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6 Reasons the Stock Market is the Dumbest in Town

Everyone tells you to follow the “smart money.” That is HORRIBLE advice. You should follow the dumb money. Why compete with the smart guys when you can compete with the dumb asses? So where is the stupid money located? To answer this question, we go to the greatest financial fuck up in modern economic history – the Great Recession of 2008. The global banking system almost collapsed when Lehman Brothers went bust in September 2008. The crisis gave us an insight into how different markets operate. It separated the smart money from the stupid money.

How do we find the dumb money? I am looking for the market that was the quickest and most efficient to assess the gravity of the crisis, discount all the immediate factors and then project what would happen in the future. Financial markets are discount mechanisms. The process current information and then discount what is going to happen in the future. The markets that reacted quickest are smart and the markets that reacted slowest are dumb. The four major markets are equity (stocks), fixed income (bonds), currency (U.S. dollar) and commodity markets. The fifth market is the derivatives market, but it derives its value from these four base markets.

The first market to hit the bottom and then recover was the currency market. The U.S. dollar, as measured by the dollar index, cratered one week after the Lehman Brothers collapse on September 22nd and then rallied 17 percent through to March 5th, 2009. Gold reached its minimum point on November 12th, 2008 and then rallied 40 percent to February 20th, 2009. The third market to hit rock bottom was the U.S. Treasury market. The yield on the 3-month treasury dipped into negative territory for one day on December 4th, 2008. This was a point of extreme pessimism showing that people had lost confidence in the banks and were prepared to pay the U.S. Federal Reserve to look after their hard-earned cash. When did the stock market hit the bottom? Three months after the treasury market. Both the Dow Jones Industrial Average and the Standard and Poor's 500 Index found their bottoms on March 9th, 2009.

This is the timeline:

22 September 2008: Currencies (U.S. dollar Index)

12 November 2008: Commodities (Gold)

4 December 2008: Bonds (the U.S. 3 month Treasury)

9 March 2009: Equities (Dow Jones and Standard and Poor’s 500 Index)

The time between the smartest money (currencies) and the dumbest money hitting their lowest levels was 168 days, which is almost 6 months. That is the gestation period of a baboon. Many believe that capital markets are linked – that currency traders talk to bond traders, who talk to commodity traders and equity traders. Nothing could be further from the truth. They are like ships passing in the night. Besides, the one market that many believe to be the smartest is, in fact, the dumbest. It is this kind of information asymmetry and gets my heart racing, my palms clammy and my pupils dilating.

The Darwin Awards are bestowed posthumously on those people who unwittingly play a key role in their own deaths. One winner was an ice fisherman with a hankering for dynamite. Accompanied by his golden retriever, he drove his new Jeep Jerokee into the middle of a frozen lake. He whipped out a stick of dynamite and his Zippo lighter, lit the stick and hurled it 30 meters out. His best friend obediently sprinted after the flaming stick and proceeded to bring it back and …..boom. The stock market is the lifetime recipient of the Darwin Awards.

Reason 1: Democratization of the Stock Market

In the old days, stockbroking moved at a different pace. You would park your Rolls Royce and take the elevator to your broker's office. He would open up a box of Cubans, offer you a glass of single malt and talk about the World Series. You would instruct him to buy 1,000 shares of Bethlehem Steel. He would write the order on a ticket and hand it to his errand boy. The errand boy would jump on his bike and pedal over to the stock exchange. He would walk over to the floor broker who would ignore the kid for five minutes as he finished dictating his lunch order to his assistant. The floor broker would then saunter over to the pit and gesticulate to the market maker and execute the order.

Today, the barriers to entry in the stock market are low. Any mammal with opposable thumbs, a smartphone and a few dollars to their name can open an online brokerage account with Robinhood. Robinhood is a U.S.-based financial services company headquartered in Menlo Park, California and requires no minimum balance. The address of Robinhood is revealing. This is not a regular broker filled with stuffy old men in pinstriped suits, Gordon Gekko suspenders and unmatched dayglow socks with a copy of the Financial Times tucked under their flabby untoned arms. Robinhood is a fintech company, filled with kids in hoodies, looking to democratize the stock market. This is going to lower the collective IQ of the stock market. For those investors that are prepared to do their homework and apply a few simple principles, this is fantastic news.

Reason 2: The Unwashed Masses Love the Adrenaline of Stocks

Stocks gyrate more than a White House intern in the 1990s. This volatility attracts the masses. Beyond Meat is a succulent example. This company makes plant-based burgers for the vegan millennials who want to wean themselves off meat to save the planet (environmentalists claim that flatulent bovines pollute more than cars). The stock IPO at $25 in May 2019 and rallied to $235 in ninety days. This is a return of 840 percent. It then declined 65 percent to $85. These savage swings attract a larger number of unskilled investors who are looking for a quick buck. It is this mass of uneducated money that provides awesome opportunities to those investors prepared to do a little homework.

Reason 3: The Proliferation in Exchange Traded Funds

Exchange-Traded Funds, also known as ETFs, are a rapidly growing industry. The numbers are quite astounding. According to Bloomberg, it took 8 years (2000 to 2008) for the U.S. ETF industry to reach $1 trillion in assets. Going from $3 trillion to $4 trillion took only 2 years (2016 to 2018). According to Blackrock, the New York Yankees of ETFs, global assets under management in ETFs is $4.7 trillion as of 2018. To understand the size and scope of this number, the nominal GDP of the United States was $19 trillion in 2018. China boasted a nominal GDP of $12 trillion, Japan $4.8 trillion and in fourth place Germany with $3.6 trillion (come along now Angela Merkel, it is time to put the foot on the gas). Total assets under management in ETFs was the size of the world's third-largest economy. How does the explosion of ETFs lower the average IQ of the stock market? To explain we are going to use the law of syllogism. A syllogism is a logical argument that applies deductive reasoning to arrive at a conclusion based on two or more propositions assumed to be true.

Here we go: Major Premise: Warren Buffett, the greatest investor in the history of humanity, says that diversification is protection against ignorance. It makes little sense if you know what you are doing

Minor Premise: ETFs are built on the foundation of mega-diversification.

Conclusion: People who invest in ETFs do not know what they are doing. Investing in a diversified portfolio is like going to a roulette table and putting half your money on red and half on black. You are hedging your bets just in case you are an idiot. Diversification is a game of “what if”. In your mind, you are saying: “I like this stock but what if I am wrong? There is a chance that the sum of all my work and research is wrong, so let me buy a whole bunch of other stocks and maybe, just maybe, one or two of those will double in value”. Diversification shows a lack of conviction and belief in your own abilities. It is an admission of defeat before you start the race.

ETFs are funds that trade like stocks. The majority replicate an index. In 2019, one of the largest ETFs was the iShares Core S&P 500 ETF with a market cap of around $200 billion. This ETF invests in the 500 stocks that make up the Standard and Poors 500 Index. You cannot get more diversified than 500 stocks in ten different sectors. Exchange-traded funds have also done a great job of attracting trillions of dollars of uneducated money. In Rebel Finance, we love the dumb money.

Reason 4: Faulty Cerebral Wiring

The human brain does not react well to stress. Neuroscientists have discovered how chronic stress and cortisol can damage the brain and hamper the decision-making process. This could explain a curious phenomenon that often presents itself in stock market investing. People tend to sell their winners and hold onto their losers. They buy a stock, it goes up 10 percent, they think they are geniuses and then take profits. When the stock goes down 10 percent, they hold onto it and pray that it recovers. It then goes down another 10 percent and they start going to mass, lighting candles and sprinkling holy water on their computers. After another 10 percent decline, they hire a priest to do an exorcism but refuse to sell. The stress associated with market loss causes short circuits the parts of the brain dedicated to making rational decisions. This inertia also stems from the fear of realizing a loss because studies have shown that the anguish of losing $100 is far greater than the joy of winning $100. Investors are overcome with the hope that the stock will recover. This irrational behavior opens the door for rational, prepared and dispassionate investors to exploit this arbitrage.

Reason 5: Romanticism of Trading

All the great Wall Street movies are about trading, making a quick buck and the debauched lifestyle associated with the stock market. People fail to realize that investing should be boring. Paul Samuelson said that investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas. This lack of patience and quest for a quick buck leads to erroneous (read "stupid") decisions.Warren Buffett said that calling someone who trades actively in the market an investor is like calling someone who repeatedly engages in one-night stands a romantic. Buffett also said the stock market is a device for transferring money from the impatient to the patient. Trading causes irrational exuberance. Level headed and dispassionate investors can exploit these irrational decisions to their advantage.

Reason 6: Corporations have Become Major Players in the Stock Market

Granny used to teach you that money does not grow on trees. With low and negative interest rates in the U.S., the Eurozone, and Japan, it looks like granny could have been mistaken. Imagine a world in which money is free. Banks and investors are throwing cheap money at corporations. Siemens, the German engineering and manufacturing giant, had borrowed 7.6 billion euros with a weighted average coupon of 0.38 percent and a weighted average maturity of 4.25 years. This is according to data from Bloomberg as of November 2019. Siemens would need to pay 29 million euros per year in interest to service this debt. In 2018, Siemens generated revenue of 83 billion euros. Assuming 250 business days in a year, that works out 332 million euros per day. Assume, like most efficient Germans, they work 8 hours a day. That means they make approximately 41.5 million per hour. They can cover the annual cost of this money in 42 minutes. That, granny, is tree-money.

So what are companies doing with all this dinero? A large chunk is being used by companies to buy back their own shares. The obvious question is whether this is dumb money? Not exactly, because who knows a company better than that very same company? That, however, is not the point. This massive flood of corporate money into the market creates a bull market that is not based on fundamentals. Stock buybacks boost stock prices, lifts the stock market and sucks more dumb money into the market. This helps to distort valuations. At Rebel Finance, we love market distortions.

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