Hello again readers, it’s your favorite snark machine.
It seems the timing of my first post was serendipity, because just as anticipated in the proposed salience-based trading paradigm, we saw some unique fun during Tuesday’s trading session.
Of course the Gamestop hype machine is also showing no signs of really stopping, leading the financial news aghast, most professional traders chuckling, and Discords alight everywhere with people dreaming of riches or extolling how smart they are for not understanding how risk-adjusted return actually works.
So what is actually going on here?
This blog post seriesis an attempt to frame the qualitative phenomenon of salience in a measurable, tradeable way.
If you’re tracking from Part 1, I argue that the market in 2020 (and, in varying degrees the years before it — pick any year after Robinhood launched) was defined by the narrative — storybook stocks which, despite flashing blistering red warning signs by any sensible valuation metric, seemed to meteorically rise. This led to such fun headlines as:
After the coronavirus crash, everyone was a stock market genius, largely because as Jerome Powell succinctly explained, stocks only go up and buying calls on anything just printed money.
However, while a savvy investor might’ve seen his money double buying Disney at the very bottom in March:
An even savvier investor (likely one with a time machine) may have selected a different set of names: Overstock ($OSTK), NIO ($NIO), Tesla ($TSLA), or of course, Gamestop ($GME).
If you picked your entry entirely perfectly, for example, and purchased Overstock stock on March 16, 2020 at $2.65 and sold it at the top on August 20, 2020 at $122.32, you would have netted 4515% return, instead of only double.
By almost all valuation metrics, Disney is a much more attractive buy. Yet Mr. Market decided in a similar timeframe that Overstock was worth almost 50 times more in August than in March.
Why is that?
Theme and the Trend
Fairly on, most traders get some subconscious understanding of “the trend”. The trend is a concept which usually escapes easy definition, however, and is often used as a scapegoat for losses or a posterior explanation for gains (or a hot streak).
When I started trading/scalping after the coronavirus crash, one of the first patterns I noted was “corona open” versus “corona close” days. Quite simply, there seemed to be (not necessarily on the order of one day, sometimes weeks) periods where sectors related to re-opening after lockdown/the pandemic would boom (travel, casinos, hotels, restaurants, etc.), while other times sectors benefitting from continued lockdown (e-commerce, streaming services, remote work, whatever we consider Peloton to be) would rise. This would often but not always be related to news (new lockdowns, lockdowns lifting). More interestingly, however, these tended to both highly correlate and oppose each other — rarely during the early months of the pandemic, for instance, would you see Marriott and Zoom both be red or green.
While this correlation has faded to a large degree, this was a dominant trend in market dynamics during the S&P’s bullish run, up until around September 2020. More importantly, this trend can be described succinctly as a theme — a well-defined topic (the pandemic) in which narratives and memes could shape investor decision making. In fact, this is a synthesis of two opposing narratives for retail investors and underpaid financial headline writers:
- The pandemic is out of control — This would happen largely when a new lockdown or some boogeyman news (e.g. the new COVID variant discovered in late December 2020) happened. This narrative would largely bolster tech (specifically stay-at-home) stocks at the expense of small caps (specifically travel and recreation), with a high chance of spiking volatility as well.
- Vaccine optimism — This was most dramatically demonstrated by the blistering rally in mid-November of IWM in response to the vaccine news by Pfizer. This narrative dictated lower volatility and rallying of small cap stocks, largely at the expense of stay-at-home (and tech in general).
Now, a savvy investor would state something about forward looking valuations and why stocks shouldn’t work like that. In a material sense, nothing about Marriott’s forward looking prospects changed day-by-day in response to a new lockdown in Guadalajara — eventually all pandemics pass, and eventually hotels will be filled and people will go back to clubbing and eating out. But, quite obviously the market disagrees with that convincing logic, and for an investor who notices the themes, playing these two narratives would be incredibly profitable.
In a normal year, there are rarely such market-wide themes of course, but there always have and always will be themes. What’s more interesting about this paradigm, however, is the speed in which themes can shift, which I’d argue is driven by the increasing hyper-connectivity of the marketplace.
Hyper-connectivity and the Reflexivity
If you’ve been around financial Twitter, you have probably heard the word reflexivity.
To quote Investopedia:
Reflexivity is a theory that positive feedback loops between expectations and economic fundamentals can cause price trends that substantially and persistently deviate from equilibrium prices.
In English, this roughly means “stocks tend to shift more in price than they should become people are dumb”. Fortunately or unfortunately, the market isn’t a machine detached from the excesses of human emotion, and prices tend to wildly deviate from actual models.
Proponents of the theory largely credit it for explaining boom and bust cycles, or rather how to understand how Gamestop was somehow worth $20 two weeks ago but $220 today.
Reflexivity is an innate part of the human condition, which is why it exists in the marketplace, which despite computers and quants reflects the excesses of human emotion more often than not. This is why, I’d argue, reflexivity has become more dramatic with the advent of the internet and super-hubs of communication like Reddit and Facebook.
While the internet has long been a medium of investment chatter (the IRC boards of the 90s during the tech bubble were a thing, not for me, but for old people), it’s undeniable that the penetration and utilization of the internet in making investment decisions by the population at large has greatly magnified in the last few years. This could not be demonstrated as accurate more terrifyingly than @TikTokInvestors, a hilarious compilation of videos from FinTok (portmanteau of financial + TikTok). In these videos, eager investors run the gamut from hyping obvious pump and dump schemes to shilling technical analysis courses to outright fraud to just misunderstanding the basic principles of the market. That said, the market is a true democracy in the sense that these people, and the people that these people inform, vote with their dollars just the same.
In the era of low information, most investors are dominated by two basal drives:
- Fear — Fear of losing money, or more commonly, fear of missing out.
These emotions tend to be as powerful as they are addictive, and the super-hubs are happy to comply. Gain and loss posts equally dominate fora like WallStreetBets. People love to see an ultimate success who became a millionaire through sheer luck or lost their shirt just the same.
What’s interesting about these super-hubs is just how massive the reach is. In the past, investor forums were fairly niche (perhaps with the exception of the late 90s tech boom). Today, WallStreetBets boasts 2.4 million members strong, more than most top websites alone count as viewers, let alone users.
In this environment, survivorship bias dominates. The victors, whether through dumb luck or true savvy trading knowledge, get to set the narrative. Low information traders blindly pile on into trades, using options to increase notional exposure and together move the needle. The belief of one can change the actions of many, and move the market.
That said, this is hardly just a game of the low information retail investors. With electronic terminals and Bloomberg and Twitter, everyone in the market can — if they choose — exist in an information frenzy, providing ample ammunition to magnify small catalysts into major, market-wide trends.
We can take this train of thought a step further. For many traders like myself, we know of this behavior. We know that others should pile on to small changes. We can then act accordingly. When a catalyst occurs, whether the beginning of a selloff or some news item (to use the above example, renewed lockdowns), these traders can assume the behavior of other participants, and attempt to front-run. If Mexico extends its lockdown, I know to buy Zoom calls. The theme continues and reinforces itself.
Similarly, the influx of news and information should, at least theoretically, shorten the duration of the trend. As each decision-maker in the market continually gets new data at a quicker and quicker pace, the chance of getting information to change trade decisions increase. A trend is a shared belief (and consequent action) by a large group of market participants that largely self-reinforces. As each decision maker has more opportunities to buck the trend (through this influx of data, as well as communication with other decision makers), there exist more opportunities for the trend to break and a new trend to form. This is doubly true for trendsetters (an example being popular users/posters on super-hubs like WallStreetBets).
In a hyper-connected world, we should see reflexivity as not just one force acting on price discovery, but perhaps the dominant force. As discussed in the first post, successful ideas (memes) in hyper-connectivity share similar characteristics — they are simple, they are salient, and they appeal to basal emotions. This holds true for trends and narratives — in our super-hubs of low information traders, the simplest ideas will dominate the conversation, shaping the trading decisions of multitudes and shifting price far more than fundamentals, news, or reality should imply.
This was meant to be a two part series, but unfortunately I tend to blather and no one has the attention span to finish a 30 minute blog post. To summarize the main points of this post:
- Investing in a hyper-connected world tends to follow the power of the narrative, especially with the advent of low-information investing and trading.
- The impulses and groupthink of investors in reaction to news and catalysts tends to lead to reflexivity, which is a major component of stock boom-bust cycles.
- In a hyper-connected world, trends (time periods dictated by themes) tend to be more dominant and also shift quicker.
- Trends tend to coincide with simple ideas appealing at some level to fear (fear of loss, FOMO) and greed.