Market “Physics”

Hey, long time, no blog.

As I have watched the broad market continue to float higher, and as I watch debacles like $AAPL gapping 50 points down back in January, I of course try to make sense of it all. WHY is it happening? For a trader, the answer is “I don’t know, I can’t know, I don’t care”. A trader just goes with what is happening. This has always been a difficult mindset for me. Still, I am always trying to improve my understanding of how the market really works so I can better take advantage of it.

Take the $AAPL case. One day the company is worth $500+, according to market prices. The next, it gets slashed by more than 10%. Did the company REALLY change value that much, intrinsically? No. It was the same company yesterday as it is today. Does the new post-dump share price represent a fair valuation of the entire company? Possibly. But what has really happened? A small subset of owners of the company with a small subset of the total outstanding shares decided (or were forced by margin calls) that they needed to sell at this price for any number of reasons. Did every share outstanding get truly revalued in a market transaction? I would say NO. Every share outstanding got marked-to-market based on these few transactions. If you try to think of stock price as a proxy for what people think a company is worth (i.e. market cap) then none of the day in, day out price changes you see in stocks really make any sense at all. In the past this has caused me to stand by in a stupor in the face of strong uptrends without joining in. It just doesn’t make sense from a market cap and company valuation perspective. As I was thinking it through, I realized something. Basically, money is created and destroyed in the stock market each and every day. There is no law of conservation of money, nor is there any such thing as “price work”, meaning trading energy applied to the stock to revalue it. Thinking of the markets in terms of physical processes (like momentum, work, energy, force) is inherently flawed. Let me explain.

In physics, things have intrinsic properties. A tank full of jet fuel contains a certain mass. It has internal energy defined as temperature. Each and every particle in the tank has these attributes in basically an equal distribution. If you wanted to heat that tank of fuel from 50F to 200F you would need to apply heat energy to the entire system. You would have to apply enough heat to each individual particle to raise its temperature from 50F to 200F. We then sum up all the heat needed for all the particles and that is the total energy required to heat the whole tank. (This is not necessarily how you would do the math, but physically it’s an accurate description of what happens in reality.) If you wanted to heat half that amount of fuel from 50F to 200F, it would take half the amount of total energy to do it.

Now, if you think of stocks in this way, your brain will turn into greek yogurt quicker than you can say “austerity”.

Say that we start with a “tank” full of stocks, such as every single share of AAPL outstanding. If the market price is $400, then we determine that all the shares in the tank are “worth” $400 each. The tank as a whole (the entire company) has an ‘energy state’ called market cap. Total number of shares * $400 = the “value” of the entire company. Now you would think that to raise the market cap by 25%, you would need to apply monetary buying pressure to each little share until they are all up by 25%, so that the whole is equal to the sum of its parts, just like in physics. NOPE.

All it takes is for a few traders to take a tiny fraction of those shares out and revalue them through transactional work in the market outside of the $AAPL tank to a new level of say $500 per share. Then the magic happens: all the rest of the shares in the tank are instantly revalued, without ANY action performed on them at all!! This may be obvious to most people, but it’s an immensely important realization. It’s like taking 1 gallon of JP-8 from a 10,000 gallon tank at 50F, heating that 1 gallon from 50F to 200F, and then dumping it back in the tank. In physical reality, the 1 gallon cools a lot and the rest of the fuel heats a tiny bit as the extra energy is diffused to all of the fuel. That is intuitive. However in the stocks case, as soon as the 1 share goes from $400 to $500 and is thrown back in the tank, suddenly by simple declaration the entire rest of the tank is at $500 as well. A miracle: wealth has been created. If this was physics, then it would mean that heat energy had been created. This is one reason why I say my science background is a disadvantage on trading. I have a fundamental worldview that is not applicable to the trading world. In the markets, wealth can be and is created and destroyed all the time through this multiplicative effect of mark-to-market. (As an aside, it’s also easy to see why they suspended mark-to-market pricing during the housing meltdown. Valuing the whole of the banking system at the depressed price that a portion of the garbage loans were trading at would have destroyed all the wealth in the world, at least monetarily, and for no real physical reason. It couldn’t be allowed to happen, so they bent the rules. At the time this made a lot of the idealistic “Blue Blazer” types very angry, including myself, but was absolutely the right call for them to make in hindsight.)

So when you see a stock chart, and you wonder “How can everyone think AAPL is worth $700 per share!?! Are they crazy?!” make sure you stop yourself and think again. In reality, a relatively few people think that a small fraction of those shares are worth that $700 right at the moment of the transaction. All the rest of the shares outstanding are marked-to-market based on this tiny sample. That is why company valuations can be so whacked out for so long.

The key is to predict how traders may react en masse when this financial alchemy happens. Besides just the revaluation of all of the stock, I think that this effect is also highly magnified by the derivatives market. Increasing the value of a million shares by $1 can result in a huge magnification of hundreds of millions in the options contracts. The tail wags the dog.

These thoughts help me to align my market paradigm closer with auction theory and away from physical analogies. The difficulty for me is turning this knowledge into actionable trade ideas.