Tesla’s magic pizza?

It seems an appropriate time to introduce you to my 11 year old son Charlie as he will be mentioned here and likely in future articles.

We discuss a broad range of issues in our household including financial matters (though it was recently pointed out to me that spending a 10 minutes walk explaining nuclear fusion to my 9 year old daughter was a touch ambitious.)

And Charlie is certainly pretty solid at maths for his age, probably better than I was at a similar age which is the way you hope things will be. However, he may also already be a very gifted financial analyst.

For he understands something very very important; if you have a pizza, it doesn’t matter whether you slice it into 2, 4, 6 or 8 slices, there is still the same amount of pizza:

1 = 2/2 = 4/4 = 6/6 = 8/8

Perhaps he should teach an Investments 101 course for “investors” in Tesla Inc. (NASDAQ: TLSA) because they are certainly disregarding this fundamental fact. On 28 March 2022, the great Wizard of Mars, the omnipotent Elon Musk ruminated on twitter that Tesla was considering splitting its shares in two (by doubling the number of shares on issue) and the market responded with rapturous applause. By the close of trading the shares were up 8.03% which represented an increase in market capitalisation (simply, share price x the number of shares on issue) of USD$84 Billion.

Let’s focus on that a little, and do some comparisons:

In one day, Tesla’s market capitalisation rose by more than the value of Ford or GM on the basis that it would split its stock in two. While there are no fundamental reasons for this, I am prepared to consider the argument that there may be some behavioural issues related to a stock split which might affect the share price.

Commonly, the old “shares rise on a stock split as the shares become more affordable to the retail investor” reason is trotted out by what pass nowadays as analysts. Are they really trying to suggest that reducing the per share price of Tesla’s shares from USD$1,100 to USD$550 is going to drive so much turnover in Tesla’s shares that they should rise by 8%? What complete and utter rubbish. Retail investors would not have the fire power to cause a 0.08% move in Tesla’s share price let alone an 8% move.

So, what is really happening? Using 2017 data from JP Morgan (the most recent I could easily locate), traditional fundamental investors (i.e. us boring people who consider earnings and the price you pay for them) represented only 10% of NYSE turnover as compared with passive and quantitative investors who represented 60% of turnover. There has almost certainly been an increase in the passive / quantitative turnover percentage since then. Why is that important? A possible future article will be on Renaissance Technologies (RenTech), one the largest and certainly most successful quantative trading firms. Quantitative trading firms use algorithms to identify investment opportunities primarily by identifying trading patterns that are likely to repeat. Even RenTech don’t always understand why their computers recommend some trades, but they have learnt to just follow them.

For instance, one pattern that the computers may have identified could be around share splits. So, the fact that in the distant past, a small number of companies announcing share splits produced gains ensures that pattern is repeated in the future because the algorithms have arguably become so large that they are trend enforcing. The patterns they locate become a self-fulfilling prophecy, a phrase most famously used by Robert K. Merton (not to be confused with his son, Robert C. Merton, Nobel prize winner, co-creator of the Black-Scholes option pricing model and much more infamously one of the co-founders of Long Term Capital Management which almost blew up the financial world in 1998). Perhaps not coincidentally Robert K. Merton also popularised the idea of “unintended consequences”.

I believe the proliferation of quantitative trading programs (aided and abetted by the inherently trend following nature of index funds) have created a variety of self-fulfilling prophecies.  Unintended consequences of this include bubble-like behaviours in a variety of markets – most particularly for the purposes of this article, Tesla.

What is more likely?

• Tesla has created a magic pizza where two-and-a-half slices are worth 8% more than the whole? Or,
• The pattern-following quants have become such a large part of the market that their patterns have become self-fulfilling? 

 I don’t believe in magic, so I am going with Charlie and thinking the latter is the case.

And if that is anywhere close to the mark, then it pays to consider what is the largest pattern out there Well, William McChesney Martin was Chairman of the US Federal Reserve system from 1951 through to 1970. He was Fed Chair during the presidencies of Truman, Eisenhower, Kennedy, Johnson and Nixon. He was replaced by President Nixon in 1970 and in August 1971 Nixon ended international convertibility of the US$ into gold (the Gold Standard). Martin’s most famous saying was that:

“The role of the Fed is to remove the punch bowl just as the party is getting started”.

Is there anyone at the Fed, the RBA, the ECB, the Old Lady of Threadneedle Street likely to take the punchbowl away nowadays? No! They are more likely to continue to spike the punchbowl. So, to my mind at least, the largest pattern out there is that the market is always bailed out. But those bailouts in the past have been largely through the mechanism of lowering interest rates ….. and they are currently at 0.1% per annum in Australia. I can imagine a day when markets can’t be bailed out and the pattern following quant’s collectively start to imitate The Robot from Lost in Space – “Does not compute. Does not compute. Does not compute.”

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