Self-Predicting Markets

The story of Hertz has fundamentally changed how I view the stock market. This isn’t a novel revelation – now that I understand it, I’ve seen the core insight mentioned elsewhere – but it took a concrete example to really drive the point home.

The short version of the Hertz story is that the company went bankrupt. They have nearly $20 billion in debt, and as far as anybody can tell, no path to recovery; they’re bankrupt because their business model has been losing money for years despite several attempts to turn things around. The twist? Their stock is still trading, and at time of writing they have a market cap of $900 million.

I notice I am confused.

On any intuitive understanding of the market this shouldn’t be possible. The company is literally worthless. Or really, worse – it’s less than worthless given its debt load. People are paying positive money to own negative money. On a naive view this is another nail in the coffin of the Efficient Market Hypothesis.

After noticing that I was confused, I tried to generate hypotheses to explain this story:

  • Maybe the EMH really is wrong and the markets are nonsense.
  • Maybe bankruptcy laws are so complex and tangled that the expected value of the company really is positive after all is said and done.
  • Maybe the markets expect Hertz to get a government bailout for some reason.

Some of these are plausible (in particular the second), but none of them were particularly satisfying, so I tried asking myself why I, in a hypothetical world, would buy Hertz stock in this situation. I gave myself the standard answer: because I expected the stock go up in value in the future. Then I realized that this answer has nothing to do with the value of the company.

I had been making the mistake of viewing the stock market as a predictor of company value over the short-to-medium term, but this isn’t true. The stock market is a predictor of itself over the short-to-medium term. If people think the stock will go up tomorrow, then the stock will go up today – it doesn’t matter what the value of the company does at all. The company can be literally worthless, and as the Hertz story proves, people will still buy as long as they think the stock will go up tomorrow.

Now in practice, there are a bunch of traders in the market who trade based on the expected value of the company. As long as these people have a majority or at least a plurality, then everybody else is destined to follow their lead. If the expected value of the company goes up, then the expected value of the stock goes up, as long as enough people are trading based on company value. But in cases like Hertz, the expected value of the company is nothing, so value-based traders exit the market entirely. This leaves only the “shallow” stock-based traders, whose rational move is now to trade based on the expected value of the stock being completely divorced from reality.

The market is really weird.

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