What's new

Efficient Market Hypthesis meets Reddit

David Harper CFA FRM

David Harper CFA FRM
Staff member
I agree @RajivBoolell it is fascinating to observe the ascendent influence of a single reddit crowd at https://www.reddit.com/r/wallstreetbets/. Who would have thought?! There have been so many takes but I liked what Tracy Alloway wrote in her Monday's Five Things You Need to Know (at https://www.bloomberg.com/news/news...know-to-start-your-day-kkd7nn2u?sref=LXZZQS7E). I thought these ideas were very provocative (as an investor, much of this makes sense to me...):
"1) Value has become a dirty word. Traditional fund managers used to identify a cheap stock and buy it in the hope that it would gain in value. Nowadays cheapness is a turn off rather than a turn on. Expensive stocks get more expensive as they attract more flows, and cheap stocks are shunned as losers rather than diamonds waiting to be discovered. One way of thinking about this is that prices used to be self-limiting. Stocks would rise to a point where valuations (earnings multiples or price-to-book) would become unattractive, which would cause the stock to go down and give valuations a chance to normalize. Nowadays, the amount of money chasing inflows means that prices can go much higher than traditional security analysis might suggest. In a world of sluggish growth and asset price inflation, chasing inflows has arguably become the best bet to generate outperformance.

2) Flows before Pros. I've written about this a lot this year. But the simple premise here is that in an environment where flows matter more than fundamentals, the guy trading stocks in his basement might be better equipped to judge where money is going next. He might have a better sense of the strength of a stock's particular "story," for instance, than a portfolio manager wedded to valuation models. In a more-than-a-little-ironic turn of events, finance professionals are now chasing retail flows.

3) The options tail wags the dog. It's certainly not the first time options activity has impacted the underlying, but I don't think we've had to consider before whether it's doing so on a systemically-important level. Traders on r/wallstreetbets have been upfront about trying to move the market with options-buying. The idea here is that buying a ton of options forces market-makers to hedge their own exposure by buying the stock in the underlying company. That dynamic may be enough to move a target share price upwards, which can then spark more call-buying in a frenzied feedback loop. For dealers on the other side of the trade, the question is whether a prudent hedging strategy turns into something else.

4) The shorts have become the target. Once upon a time, short-selling firms would unveil a new position to great anticipation and attention (if not acclaim). The current scrum over Gamestop — in which retail traders have gone head-to-head with short-selling firm Citron — suggests that might become a thing of the past. As Scott Nations at Nations Indexes points out: "The old game of shorting a stock then putting out a negative report is done. From now on that will just be the signal to start a massive short squeeze." A hedge fund or short-seller advertising a bet against a stock might now be the equivalent of waving a red flag to r/wallstreetbets' herd of bulls: a signal to charge in with call options and force a move higher. The predators have turned prey.

5). Fantasy becomes reality. It would be tempting to dismiss all of the above as a market curio if it weren't for the fact that it was, you know, actually moving stocks and impacting real companies. Meme stocks gifted with retail attention and inflows do find themselves in a better position. Shares of Gamestop, the ultimate posterchild for "flows versus pros," have surged more than 400% so far this year. Message boards are alight with suggestions for what Gamestop could actually do with that very real money (think strategic acquisitions and expansions to grow its market share). Flows may matter more than fundamentals, but at some point those flows start impacting fundamentals too." -- Bloomberg's Tracy Alloway, January 25th 2021 at https://www.bloomberg.com/news/news...s-you-need-to-know-to-start-your-day-kkd7nn2u


What an interesting piece. I perhaps would add my own comment from what is written above.
1. Value has become a dirty word --->I always think of financial markets as "public utilities" in the sense that they provide price forming and liquidity something that is essential for modern finance to function (by extension modern societies) . I'm not saying market manipulations and failures do not happen. It's just that in this case, the SEC were to leave it at that then wouldn't that set some sort of precedent? How many Jonathan Lebed are just waiting to make a quick profit?
Moreover rallies like this might have a huge impact on fair value accounting. I'm no expert but just thinking about gamestop... can we really from a realistic point of view consider the current valuation as fair?

3) The options tail wags the dog. (...) That dynamic may be enough to move a target share price upwards, which can then spark more call-buying in a frenzied feedback loop. For dealers on the other side of the trade, the question is whether a prudent hedging strategy turns into something else. --> Scary :eek:

I just had a twitter chat with a guy who bought the rally. I might be mistaken and my evidence is only anecdotal here so please take what I'm going to say with a pinch of salt.
It seems that quite a few who are buying are doing so to support a firm they believe in. A financial grassroots movement of some sorts. In a way this is their way of sticking it up to the man (the man here being Melvin Capital)
However, I find it sad. What they do not realize is that the excessive valuation is just the opposite of grassroots.
If we were to "see through" their paradigm, I would even say they failed blatantly. Their actions will only benefit George Sherman, the CEO, (who must be very happy with his stock options right now).
I do not believe that gamestop employees would benefit from that kind of rally. and this I say with the knowledge that they have been really mistreated during the covid pandemic (https://wccftech.com/gamestop-want-employees-to-dance-for-work/) . Heck their management tried to have them flagged as essential employees so that they keep working at one point.
I think In a way the grassroot investors have given "the man" just what he wanted...