What Everyone Gets Wrong About The Stock Market

The stock market has a fundamental problem. Most of the time it doesn't actually work. Now when something is the case for a long time people believe it's normal and that's especially true in the investment business. Take for instance this stock chart of Tattooed Chef Incorporated. For two years it remained stable but then in 2020 the price jumped violently, eventually taking the company's value to more than two billion dollars. Why should you care about a business that sells plant-based frozen pizzas? Well the shocking part is what happened to its stock price after 2020. The stock collapsed in spectacular fashion, from once trading at almost 30 dollars per share to today it sits at 0.0001 dollars. The company is bankrupt and the shares will most likely be worthless once the court proceedings are complete. How is it possible that the stock market could get it so wrong? Well you might say something like back in 2020 the company really was worth two billion dollars but some completely unexpected black swan event hit the company and now it's worth nothing. You could say that but you'd be wrong. This business was always terrible. I've seen comedy specials that are less funny than these financial statements. Between 2020 and 2021 they sold 58 million dollars more of their products but the cost of goods sold increased by 65 million. That means that they were selling these additional products for less than even the direct cost of the ingredients manufacturing and packaging. The truth is that Tattooed Chef was never actually worth two billion dollars, it was always worth nothing but the market just got it wrong. And you should care about this because it's happening right now not just to one stock but to the entire US stock market. But that's where the pain will come in the future. The way the stock market actually works is so severely misunderstood but thankfully one of the greatest minds in finance Howard Marks released a detailed memo that helps us unravel some of the core mechanisms and use them to our advantage. How the Nobel prize winning financial model used by the finance industry is deeply flawed, the role human behaviour plays in market booms and busts and how we can navigate it. In 1990 William Sharpe, Harry Markowitz and Merton Miller were recipients of the Nobel prize in economics for their contributions in financial and economic modelling. Their independent work along with some others radically changed the framework used by much of the finance industry. William Sharpe made many contributions to modern financial modelling but the most notable was his work in developing the capital asset pricing model or CAPM. It's a fairly simple formula that allows an investor to compare the expected return of different investments. Today the model is a fundamental part of how investment portfolios are managed by professionals but it's widely criticised particularly by some of the most successful investors ever such as Warren Buffett and Howard Marks. The model is based on a number of assumptions that don't exist in the real world. The big one being the assumption that the stock market is dominated by rational risk-averse investors when in reality the market is full of irrational behaviour by people swept up in extreme optimism or extreme pessimism and you don't have to look much further than the last two years to see it. In 2022 investors were extremely pessimistic. The US and much of the world were facing the highest rates of inflation seen in decades. For businesses this meant costs of materials went up, wages for employees rose and utilities like electricity became more expensive. A lot of these costs were passed on to customers but that's not as simple as it sounds. A business like Apple can raise the price of the iPhone to anything and their customer base will pay for it. But for many businesses raising prices drives customers to seek out cheaper alternatives. 2022 was also the year that the Federal Reserve began raising interest rates from practically 0% to over 4% by the end of the year. For businesses that use debt as a part of their capital structure this means higher interest payments. It means investing in expanding their operations becomes more expensive so they also do less of that. And borrowing money becomes more expensive for their customers so they have less money to spend. More broadly a rate hike cycle more often than not has led to a recession. So investor sentiment in 2022 was very negative and the result for the stock market was a negative 19% return for the year. Then 2023 rolls around and market optimism returns in full force. Inflation begins to come down, the rate hikes stop in August and suddenly there's a possibility of rate cuts on the horizon. In 2023 the stock market rose more than 20% reversing the previous year's retraction. This year 2024 has been another year of investor optimism. While no rate cuts have actually happened yet there's been a persistent expectation of them with the first expected later this month and the result is a 16% return year to date. But even in such a strong year for the stock market there have been some wild fluctuations. An 8.5% drop in three weeks occurred across July and August. It was caused by the Japan carry trade collapsing, economic data releases including an uptick in unemployment and the news that Warren Buffett had dumped tens of billions of dollars of stock to invest more in short-term government debt than even the federal reserve themselves. I spoke more about each of these in a recent video. I'll link it in the description if you want to check it out. Also if you could take a second to hit the subscribe button it would mean the world to me. Let's get this community to 200,000 subscribers before the end of the year. The best explanation for the wild fluctuations we've seen in the markets over the last couple of years comes from Benjamin Graham's analogy of Mr. Market. In his book The Intelligent Investor he writes, imagine that in some private business you own a small share that cost you $1,000. One of your partners named Mr. Market is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often on the other hand Mr. Market lets his enthusiasm or his fears run away with him and the value he proposes seems to you a little short of silly. Mr. Market is a great metaphor for the irrationality that often dictates which way stock prices move. With the message being that on any given day the stock price of a company could be very different from the actual value of that share of the business. When investors are feeling very optimistic they're willing to bid for stocks at prices above their value and when they're they drive the price of that business down below its value. In his memo Howard Marks mentions another valuable insight from Graham. The day-to-day market isn't a fundamental analyst, it's a barometer of investor sentiment. You just can't take it too seriously. Graham's Mr. Market metaphor is a really good way to understand market movements because just like any individual human the market itself experiences mood swings. The mood swings of the securities markets resemble the movement of a pendulum between euphoria and depression, between celebrating positive developments and obsessing over negatives and thus between overpriced and underpriced. This oscillation is one of the most dependable features of the investment world and investor psychology seems to spend much more time at the extremes than it does at a happy medium. That's a quote from Howard Marks 1991 memo. When the prices of stocks collapse it's often because investors perceive the environment for businesses to be bad rather than the environment actually being bad for businesses. He outlines three core human biases that cause these fluctuations. Heightened awareness to one emotion at a time such as fear or greed, the overlooking of facts to the other side of the story, and interpreting incoming data in ways that fit the current narrative. There are all kinds of economic data points coming out all the time. Job reports, inflation releases, federal reserve conferences, company quarterly earnings, consumer confidence reports, the list goes on. At any given moment some of these will be positive and others will be negative but if the current market sentiment is that conditions are worsening then investors are more likely to focus on the few data points that support the current media narrative. Much of the modelling and forecasting done in the finance industry relies on the idea that investors have access to all public information and make rational evaluations of the data in their decision making. If security prices were really the result of the rational dispassionate evaluation of data presumably one piece of negative information would move the market down a little and the next such piece would move it down a bit more and so forth. It doesn't at all explain the violent upward and downward swings we see from time to time. In reality investors are mostly influenced by market sentiment meaning they reject data that opposes the current sentiment until it builds up and up and up. Then sentiment shifts, sometimes very quickly in the other direction. The air goes out of the balloon much faster than it went in. That brings us to probably my favourite psychological phenomenon that is not only relevant in financial markets but in pretty much every aspect of your life. Cognitive dissonance. It describes the circumstance where your behaviour clashes with your belief about that thing. For example the smoker who continues to smoke even though they know it's bad for them. Cognitive dissonance is extremely uncomfortable and it usually collapses in one of two ways. Either the person changes their behaviour to match their belief, so that would be the smoker quitting smoking to match their belief that it's bad for them, or they change their belief to match their behaviour so the smoker continues to smoke but convinces themselves that it's justified in some way. In finance the behaviour might be having a portfolio of highly risky stocks that have been making you a lot of money. Then you come across some information that teaches you that if you continue with this strategy your portfolio is probably going to blow up. So you're likely to stop investing in risky stocks to match your new belief, or you might just reject the new information and continue the way you were. But the most important part to understand is the choice between changing behaviour and belief are not equally weighted. A behavioural change often requires some significant conscious action, whereas your beliefs can change without you even realising it. So more often than not it's the belief that changes, not the behaviour. So if stocks are pushed around by all of this irrationality and human behaviour, then what are stock prices actually showing us? Well to put it simply, stock prices show us what investors think the value of businesses are, not what the value actually is. Nobody has a crystal ball that they can use to look into the future, so nobody can actually ever know for certain what a business is worth. But that doesn't mean that investing is just a pure random game of chance. For any business you can think of their true value as a field of possibilities, but for some businesses this field or range of possibilities is actually quite narrow. For example, well-established companies with long-standing brands and prudent financial management are actually a lot easier to forecast. For young businesses that are not yet profitable but have the possibility of becoming a dominant competitor in the future, it's not so easy. I want to finish with one more very important quote from the Howard Marx memo. When shares in a company that was worth 10 billion dollars a month ago trade at prices implying a valuation of 12 billion or 8 billion, it doesn't mean the whole company would change hands at these prices, just a tiny sliver. Only a small percentage of shareholders are even trading their shares regularly. Most shareholders are just sitting on their stock watching the market bounce around. So when a stock drops 10%, or even the whole market for that matter, you're actually just seeing the opinion of a small number of investors. So have your own deeply informed view of what your stocks are worth, and don't be swayed if Mr. Market disagrees. Subscribe if you enjoyed the video, it's free and it really helps me out, and consider checking out some of these videos next.