There’s No Gravity in the Stock Market

For millennia, moths and other nocturnal insects used celestial navigation – stars and other points of light in the night’s sky – to find their way, not unlike how sailors used the North Star to chart a course.

Then humans came along and developed terrestrial light sources, first fire, then electricity in the form of light bulbs. With no evolutionary history of encountering close-by points of light generating enormous amounts of heat, they can’t process the conflicting signals and follow their instincts, flying directly into flames – and their demise.

“I think I’m going to short Snapchat,” said my friend, whose only activity in the stock market consists of checking his 401(k) quarterly.

“First, let me ask you a question,” I said. “What is it about a stock that’s been trading in a range for six months, and is up almost 50% today on record volume, that makes you want to short it?”

“Their revenues are going to be bad next quarter,” he said, explaining that since he worked in the same industry he felt he had some unique insights into how their ad platform would perform going forward.

“Okay. I’m not trying to talk you out of this trade,” I said – as I tried to talk him out of the trade. “But let me ask you a question?”

“I’m sure you know your business. But what if…just what if, the hundreds of analysts, and traders, and funds that follow Snapchat daily feel that with all the information available – including your insights – the company is fairly valued today, and was actually undervalued yesterday?”

“Hmmm?” he said.

Sensing an opening, I continued, eventually convincing him to think this idea through before committing any money to it.

I’ve seen this phenomenon many times before – wanting to short an asset moving into new highs – but I’ve also seen the opposite response.

“I think I’m going to short Tesla,” said my brother-in-law after the stock had dropped 20% in eight days last July.

“Okay. Let’s talk about this,” I said.

It makes no sense to me when passive investors suddenly want to become traders and short extreme moves, and I’ve always wondered what motivates them to do so?

I’ve concluded that, like the moth, it’s really our evolutionary history that does them in.

Over thousands of years, mankind learned to obey the laws of physics or suffer the consequences. Then the stock market came along, and with it, strange and conflicting ideas that challenge how we’ve been conditioned to view physics.

Case in point: Strong stocks tend to get stronger and weak stocks get weaker. But stocks that move hard and fast one way or the other are also susceptible to violent counter moves.

Some passive investors, when alerted to an extreme move in a stock, put on their physics hat and default to one of two mindsets – what goes up must come down, or what goes down will keep moving down.

But there’s no gravity in the stock market, and with no practical experience to inform their analysis, they can’t process the conflicting signal and instead follow their instincts like a moth to a flame – usually with the same results.

 

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