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“The only thing I do know is that we have to be kind. Please, be kind. Especially when we don’t know what’s going on.”

— Waymond Wang, Everything Everywhere All at Once

Thursday Mailbag

Q: Why’d everything go down all at once?

The standard answer is “yen carry trade” and I guess that really is the most plausible explanation for the dramatic selloff in global risk assets on Sunday and Monday. 

But it’s a partial explanation, at best — the cause-and-effect for Japanese equities is clear, but I don’t think many people borrow yen to buy, say, US equities or crypto, so I don’t know how explanatory the carry-trade unwind can be for why everything went down.

You might then layer on some other news to come up with an explanation that matches the magnitude of the move in US equities — weak jobs data, changing election odds, rising geopolitical risks.

But this kind of reverse engineering can get you in trouble — if your starting point is the size of the market move, you’ll be prone to overestimating the real-world impact of what seemed to cause it.

Not every canary just flew out of a coal mine.

Instead of assuming that every consequential market move has an equally consequential cause, I think it’s more productive to view market moves first and foremost as a function of flows — because it takes a lot less than you probably think to move even the most liquid markets, like US equities.

An academic study of the “elasticity” of markets found that $1 of flows will move the valuation of the US equity market by roughly $5.

Markets are “surprisingly inelastic,” according to the study, because it's just not that easy to find $1 of demand to offset $1 of supply (or vice versa).

Mostly that’s because professional investors tend to be fully invested at all times — the number of marginal buyers or sellers at any given moment is far smaller than the huge trading volumes that, say, equities or crypto would have you think.

Trading volume in ETH, for example, is high ($20 billion+ per day), but liquidity is low.

Ethereum had a $400 billion market cap as of last week, but Jump Crypto selling just $500 million of ETH on Sunday appeared to make it worth just $300 billion.

This is not unusual — many of the biggest mishaps in markets are a product of people overestimating the liquidity of the things they think are long (see: Black Monday). 

So, here’s an alternative way to think about markets: We live in a high FDV, low-float world.

“High FDV, low float” is a crypto concept — the idea that the sky-high valuations of many crypto protocols (the FDV) is mostly a function of the low numbers of tokens available for sale (the “float”).

But this applies to markets generally, as well: There are not nearly enough dollars in the world to buy all of the dollar-based assets at current valuations.

Let’s do the math.

Using M2 money supply as a rough guide, we can estimate that there are about $21 trillion US dollars in existence.

On a market-to-market basis, however, US equities alone are worth twice that ($42 trillion).  

Owner-occupied real estate is worth $46 trillion; commercial real estate is worth $26 trillion; US farmland is worth $3.2 trillion; crypto is “worth” $2.2 trillion.

So even before getting to things like my childhood baseball card collection, that is $21 trillion of real money supporting $120 trillion worth of on-paper valuations. 

(A 1:6 ratio that is weirdly not far off the aforementioned study finding a 1:5 impact of market flows.)

You can intuitively see how this happens: Jeff Bezos’ net worth of $180 billion has a cost basis of approximately $0, for example.

And the $1,000 of baseball cards I bought in the 1980s is now worth, well, $600, probably — but you get the idea.

Now imagine if everyone decided to sell everything everywhere all at once. 

There is only $21 trillion to go around, so even if all of it was available for investment purposes, prices of the $120 trillion of assets would have to go down 82% for everything to clear at the same time.

A mini-version of that is what happened on Monday.

When a large room of people all try to exit by the same door at the same time, things get messy.

Q: What about Eurodollars?

You’re right that Eurodollars don’t show in the Fed’s M2 data, but that’s because they’re not dollars, they’re credit — credit that’s collateralized by actual dollars sitting in a US bank account somewhere (which does show up in M2).

The occasional difficulty of finding a real dollar in a real US bank account is what makes markets occasionally crash. 

Q: Is everything 6x overvalued, then?

No, because most of those assets (with the exception of my baseball cards and possibly crypto) are productive assets — investors can make a return on them without ever having to sell.   

If every asset was instead of the greater-fool variety, where returns can only be realized by selling at higher prices, asset prices would eventually have to collapse back to the number of dollars available to buy them with.

But investing in productive assets is a positive sum exercise — so as long as your investments are productive, you shouldn’t ever have to worry about how many dollars there are to buy them. 

Q: Does this invalidate the efficient markets theory?

One takeaway from the “inelastic markets hypothesis” is that buying back shares will have a much different effect on a stock price than paying a dividend does: Paying a $1 dividend will only ever make shareholders $1 richer, but buying back $1 dollar of shares will make them $5 richer (on paper, at least).

That seems like an inefficiency — returning value to shareholders should, in theory, have the same value no matter how it’s returned. 

But that doesn’t mean that markets are inefficient.

Contrary to popular belief, the test of an efficient market is not whether prices always perfectly reflect all available information — they don’t. 

Instead, the test is whether markets are perfectly unpredictable.

Recent events suggest that they are.

— Byron Gilliam

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