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Fascinating and surreal. This is how I would describe the recent social distortions of long-standing economic principles
Intro:
Fascinating and surreal. This is how I would describe the recent social distortions of long-standing economic principles of modern society when it comes to the discussion of “meme” stocks like AMC Entertainment Holdings (Ticker: AMC) and GameStop (Ticker: GME). I do not think any serious fundamental analyst or experience business valuation expert would consider the recent prices of these stocks to represent a “fair valuation” and I do not care, that is not what this article is about.
I have seen the numbers and they defy any finance or economic logic. It should be noted that the secondary market for stocks is 100% based on the demand to own a stock (buy it) and the available supply of shares to buy (the float). Even more important to understand is the underlying assumption that market participants are “rational” and make decisions base on publicly available information, financial calculations, the economy and a company’s prospects for the future.
Someone could pay any price they want for a share of company ownership. But should they and is there an inevitable result of doing so?
My simple suggestion, stay away from stocks that are being manipulated by a horde on a social media platform. Stocks are more than a “piece of paper”. Ownership of common stock represents partial ownership in a business. This is an amazing equalizer and feat of democracy/capitalism. Anyone that saves money in America can own a piece of our greatest companies and the greatest companies in the world.
Should we not want to own amazing businesses with great prospects for the future? Should we not care how they are managed? Should we not care about the fundamentals of finance and economics?
So, is there an inevitable outcome here? That is hard to say definitively, so let us just call it a likely outcome. I would like to explain two high level economic/mathematical theories that may shed light on the end game to AMC stock, GameStop stock and other stocks detached from fundamentals.
Key Takeaways:
Game Theory
Some of us may remember the movie A Beautiful Mind starring Russell Crowe as American mathematician John Nash Jr of Princeton University. Professor Nash’s advancements and contributions to such areas as game theory led to a Nobel Prize in Economics in 1994. Game theory is widely used in economics to help understand decision-making and outcomes.
Game theory is a “theoretical framework to conceive social situations among competing players and produce optimal decision-making of independent and competing actors in a strategic setting”. Does this sound like a stock market to you? Or any market for that matter.
A stock market is often incorrectly considered a “zero-sum game” by some because as a trade is made one player is buying and the other is selling. The advantage of profit is won by one side and lost by the other. Alternatively, the avoidance of a monetary loss is avoided by one side and experienced by the other. Add the collective economic gain/loss together the sum is zero.
Collectively nothing tangible has been created or destroyed (we can leave our egos out of this one). One person will make/lose money and the other will lose/make money. In the grand scheme, total collective societal wealth is either gained or lost. All there really is left is if you were the one that gained or the one that lost. Simply put, someone made money, will make money in the future, someone lost money or will have lost money in the future.
However, stock markets should NOT be considered a zero-sum game and should be looked at as price discovery mechanisms based on a business’s fundamentals and expectations of an unknown future. Therefore, fundamentals of business, finance, economics, accounting and valuation matter.
Check out this video to understand if speculation/gambling on meme stocks is in fact leading to a zero-sum game, click here.
When it comes to meme stocks like AMC Theaters or GameStop just do not be the last person to execute a buy order before the shoe drops. The next bid could be a long way down.
Speculators in these meme stocks have turned the trading in these stocks into a zero-sum game that only those how choose to play will be a winner or a loser. To me that is not investing and that is not how to be successful in your personal finances.
If anything, this social media phenomenon of bidding up companies that were on their way into bankruptcy has done two things:
Our first stop in considering the outcome of “meme” stocks, Game Theory, has taught us do not be the last person “holding the bag” when the party or in this case the bid stops when an investment is not based on fundamentals. Someone will win and someone will lose.
Luckily for the rest of us, these “meme” stocks are so insignificant in our multi-trillion-dollar US markets that it is unlikely to affect those not playing the game. Once again, it is only the media that has drawn attention to one house fly in an entire infinite universe.
Let us remember that businesses fail all the time, and this is ok. When we try, we fail sometimes. When we do not try, we never succeed. Failure is not the point. Fair and efficient use of economic resources and an understanding of whether you are investing or playing a zero-sum game is the point.
The Prisoner’s Dilemma
Step two: how can we determine that the horde of social media market manipulators will not stick together in the end? This brings us to a paradox in decision making, the prisoner’s dilemma. The paradox is that two individuals acting in their own self-interest do not produce the optimal outcome for the group.
A prisoner’s dilemma is a situation where individual decision makers always have an incentive to choose in a way that creates a less than optimal outcome for the individuals as a group. These situations happen often in many different parts of the economy.
To understand the original prisoner’s dilemma of two suspects in a crime here’s an educational link to the Khan Academy, click here.
Now let us assume that owning “meme” stocks will in fact be a zero-sum game and look at the possible decisions of two speculators. Also, let us assume that they will act in their own best interest, cannot know what the other person will really do and that fundamentals eventually bare out overtime that these stocks are worth far less or worthless (bankrupt). What are the choices when faced with this reality?
Choices:
When this speculation comes to an end and I believe that it will. Inevitably there will be a frenzy of selling with no significant buyers on the other side causing these meme stocks to plumet in large percent chunks overtime until the last buyer, at pennies on the dollar of current valuations, holds the stock into bankruptcy because they are not risking an amount of money worthy of selling.
I believe all of this will happen because the speculators will act in their own best interest in the end and will not be the ones willing to go down with the ship. Even if they were the one that started the frenzy of buying on social media years prior, it will inevitably come down to the prisoner’s dilemma and they will lose their conviction. They will sell, keeping what they made or can hold on to and will not have a care for the sorry sap that bought the shares from them.
Moral of the story
Do not be the sorry sap. Do not speculate. Do your research. Do the analysis or read from those that do. Understand that the stock market is not a zero-sum game unless you are among those that choose to make it one.
The US markets are the envy of the world and we are all lucky to be able to participate in the growth and profits of great American companies; if we choose to save and then invest wisely. If we make that choice, we need to educate ourselves, understand and choose to invest in one of the many hundreds of publicly traded companies that have a viable future within their business.
Markets function on differences of opinion. That is great. That is what makes it work and creates liquidity. If you have an opinion or a company that you like, that is just the start. A good company does not always mean that in the short term, the market is pricing the future accurately.
That is where fundaments come into play. If the company is great and you love the products or services, the next step is to understand what you are paying for the future revenues, cash flows and/or profits that company is likely to generate.
It is never a good idea to be a buyer of one company’s stock at ANY price. Valuations matter and blindly paying any price to own a company never ends well. Consider what you are willing to pay for ownership of a company and what your expected return is over the time frame you plan to invest.
If you do not have the time or desire to do what is necessary to make prudent investments in individual stocks, we are also lucky to have many other options to invest like EFTs, funds or a trusted investment advisor that is knowledgeable, fiduciary, and will invest for you in your best interest (this requirement only applies to fee-only, Registered Investment Advisors, unless Congress sees the light).
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