In today’s issue:
- Passive aggressive investors will pay anything
- Why it’s a seller’s market
- It’s no time to be agnostic about value
Stock markets used to function very differently. Legendary investor Bill Fleckenstein reminisced about it in a recent interview. As he recalls, insight, analysis and fundamentals used to drive prices up or down. If the price of a stock moved, it meant something. There was a truth to it.
Or, at least, someone claiming to have found the truth had put their money on the line. They did this because something about the company had changed. They’d figured something out and moved the market by taking a position.
Perhaps a company’s drug had worked, or their competitors had a good quarter.
Other times rigorous analysis would lead to exposing something that’d been hidden. Perhaps some dodgy accounting on the balance sheet, like Enron’s. Or the demand for Nvidia’s products which AI innovation would trigger.
When the price of a stock moved, people presumed there was a good reason for it. And tried to figure out what it was.
In hindsight, the move was always explained. And those who had foreseen it were congratulated… with profits. Those who were wrong lost money. Either way, everyone knew why it had happened.
But these days, people buy and sell stocks for very different reasons. And that has undermined the meaning of prices.
Passive aggressive investors will pay anything
People now buy stocks based on what their favourite Instagram influencers promote.
Or university students gang up on a hedge fund with large short positions in a stock. That’s how some of the biggest stock price moves of the pandemic occurred. Here’s how it worked…
Kids on the blogosphere find a company that hedge funds have a large short position in. They buy the stock, pushing up the price. This forces the hedge fund to exit the position to avoid further losses. But reversing a short position only sends the price soaring even more. Until the spike becomes extreme. It’s complete chaos. But the company itself remains entirely unchanged during the whole drama.
Arbitrary rules about what funds can invest in can trigger a rush into or out of an asset too. For example, when a stock is included into an index like the FTSE 100, it suddenly becomes an investable asset to those funds restricted to FTSE 100 stocks.
Similarly, funds might have to sell stocks that fall out of their remit when they’re cut from an index. Even if the company’s prospects haven’t changed one bit, the price can move as a result.
There’s also wilful ignorance, better known as passive investing. Some pension funds allocate members’ contributions to a list of stocks without pondering what they’re actually buying. They see it as the FTSE 100, not a list of individual companies with very different prospects.
And their members haven’t the foggiest idea what they own via their pension fund either. How many climate change protestors own BP in their pension without realising it?
But the point is that this means share prices can move for reasons that have nothing to do with company at all, only with pension inflows and outflows.
A seller’s market
I’d like to propose a bizarre theory about what this shift means for stocks. In short, the seller now determines the price, because the buyer is wilfully blind.
In the world Fleckenstein recalls, both the buyer and the seller worked out the price between them equally. Both were trying to get an edge somehow. They tried to work out whether the value of each stock was higher or lower than the market price. And both could move the market by taking a position.
But many investors today don’t buy stocks based on valuations, fundamentals, predictions, or any such measure about the company. They buy for all the bizarre reasons outlined above. They don’t care about price.
Often we’re just paying our pension contributions to a passive fund and the fund allocates the inflow to the index. It is an indiscriminate purchase that depends on the amount of pension contributions and the makeup of the FTSE 100 or FTSE 250. The prospects of individual companies have nothing to do with it.
Demand has become agnostic about value
Put to one side whether you think this is a good or bad thing. Instead, consider the implications. If demand is not setting the marginal price based on the merit of the asset, what’s left?
On the selling side things are a little different.
Everyone has their price, as they say. And so it is for every asset they own. At some price, they are willing to sell.
Based on this, my conclusion is that stock market prices are now driven by a seller’s estimates of their stock’s value. Only once buyers bid up to the marginal seller’s willingness to sell does a transaction take place. And then it is recorded as the market price assigned to the ticker code.
Thus, if sellers believe an asset is worth £10, and buyers don’t care what the price is, the transaction takes place at £10.
What makes this intriguing is that owners of an asset inherently have a rather high opinion of it. They believe the value is great. That’s why they own the stock. This means their perception of value is a little one-sided. Stocks are constantly getting bid up to the seller’s rosy views.
Without sceptical buyers who believe the stock is worth less, prices are out of kilter.
Let me know what you think of this theory: [email protected].
What’s an investor to do about the way in which the stock market has changed? Well, this is no time to be agnostic about value. The market’s passive aggressive nature has created risks and opportunities to profit. More about how you could profit in coming days.
But first, consider that any wakeup call for buyers could do. It’d make them discover what’s been going on. By buying indiscriminately, they’ve been overpaying for assets. Their true value is much lower.
The buying could drop out of the market. The result would be a crash based on nothing more than buyers paying attention to the value of what they buy. A real “emperor has no clothes” moment for passive investing.
Until next time,
Nick Hubble
Editor, Fortune & Freedom
