Does the stock market even work anymore?I (Dan Ferris) ask because two weird things happened on Monday.
The first probably seems normal because it has happened so many times in the past three years. But I promise you, it's not.
I'm talking about another rapid, steep rise in the price of meme stock GameStop (GME).
On Sunday night, GameStop's famous booster, financial analyst Keith Gill, posted a screenshot on a Reddit subreddit called r/Superstonk. The image was of a brokerage account showing that somebody – assumed (but not confirmed) to be Gill – owns 5 million shares of GameStop worth about $115.7 million as of last Friday's close. The account also has 120,000 call options with a $20 strike price, which expire on June 21, for which it paid $5.68 each.
The market responded as you'd expect – by going nuts. GameStop's share price soared nearly 80% in pre-market trading Monday morning.
This morning, GameStop's management decided to take full advantage of the fact that the stock was up about 100% as of yesterday's close.
The company unexpectedly announced first-quarter earnings so it could quickly sell 75 million new shares into the market. The result was just as you'd expect, a 40% drop in the share price, obliterating most of the week's gains. The stock was currently up around 20% for the week as we went to press.
The situation is weird because Gill's initial call on GameStop was based on the fact that the stock was very, very cheap. That's no longer the case. It's horribly overvalued today.
So if the screenshot really is of Gill's account, he's betting on a massive meme-stock run over the next two weeks. I expect Gill will pull the same stunt again this Sunday night, posting to get people excited before the market opens Monday morning.
Gill is finally a true meme stocker, betting that others will throw caution to the wind in an attempt to make a lot of money in a short period of time. And he's attracting some unfavorable attention...
The Massachusetts securities regulator is investigating Gill's trading activity. The
Wall Street Journal also reported that E-Trade is considering kicking Gill off of its platform.
But something even weirder also happened on Monday...Shortly after the market opened, Class A shares of Warren Buffett's $890 billion market cap mega-conglomerate Berkshire Hathaway (BRK-A) crashed by more than $625,000. Yes, you read that right. Shares went from $625,735 Monday morning to $185.10 per share. A few trades occurred at that price before the New York Stock Exchange ("NYSE") could halt trading.
When I logged into my Charles Schwab account, the following message popped up on my screen:
NYSE Quotes may be inaccurate
Technical issue with New York Stock Exchange quotes.
Due to a technical issue at the New York Stock Exchange (NYSE), NYSE quotes for some securities may be inaccurate industrywide. Some impacted securities may have trading halted. This may affect certain account balances, including margin buying power. As a result of this issue, we are experiencing higher call and chat volumes, and clients may experience longer wait times.The Consolidated Tape Association ("CTA"), which provides real-time price quotes for major exchanges, said the crash was a "glitch." It may have been from a software update that affected the Limit Up/Limit Down ("LULD") price bands the CTA publishes to help combat excessive trading volatility.
The glitch affected 40 other stocks, including a Mexican airport stock, a Pimco bond fund, and an Argentine equity exchange-traded fund. Trading was halted for all of these stocks, and the NYSE canceled all trades below a reasonable price. By 11:45 a.m., the issue had been completely resolved and trading was back to normal.
I've warned you that something like this could happen...I've said before that it's possible for the S&P 500 Index to fall more than 20% in a single day, despite the NYSE's three "circuit breakers" that trigger the exchange to shut down if the market falls too far, too fast.
The first circuit breaker automatically halts trading for 15 minutes if the S&P 500 falls 7% in a day. The second breaker halts trading for another 15 minutes if the market falls 13% in a day. The third breaker shuts the exchange down for the day if the market falls 20%.Now, I don't know if the LULD bands the CTA tracks are part of the NYSE's circuit breaks or not. But it doesn't matter... they're undeniably circuit-breaker-like.
You see, a stock is supposed to halt trading if its price is higher than the upper band or lower than the lower band. So it's supposed to be impossible for a stock like Berkshire Hathaway to open at around $625,700 and plummet to $185.10...
and still trade.
The LULD bands failed on Monday...I can't spell it out any more plainly.
Investors
think they know how the NYSE will work under various conditions. But no one really knows for sure... or even
if the NYSE and its breakers will work correctly when they need to... like if all hell is breaking loose and you and a few million of your closest friends feel the need to sell everything before it all gets worse.
Now, I know the glitch was supposedly caused by a software update. But that's just what they're telling us. What large organization is in the truth-telling business? At least one trader told
Forbes that he doubted Berkshire's massive price drop had anything to do with the glitch. I'm not saying he's right, but how do we know he's wrong?
The point is... I warned you that something like this could happen.
The cat is out of the bag...The NYSE and CTA don't control the movement of securities prices.
You could say they really just don't have control over their software updates. But what's the difference? Software "ate" the world – including stock-exchange trading – like tech entrepreneur and venture-capital investor Marc Andreessen
told us it would nearly 13 years ago. And given Monday's episode, it's obvious that we can't predict what the software will do.
That's why I expect we'll see more bizarre, extreme market action – no matter what mechanisms the securities regulators and stock exchanges put in place to prevent it.
Now, maybe the S&P 500 will never fall more than 20% in one day. Or maybe the complexity of markets and modern technology means the index is destined to lose much more than 20% in a single day.
The point is... I don't know what'll happen... and neither does anybody else, including the NYSE and the CTA.
It reminds me of something my friend, investor, and author Vitaliy Katsenelson, said...A few days ago, Vitality posted on social platform X:
Every person should learn to say these 3 words:
"I don't know."
The problem is, nobody really likes hearing those words... which makes them harder to say.
Your boss doesn't like it when you say them at work. Patients don't want their doctors saying them. And clients want asset managers who pretend they know everything (I promise there's no shortage of those folks in finance!). No matter what you do for a living, you need to learn to say, "I don't know."
However, most folks never will.
That's too bad, since people fail catastrophically in investing by pretending to have more certainty about the future than they could possibly ever have.
It's one thing to believe the sun will come up every day for the rest of your life. But it's quite another to believe that the Federal Reserve will cut rates to save your investments... that the NYSE circuit breakers will keep your 401(k) from losing half its value in a day or two... or that GameStop soaring in price is a "lock" because some random guy on Reddit owns call options.
This type of thinking exposes investors to risks they won't even acknowledge. Eventually, that could really damage their portfolios.
For example, during Monday's weirdness when Berkshire Hathaway fell from more than $625,700 to $185.10 per share, several sell trades took place before trading was halted. That means somebody sold for a more than 99% loss! I sure hope they didn't have too much money in the stock.
So catastrophic losses don't require the stock market to drop 75% and stay there for years. All it requires is a steep enough drop to scare folks enough to sell before it gets worse.
Catastrophic losses and phantom consequences...The best book for investors that deals with catastrophic loss is
Ergodicity: Definition, Examples, and Implications, As Simple As Possible by Luca Dellanna. Ergodicity is a complex mathematical concept, but Dellanna brilliantly explains it in terms anybody can understand. The important part of understanding ergodicity for investors is survival:
In theory, performance determines success. The fastest skier wins the race, and the most performing employee becomes the most successful one.
In practice, performance is subordinate to survival. It is the fastest race of those who survive that wins races, it is the most performing employee who doesn't burn out that becomes the most successful, and so on.Dellanna isn't merely saying that survival matters, but that
it matters more than performance over the long term.
Performance is how much investors make on average over their entire investing careers. Survival means avoiding a catastrophic loss.You see, if a catastrophic loss happens early enough in life, you can recover. But if it happens late enough in life, it could prevent you from rebuilding your wealth to pay for retirement.
Then there are the "phantom consequences"...Dellanna says these consequences aren't necessarily observable in the short term, but they affect the long term. For example, his friend was badly injured in a ski race. The injury was a near-term consequence. But Dellanna's friend was never able to compete in another race. That was the phantom consequence. Dellanna calls ergodicity the study of phantom consequences.
We started out with another phantom consequence today...
On October 19, 1987, the Dow Jones Industrial Average fell 22.6% in one day – the biggest one-day drop ever. Lots of folks panicked that we couldn't let something like that happen again. So regulators came up with circuit breakers in 1988 and LULD bands in 2012 – confident they solved the problem. The episode on Monday was a phantom consequence of those decisions.
I doubt that anyone behind these circuit breakers or LULD bands ever said, "There's a chance that if these fail, the resulting volatility could be even worse than if there were no circuit breakers or bands."
The idea of doing nothing never comes up. Meanwhile, folks are lulled into a false sense that the authorities have it under control. They don't. They never have and they never will. Extreme events can always happen.
The problem with big losses is it's often difficult to see them before they happen...The risks could be staring everyone in the face and almost nobody will see them. Folks either don't believe it or just don't want to hear it.
For example, if I tell you AI darling Nvidia (NVDA) is a lousy bet today and lots of folks are destined to lose money buying at these levels, many folks will think I'm an idiot. They'll point to its recent performance, which has been breathtaking.
Investors who got into the stock near the lows of 2018 – at prices below $40 – had the chance to make as much as 37 times their money... a truly epic run. Anyone who bought the stock in the past year has also made money. Shares are up more than 140% since January 1.
The fact is that past performance is no indication of future results. And I said the stock was too expensive two years ago, after which it proceeded to rise sixfold. So I'm obviously better at avoiding great stocks than identifying big risks, right?
I don't know.
