Zoom Technologies, Inc. vs. the Efficient Markets Hypothesis

I think it's worth steelmanning the EMH in this case.

Let's compare ZTNO (the False Zoom) and ZM (the True Zoom) for the last 6 months:

False zoom prices

True zoom prices

True zoom began climbing on around Feb. 1st and seems to have continued climbing.

False zoom had a couple little bumps in February, but it only started rising consistently around Feb. 24th, and the spike you're noticing mostly took place from March 12-20th, over about a week's time. Then it plummeted, got a hold put on it, and declined once the hold was released to an unprecedented low of $0.70/share.

How big of an error is this?

Market cap is the price of stock multiplied by the number of outstanding shares of stock. Its current market cap is $300.9 million, so at a share price of $.70 cents, it should have about 430 million outstanding shares.

Let's assume the worst-case scenario: today's lowest-ever price was the correct price for ZTNO from Feb. 24th on.

In that case, for investors who owned ZTNO at its peak price and held it through to today, they suffered a collective loss of around $9 billion.

The world's market capitalization is around $78 trillion, so that's around 0.012% of the world's market cap.

What's the strongest defense of the EMH I can offer here?

• Even a very strong EMH might allow for occasional fuckups, when we're talking a tiny fraction of a percent of the world's publicly traded companies, for about a week's time, in very weird circumstances. If you go around cherry-picking for missed opportunities in hindsight, you're sure to find them.
• It's called the Efficient Market Hypothesis, not the Ideal Market Hypothesis. Saying "Asset prices reflect all available information" is not the same as saying "Asset prices reflect all information." Ground-level economic information, such as the bankruptcy of a small-cap company in a foreign country, might spread at a speed that is proportional to its expected value. Perhaps most or all investors in ZTNO prior to January had such small segments of their portfolio allocated to ZTNO that it didn't make sense to check whether or not it existed, since presumably the vast majority of listed companies do exist and it probably takes quite a bit of work to check.
• Did ZTNO really look like a bad buy at the time to someone who knew it wasn't the True Zoom? Maybe you noticed early that people were buying because of name confusion, and you bought for that reason, hoping to time the market and sell before the bubble burst. That's not illogical. Then again, ZTNO is a Chinese videoconferencing company. Maybe you reasonably expected that they, like ZM, would profit from increased demand due to COVID-19. I admit that the company sounds dubious, but that's not a sure thing.

My small experience with stocks is that the more I look into apparently bonkers violations of the EMH, the more I discover that I just didn't understand the full context. Search a little harder under the assumtion the EMH is true and you're just missing something, and there's a good bet you'll find an explanation that makes the prices make sense.

From my own experience reading the literature, I propose the following: The Bimodal Market Hypothesis.

The BMH states that the market is either a terrifying beast of infinite power that has priced in the number of grandchildren you will have into McDonald's stocks, or is so stupid it kinda makes you want to cry. Evidence for this includes:

1. The Dot-Com bubble, the fact that Bitcoin has a price exceeding $0 despite there currently existing cryptocurrencies that are strictly better in every way, and that time the market proved to be incapable of doing addition. Maybe it's when tech is involved?

2. But also, the Peso problem, where an apparent decades-long anomaly in the markets turned out to exist because the market was accurately estimating the probability that the Mexican government would be unable to maintain its peg.

Situation 1 occurs when idiots outnumber financial experts, and overwhelm the ability of "Smart money" to accurately price a stock in the face of a hype wave. Everyone reasonable avoids these stocks like the plague; shorting them exposes you to the possibility of bankruptcy in the case that the madness fails to subside in time. Situation 2 happens when financial experts poring over spreadsheets determine the value of a stock by rereading every statement until it's become their favorite work of literature before making a decision.

Policy proposal: Make it illegal to trade stocks if you haven't read A Random Walk Down Wall Street, don't know what a PE ratio is, if you do know what a candlestick graph is, or if you think that the reason why stocks go up is something like "Everyone thinks they will."

But ... this is nuts, right? It makes sense that a pandemic would make a videoconferencing company more valuable. It doesn't make sense for a completely unrelated company that may not have actually existed since 2015 to become more valuable because it happens to have a similar name as a videoconferencing company.

Seconding the call to check out Matt Levine's column, which has taught me that this kind of weirdness makes perfect sense, and is entirely consistent with EMH. If we have evidence that people often make these kind of blunders, and will continue to do so in future—another common one is KO (Coca-Cola Company) vs COKE (a bottler and distributor)—then even a totally bogus company really is 'valuable', in a very stupid but fundamentally accurate sense.

In short: the fact that people don't read tickers carefully is part of the information that markets are constantly aggregating.

Levine:

To stylize the situation, you can think of ZOOM as sort of a dormant corporate shell that owns one asset, the ZOOM ticker. It owns that asset more or less by accident, and it is not ownership in the traditional sense; stock exchanges assign tickers, and ZOOM can’t just go and sell its ticker. But still every now and then the ZOOM ticker becomes a valuable asset and starts generating revenue. In good-for-ZM times, you can make a couple of million dollars a day selling ZOOM, which I suspect—again, they don’t file financials—is more than ZOOM can make selling mobile-phone components.

If that coupling gets diluted to higher simulacrum levels [LW · GW], such that prices only reflect a free-floating consensus of what traders think that traders think that traders, &c., then a market that is efficient in a narrow technical sense, may not be performing the kind of information processing that some naïve EMH proponents might think it is.

I think this is an important point. And also that there is a time horizon component to it. As Benjamin Graham (mentor to Warren Buffett) put it:

In the short run, the market is a voting machine, but in the long run, it is a weighing machine.

I have a pet theory that part of the way that the market reacts to news is analogous to the blue-eyed islanders, where everyone is trying to do induction on what everyone else thinks.

Suppose I learn some new information (or do some analysis) that suggests that stock prices should fall (e.g. because a new epidemic will be worse than generally thought). But stock prices aren't falling yet. Is that because the rest of the market participants don't know what I know, or is it because they also know some countervailing fact?

After some time, prices still aren't falling. Surely other people would have figured it out by now. What's going on? Is there something obvious I'm missing?

(And how many other people are in the exact same epistemic state, and also asking the same question?)

Finally, prices start to fall. Maybe someone got brave, and decided to bet on the same inside view that I had. Or maybe some other random event caused them to fall. But they're falling now.

Normally, you might think that if you have an inside view of where prices should be, and then prices fall, things that looked expensive to you before should look cheap, and so you should want to buy. But if you're in the epistemic state I describe above, prices falling is validation of your belief that prices should fall, and evidence against the hypothesis that there's some important countervailing fact that you're missing. So as prices fall, your own "fair" price for assets falls too.

So all the islanders leave on the same day. And all the traders sell at the same time. And market moves happen more sharply than they would if they were purely the result of updating on external information.

I'm not sure if this view is correct, but it's my impression. (For a related idea, see Soros's notion of reflexivity.)

I recently came across Tiziana Life Sciences, a small UK biotech company with the US ticker TLSA — which is a fat finger error away from Tesla ($TSLA).

Tesla's share price has increased by ~250% year-to-date. In the same period, Tiziana Life Science has increased by ~220%. Other biotech stocks are doing pretty well, but the small-cap index $BTEC has climbed only ~22% in 2020. Perhaps I'm missing something about Tiziana's business, but it looks suspiciously like their valuation is typo-driven.

This argument misses the fact that some of the sellers in the market are selling because of other circumstances in their life or business. This doesn't affect the price on average, but it does make it unreasonable to say "you need to buy them from someone who's willing to sell at that price—who presumably does not agree that the price is going to go way up."

At any point in time, some of the sellers in the market are selling because their daughter is about to start college, or they are nearing retirement, or there's some other valuable they want to invest in with somewhat better prospects, and they need financial liquidity to do so. Similarly, there are buyers who just sold an asset (real estate, e.g., that finished construction) or received a bonus, or sold something else to protect their gains and need to get back into the market.

The point isn't that these behaviors move the price in one direction or another, it's just that not all activity in the financial markets is driven by disagreements about prices.

I think there are two areas that need to be included in the discussion here.

1) EMH as a static equilibrium concept and as a dynamic equilibrating process. I don't think EMH comes out too great in either setting but still do think that the hypothesis is largely true: information matters, is used and is largely reflected in the prices as it become more generally know (private information allows alpha but also has controls on its use and typically those with it cannot take full advantage due to resource limitations).

2) What do market prices really reflect? It is not really the enterprise value directly, though clearly that will be related, but more about the relative supply and demand for the shares at the margin. All sorts of think affect that marginal pricing -- I have to sell something to do something else that is a better alternative so that sale is my opportunity cost -- that has little to do with the underlying enterprise pricing question or the information related to that question.