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Passive investment megatrend blurs market price discovery

11 April 2021 Gareth Stokes

Last night I spent a few hours debating crypto assets with family and friends. The central theme of the debate was how one went about determining a sensible valuation for a digital token, let us say Bitcoin, given that it is little more than a string of 0s and 1s that changes hands in the cloud. Our conclusion was that there is no rational way to value an asset that has surged 696% over the past 12 months from an already ridiculous US$6624 per coin.

Chasing 10x, 50x or 100x

Investors (and I use the word loosely) in the post-Millennial generations seem to ignore the value debate when pouring their hard-earned cash into crypto or other traditional asset classes. They are not as concerned with what an asset is worth as they are at the prospect of that asset growing to 10x or 100x its initial cost. Nor do not seem to base their decision on a ‘sum of the parts’ assessment, preferring to invest in a concept or story that is in favour among their peer group. One possibility is that those growing up during the fourth industrial revolution (4IR) have learned to accept things that work without necessarily understanding the technology that underpins it. In answer to the question “What gives Bitcoin value? they might simply respond, “Who cares? It works!” 

The more I think about value under a crypto asset context, the more I question value in today’s equity markets. In the past, asset managers or ordinary investors would use fundamental analysis to determine the intrinsic or real value of a share. The intrinsic value of a business boils down to the present value of all its future cash flows, discounted at an appropriate discount rate. I will not delve into the calculation in this article, except to say that care must be taken in determining the discount rate. Analysts must consider the risk free rate of return and the return on capital of the particular company or industry they are assessing, among other factors. 

Intrinsic value versus market price

Investors understand, or at least they used to, that the market price at which they bought or sold a share was different to its intrinsic value. The market price is the product of interactions between buyers and sellers in a free market, facilitated over an exchange such as the JSE or NASDAQ. We might therefore think of the prevailing market price as the fairest indication of a company’s value in that it reflects all that is known about a company and its future prospects at a given point in time. Investors will reflect on differences between the intrinsic value and market price to decide whether to buy, hold, ignore or sell a company. 

Unfortunately, investor sentiment, coupled with certain physical market constraints, can make a right mess of market pricing. The potential for mis-pricing in a functioning financial market is clearly illustrated by excessive positive investor sentiment. As investors rush in to buy a share, they risk chasing the price way higher than a fair market value. All you need is another market constraint such as illiquidity (few shares on offer) or hedge funds being caught in significant short positions for the share price to surge to ridiculous levels. We had a real world example of this when Reddit users whipped investors into a frenzy over the prospects for GameStop (NYSE: GME). The share price surged from around US$20 per share to above US$400 in intraday trade, one day in January 2021. 

Demand-driven bubble in equities

The general economic construct of demand and supply that is used to explain price movements for goods and services also applies to financial markets. As we power into Q2 2021 it is becoming clear that the record amount of fiscal stimulus being pumped into global economies to mitigate the economic impact of pandemic, coupled with low interest rates, is causing a demand-driven bubble in equities. Retail investors are pouring every spare cent into the stock market because equities are the only asset class capable of generating real return in the current economic climate. The resulting demand for shares could, in part, explain the disconnect between financial markets and the general economy. 

There is another problem. US investor, Michael Burry, who gained fame for being on the right side of the 2008 Global Financial Crisis, recently observed that the record cash inflows into equities, combined with a trend-shift in the asset management industry from active to passive investing, was distorting market prices. “Passive investing has removed price discovery from the equity markets,” he said, in an email interview with Bloomberg News, excerpts of which were published on 5 September 2019. Website defines price discovery as “the overall process, whether explicit or inferred, of setting the proper price of an asset, security, commodity or currency”. 

Asset managers who collectively control billions of dollars in passively-managed funds have to invest this money in line with their fund mandates. This means they are channelling all the new cash they receive into indexes or narrowly-defined segments of the equity market without any consideration for the price of the underlying assets. The only way for the market to accommodate this endless flow of cash within a finite investment universe is for share prices to go higher and, inevitably, to far exceed the proper price. Many market commentators disagree with Burry; but the recent performance of the S&P 500 index suggests otherwise. 

Bitcoin to the moon...

It is quite simple to transfer Burry’s pricing discovery argument to a crypto asset like Bitcoin. In this case we see bucket loads of cash seeking an outlet into a digital currency with limited supply: there will eventually be a total 21 million Bitcoins in circulation. The coin will surge to record levels for as long as asset managers seek to include Bitcoin in their passive funds; as companies include Bitcoin in their treasury programmes; and as individual post-Millennial investors chase the crypto in search of their next 10x thrill. This asset, if we can call it that, does not need a value underpin because its value is 100% linked to investor sentiment. And that means that Bitcoin, as predicted by the crypto exchanges and YouTube influencers who back it, will be going “to the moon”.

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