The Future of the Stock Market
Note: We’ll take a break next week. Happy 4th!
Fortune ran an article in its June/July 2021 issue that was absolutely a delight to read. It was titled: Your father’s stock market is never coming back. It is unfortunately behind a paywall, but we suggest that you find a way to read it. Hey - do it legally; be a subscriber or buy the print issue.
The Fortune story takes us through the journey of a father and son. The father invested the old-fashioned way with lots of due diligence and research. No getting rich quick, no risky stuff, just patiently accumulating wealth over time. The son did it differently. You know, with coins and stuff, and using leverage. He started with $25,000 and turned it into $800,000 in 12 months. 12 months!
It is hard to call this investing at all, but can you argue with the results? Is the dad just a sucker who doesn’t understand the new world? Or is the son a dangerous speculator who will likely lose most of this wealth when the tide turns? (Take profits along the way is what we like to recommend.)
This old guard vs. new guard theme is not going anywhere. As Warren Buffett gets ready to hang up his shingles, and Chamath Palihapitiya tries to become the new king, this generation seems unprepared to navigate through a world when credit won’t be cheap, the stimulus money will be gone, and the stock market will stop going straight up. When that happens, and it’s not a matter of if but when, there will be much blame that goes around. People who may not have appreciated that the reason they made so much money in the first place was because they were speculating and not investing. There will perhaps be a “come to Jesus” moment when people realize that what separates speculation from an investment (in a financial asset) is the margin of safety; the more margin you are willing to give up, the more risk you are taking and the more risk you are taking, the more money you can potentially make.
Yet, today we clearly live in a world where, in the words of the infamous John Maynard Keynes, “animal spirits” rule.
Speculation is as raw a desire as they come. The possibility of making it big, with as little effort as possible, is a dream that most of us have, at least from time to time. Entrepreneurship, after all, is a form of speculation. It is the very idea that you can put together a business better than somebody else. You can point out, and you would be correct, that entrepreneurship is not exactly making it big with “as little effort as possible.” It certainly isn’t! But if you are going to work 80 hours a week anyway, and make somebody else rich, you might as well have the upside.
Here is what it comes down to: most businesses fail, but from an entrepreneur’s standpoint, there is always hope that they are the exception. If your son, your friend or your significant other wants to become an entrepreneur, you will support them, but you will likely feel an obligation to remind them that the statistics are not on their side, that the odds are stacked against them. Entrepreneurs, on the other hand, believe, because they have to, that they can defy the odds. You would not coach a young basketball player to take a shot from the logo, but if Steph Curry never took those shots, 100% believing that he can make them all, he would not be Steph Curry. Different rules apply if we are talking to ourselves vs. others.
Speculation in the form of entrepreneurship will create winners and losers, but on the balance, it is generally forward progress for society. Whether speculation, at least the excessive version, is good for financial markets, is less clear. Done right, it not only helps with price discovery on the secondary market but also incentivizes more capital formation in the primary market; knowing the destination arguably creates more entrepreneurship on the front end. Go overboard, however, and stock markets can become disconnected from reality with all kinds of implications.
Even if speculation is a natural desire, arguably it was fairly bottled up. It always existed in some corners of the stock market, but it wasn’t quite happening in a coordinated way. There were no memes, no diamond hands, no gathering online where you can tell YOLO (You Only Live Once) stories. There were also not a lot of tradeables that you could speculate on. The stock market was there, sure, but we engaged with it differently. There were no apps, no confetti when you completed a trade. Derivatives markets were largely boring, and at least until 2000, there was this thing called the Economic Purpose Test, which did a pretty good job of keeping entertainment out of the market. If your product served a purpose to society, it was a go and if it didn’t, then it didn’t hit the market. Even after the Economic Purpose Test was repealed, it continued to be a relevant yardstick, and resulted in, for example, the election markets not becoming a thing.
So if you wanted to speculate your choices were rather limited. You could try your chances in the stock market, but i) if you were a retail trader, you were not exactly encouraged to participate in the stock market; ii) futures markets were largely boring and you probably did not qualify anyway; and iii) sports gambling was off-limits, because of a variety of laws such as the Wire Act, PASPA, etc. Faced with these choices, most people participated in low-cost index investing or they sat the whole thing out.
In just the last few years, some material changes happened in all of these areas. You can entertain yourself on Robinhood quite a bit while keeping Reddit open in a second window. Derivatives markets haven’t arguably changed that much, but somebody tried to sneak in some football contracts while trying to argue there is hedging utility (they didn’t go anywhere), but it may be indicative of what is to come. Finally, PASPA is gone and sports gambling is expanding.
These are topics we have covered in the past and we can easily write many more pages on each of them. Today, though, it suffices to note that this moment feels like a dangerous perfect storm where the pendulum may have swung a bit too much in the direction of unlimited entertainment, and while the costs to society are neither immediately visible or easily quantifiable, they are very real.
The Fortune article recognizes this tension. Below, some excerpts: (Fortune - we trust that you are ok with this. We are trying to send people your way.)
Remember when stocks traded on fundamentals? Or at least they traded based on people’s perceptions of the fundamentals. What do they trade on today? It was always a popularity contest. Now it’s a three-ring circus.
Bingo. For decades, MBAs were told that markets are efficient, and if they weren’t, you weren’t likely fast enough to capitalize on, because somebody else would have already done it. Institutional money was smart and retail money was dumb. Smart money did fancy valuations and retail acted on their emotions. The markets didn’t always agree with you, but if you had patience and capital to ride out the storms, prices eventually converged (mostly) to value. Being rational was a good trait and having good information (or vision) was generally rewarded.
To say that markets are efficient now is really a stretch when AMC can go from 2 to 60 faster than a Tesla. Or, when retail traders started accumulating Hertz shares in the middle of a pandemic after they had declared bankruptcy they actually got rewarded with substantial price appreciation. Or, when GameStop speculators made a killing when it was hard to find any remotely plausible story as to how it would successfully pivot to a 21st-century company, which may be the only path that could justify its stock price. Perhaps the markets were efficient at some point, or they were reasonably close. Today, though, it seems like everything just goes up!
The starting point in economics is that people are rational. Even when irrational behavior was documented time and time again, the profession looked for some rational explanation that may have been unthought of. Claiming that the homo economicus is irrational? How dare you! Surely, there was an explanation lurking somewhere that we missed. This was nowhere more obvious than in finance. In consumer choice, at least there was some myopic behavior which can rather easily be explained with people being impatient. Or perhaps the costs were not easy to calculate. In finance, the costs were both easy to calculate and they were immediate. If you completed a bad trade, you felt the pain immediately. You had to be rational or you didn’t participate at all.
We are not sure whether that holds anymore. When the Reddit crowd wears trading losses as a badge of honor, it becomes difficult to develop an investment thesis, act on it and sit back and wait for the market to reward you. At the end of the day, nobody really pays dividends anymore, so to make money, you need to find a buyer. If buyers are buying not because they expect cash flows to be higher in the future but for other reasons, what is the point of being good at estimating cash flows?
Millions of new brokerage accounts. Trillions in value transferred from taxpayers and the Federal Reserve into accounts at Robinhood and Coinbase. More money pouring in with every paycheck. Leverage, too, because this generation is truly fearless or (more likely) they haven’t had enough time to lose money yet. Either way, they decide what’s important to pay attention to and what’s irrelevant. If they choose to react to 10-word Elon Musk tweet rather than a three-hour Warren Buffett monologue, how will you stop them?
There are two excellent points made here. First, if you never experienced pain, you are not (yet) incentivized to act differently. Second, if you don’t care about cash flows, then presumably you don’t care too much about people who have been historically good at estimating cash flows, like Warren Buffett. At Money Stuff, Matt Levine actually created the Elon Markets Hypothesis. “Things are valuable not based on their cash flows,” he says, “but on their proximity to Elon Musk.” Hey, he is only half-joking. If that’s how people trade, there is also little reason to comb through the corporation’s 10-K. What good is information if the majority of the market is not going to act on it? This turns the whole concept around regulating information asymmetry on its head and creates all kinds of difficulties with protecting investors. After all, if investors don’t care about protection, what do you do? If they trade on Elon’s tweets, is that not a choice they have? (assuming Elon is not disseminating material nonpublic information, of course).
We locked everyone in their homes for a year and gave them a virtual life to live on their screens. why should we be surprised if they treat money and investments like prizes in a video game.
We talked about the gamification of investing a lot here. This is a very difficult problem to solve. Investing is, or was, serious business with serious consequences. With the pandemic, it became an entertainment device. Matt Levine has a name for this as well, the “Boredom Markets Hypothesis”. The Boredom Markets Hypothesis says that people will buy stocks when buying stocks is more fun than other things they could be doing for fun.
Whether things will go back to normal remains to be seen, but one thing is pretty clear: we as a society have never been this confused about games and markets.
With a Robinhood account, your first exposure to cryptocurrencies does not frame them as an unproven alternative to stocks. The two stand on equal footing. Coke and Pepsi. Feel like trading one or the other? Have at it, no difference. This is radically different from the experience of the Gen X and boomer investors … The generation creating the new conventions of the investing landscape views stocks and crypto coins as interchangeable.
Another excellent point. If every tradeable is a financial asset and every trade is an investment, then the world of finance turns into an utopia that was unfathomable just a few years ago. Everything trades and nothing matters. What people are buying or whether they know what they are buying becomes pointless. It trades! That’s all that matters. If you can buy it, it means that somebody else can buy it from you and potentially at a higher price, so you can become a zillionaire overnight. Almost everything becomes an application of the Greater Fool Theory and bubbles develop all over the place. Do bubbles ever remain bubbles?
As we have long maintained, going back to definitions solves this problem. Stocks and crypto are NOT interchangeable. Investing and speculation are NOT the same thing. A financial asset and balance sheet asset are two entirely different things. Trading everything and anything under the sun is likely not in society’s best interest and it certainly isn’t when these definitional nuances are not appreciated. (see, e.g., the Dutch Tulip Market)
It has taken us a while to figure this out, but AllSportsMarket is not just a sports stock market. It is also an opportunity that helps us go back to basics, a vehicle that teaches us finance, a tool that will make finance, finally, accessible to most if they choose to engage.
The Fortune article also takes a bit of a pessimistic view for the father, the prudent investor. The article says the father has “got his work cut out for him.” Maybe so, but it is not a foregone conclusion that we will all speculate endlessly to entertain ourselves; in fact, we think it’s the opposite. We will finally understand the differences, appreciate the nuances and re-build the world of finance into what it has always meant to be, a great equalizer that gives everybody access to opportunity.
We’ll get there, but we’ve got our work cut out for us.