To Know and a number of other books. At Material Risk he details his observations from the world of commodity markets, economics, and investing.

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