Narratives drive flows, and then flows drive performance. The reality of today’s markets is different than the math puzzle we were told about.
While there is no alpha to be found in the Capital Asset Pricing Model or the Gordon Growth Model, there is a whole lot of alpha to be found in understanding the narratives that move markets.
Narratives drive flows, and there is no more powerful narrative today than the narrative of Nvidia.
If you haven’t been paying attention, Nvidia has gone vertical. Nvidia is now the third largest company in the world by market cap. Bigger than Google. Bigger than Amazon.
The narratives around artificial intelligence are powerful, and rightfully so. And those narratives have coalesced into one trade more so than any other: Nvidia as the beneficiary of the world’s A.I. hopes and dreams.
And what of Nvidia’s value? At what price does even the most optimistic view of Nvidia’s future make the stock untouchable? There is no such price. Value, these days, have nothing to do with it. Narratives are running the show.
Nvidia's market cap is higher than the entire US energy sector - with another $200 billion left over - despite Nvidia generating only 13% of the energy sector’s net income. Like I said, value’s got nothing to do with it.
Nvidia is worth more than the Canadian GDP. Nvidia is worth more than the entire Chinese stock market.
“There are no price-setters, so there’s no friction! A stock in motion stays in motion! It’s just flows and vibes, coach. Flows and vibes!” -Travis Kelce, probably
It wasn’t always this way. Investors used to buy stocks for the future cash flows of the companies they believed in. Companies used to IPO for capital to better satisfy their customers w products and services.
Now, for both parties, the stock price itself is the product. It’s a big game of Number Go Up.
There were a few interesting things that David Einhorn said on Barry Ritholtz’s podcast last week.
For one thing, he said he is still looking for value. But since he can no longer rely on the market to correct itself to reprice stocks based on value, he now gets paid for value bets directly through company cash flow. This is a huge change in approach, and I wonder if other value managers will follow suit.
He also talked about price discovery being broken in markets. After all, narratives are running the show.
Einhorn explained how market cap weighted index flows are exacerbating divergences between price and value. In market cap weighted index funds, money is increasingly allocated to bigger stocks as they grow even bigger, so the outliers to the upside just get driven further and further into the stratosphere.
And that is how you get to the top five stocks in the S&P representing more than 25% of the weight. You get there when there is a consensus narrative that passive market cap weighted index funds are the proper and correct way to invest. And you get there when the best narratives continue to favor tech monopolies. Five companies, from the same sector, same part of the same country, facing the same risks of antitrust legislation or tech obsolescence, representing more than a quarter of the entire market. Whatever that is, it ain’t diversification.
That is how you get to index funds now sitting in violation of the 1940 investment company act diversification rules. The minimum diversification rules that for decades have dictated how concentration limitations allowable for active managers.
Investors chasing narratives give no thought to the future cash flows or long term ownership in specific companies that they believe in. Company management teams give no thought to using capital from the public markets to make better products over the long term. Both sides are focused on short term stock price appreciation.
And fund managers are no longer incentivized to provide price-setting friction that can dampen the kind of runaway moves like we are seeing now with Nvidia.
The markets are on all time highs. Investors are happy. As long as Number Go Up these problems have no urgency. Until the unwind, when the same forces that drove overvalued companies yet higher will play out in reverse.
The same stocks susceptible to narrative-driven moves to the upside will be susceptible to panic narratives on the downside.
Except on the way down, this time, all of the friction provided price-setting active managers and all of the would-be bargain buyers with their Capital Asset Pricing Model and their Gordon Growth Model, they are all gone.
But don’t you worry. Mayor Vaughn wants to assure you that the waters are safe.
I have always suspected the flows derive performance ("reflexivity") bit, but could find no formal literature to support it. I'd have to dig through my notes, but anecdotally two channels come to mind:
1) there were stories (by Jim Chanos) i believe where high stock prices flowed into "venture capital arms of the cos" investing in BUYERS of their product! Dot Con Era 1999-2001 vintage!
2) The tremendous incentive stock options put on suitably machiavellian sociopathic CEOs is another channel.
I'd be curious if you have any cases to add, where high stock price gets monetized into higher "business activity" in some causal way...?
cheers.