Updating The Spock Market

 

Stock Market’s Wild Mood Swings Can Be Explained by Mr. Spock
Think of the “Star Trek” character and the calm punctuated by fits of euphoria and bouts of despair will be easier to understand.
Bloomberg, June 22, 2020

 

 

 

 

The Spock Market

Clients, colleagues, even family members keep asking the same question: “Why have stocks decoupled from the economy?” These are not people who obsess over the Federal Reserve’s asset balance sheet, or spend time with the Bureau of Labor Statistic’s Birth-Death model. They just want to know, “What the hell is going on?”

The gulf between peoples’ daily experiences and the market has never been greater. It is a huge source of confusion. Traders, are alternatively exuberant and panicked, swinging markets up or down 10% in a day. By March 2020, indices had fallen 34% from the previous month’s highs; despite horrific news flow, they bounced back 44% from those lows. My Bloomberg colleague John Auther describes it as the “Insanity Trade.”

No wonder the public thinks Mr. Market is dangerously bi-polar. They do not want to hear abstract academic theory: that markets are probabilistic mechanisms, collectively allocating capital by incorporating imperfect information about an inherently unknowable future. Discounted cash flow models and the efficient assimilation of market information reflected in price leaves them cold.

What they want is a simple, easy-to-understand explanation. I have discovered a way for them to better understand Mr. Market. All it took was to reveal his true name. Gentle readers, I share this previously unknown moniker with you now:

Mr. Market’s true name? Mr. Spock.

A short explanation for the non-Trekkies: Spock is the science officer and 2nd in command aboard the starship U.S.S. Enterprise;[i] He was born to a Human mother and a Vulcan father.[ii] The Star Trek Universe portrays Humans as emotional, unpredictable and irrational (in other words, accurately). Vulcans are an ancient civilization, whose history of violence and emotion brought them to the brink of self-destruction, which was avoided only when the entire species embraced a radical control of their emotions.

 

Raised on planet Vulcan, Spock fully embraces the Vulcan philosophy of logic.[iii] But since he is half human, he struggles balancing between logic and those emotions. Once you accept that Mr. Market is Mr. Spock, the raging disconnect between the economy and equity prices disappears. Consider the following:

 

Investors are rational: Much of the time, markets are understandable and make intuitive sense to investors. Profits rise, so too do stocks. The economy tanks, stocks roll over. There are long trending periods when stocks meander upwards, reflecting positive developments in technology, taxes, inflation, etc. This is the Vulcan logic of equities, a reflection of investors’ inherent rationality.

 

Investors are irrational: At extremes, traders seem to lose their minds. They are really indulging their emotional halves. It is especially obvious at turning points: Recall the March 2000 dotcom highs, when new companies were trading at 100 times earnings. Or the March 2009 financial crisis lows, when prices were cut in half and selling was indiscriminate. The points where groupthink takes over the crowd, where emotions run rampant and greed and fear can overwhelm investors – that’s investors indulging their human half. The Nobel prize committee recognized this in 2013.[iv]

Day traders buy bankrupt companies because their prices are rising; they sell quality holdings at very low prices because others have done so also. What could be more human than FOMO – the fear of missing out on gains? Perhaps only loss aversion, the panic we feel when real money disappears into an ugly sell off. Irrational investors create opportunities for those who recognize this in real time.

Markets are Efficient: The volume of information is so enormous, it can never be fully grasped by one person. Yet prices reflect all of what is known, manifest when people act on their collective knowledge. This lets markets effectively communicate all of the known information and data that has been expressed by these information holders through their buying and selling of equities.

Price, in other words, is the most efficient collective probability bet about the future. Very rational, indeed.

Markets are very Inefficient: Efficient, yes, except when those efficient expressions turn out to be wildly wrong. Note this is not when a trade turns out to be a loser, but part of a good probabilistic analysis. Rather, when the analytical framework underlying the trade turns out to be completely unfounded.

This is when our emotional half makes the rational half go off the rails. Rather than describing markets as “efficient,” it is more accurate to describe markets as somewhat efficient, much of the time, getting there eventually, with its efficiency rising and falling in opposition to levels of human emotions. Markets are more or less efficient, except when they are not.

Most Investors do not know they don’t know: Listen to any explanation of market behavior; they are usually filled with hindsight bias and rationalizations. It is rare to hear someone asked a question about market behavior and not give a detailed after the fact narrative. Few are willing to says “I don’t know” or “Its essentially random.”

Spock, however, is far along the Dunning Kruger curve. He often notes his lack of understanding with a simple response of “Fascinating.” His logic and ego control allows the admission of not knowing. Investors often get into to trouble when they imagine they have an understanding about things they do not. They are much further back on the DK curve.

Spock’s mixed Human-Vulcan heritage was a great plot device that allowed Star Trek to subtly comment on human nature and the ongoing cold war. Long before Amos Tversky and Danny Kahneman started their research, the duality was an obvious metaphor about the battle between logic and emotion, between our intellectual capacity and our baser motives.

Investors who the recognize the Spock market[v] will better understand both what is going on in the world, and the impact of their own behaviors on their portfolios.

 

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1. Spock also served as a Captain, Admiral in Starfleet, and Federation ambassador.

2. Due to this mixed species heritage Spock had to be removed from Amanda’s body and raised in a test tube for two months, during which time Vulcan scientists made subtle chemical adjustments to the fetus to ensure its survival. The fetus was returned to Amanda’s body to complete the human gestation period, then put in an incubator for four months to complete the Vulcan gestation period. He is the first such mixed race child to survive.

3. If you want to learn the history of Vulcan philosophy, begin with Surak, “the most important philosopher in the history of the planet Vulcan.”

4. By awarding the Nobel Prize to both Fama and Shiller, Stockholm recognized this schism. Fama’s thesis was pricing mechanism of markets were so efficient that they were difficult (if not impossible) to beat; Shiller’s data overwhelmingly showed that markets could be irrational as the humans who traded them. Bubbles form, prices detach from reality, then crash back to Earth.

5. Not to be confused with the trading game of the same name – Spock Market – was similar to fantasy football, only with Start Trek characters during reruns and a sort of drunken bingo:

“The Spock Market is actually kind of fun. You set up an account and are given 15,000 Federation Credits or FDR. You can then buy and sell different “stocks” based on characters and items from the show. For instance, my portfolio is composed of Scotty (SCT), Chekov (CKV), Communicator and Communications, Inc (COM), Federation Costume and Uniform (FCU), Dilithium Mining and Mineral (DMI) and Red Shirt (RDS). The object is to be one of the top 6 Traders.”

 

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I originally published a shorter version of this at Bloomberg, June 22, 2020. All of my Bloomberg columns can be found here and here

 

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