The Paranoid Style in American Investing

Here’s a taste of the madness: Entrepreneur and social media puppet master Elon Musk became the world’s wealthiest person. Tesla Inc.’s market capitalization exceeded $1.2 trillion, more than the next nine largest automakers combined.

One of those others, Rivian Automotive Inc., went public in November and only recently started generating revenue. It was soon valued at $150 billion.

Hundreds of special purpose acquisition companies, or SPACs, together raised more than $150 billion to find a company to list on the stock exchange, with their targets often more of a business plan than a business.

Cryptocurrencies, the bulk of which have no intrinsic value, were at one point collectively worth more than $3 trillion. A non-fungible token artwork (NFT) — in this case, a JPG file by an artist named Beeple — sold at a Christie’s auction for $69 million.

Struggling video games retailer GameStop Corp. and cinema chain AMC Entertainment Holdings Inc. soared as much as 2,450% and 3,300%, respectively, when Redditors coordinated online to punish hedge funds that were betting on the companies’ demise.¹

And because there’s no gold rush without pickaxes, retail brokerage Robinhood Markets Inc. and crypto exchange Coinbase Global Inc. became two of the year’s biggest initial public offerings: At the peak they were valued at $59 billion and $75 billion. (In December the home of WallStreetBets, Reddit Inc, announced it had filed confidentially for an IPO)

Investors have poured an astonishing $1 trillion of cash into equities funds in the past 12 months, or more than the combined inflows of the past 19 years. At the peak in January, retail investors accounted for almost one quarter of U.S. equities trading, according to Bloomberg Intelligence.

An estimated 16% of U.S. adults have invested in crypto, according to Pew Research Center; among twenty-something men, that proportion is closer to half. In 1929 shoeshine boys gave out stock tips; today’s teenagers ask their parents to open a crypto trading account on their behalf.

The short explanation for all this feverish activity is that thanks to central bank and government stimulus, far too much money is sloshing around in the financial system. The aggregate money supply has increased by $21 trillion since the start of 2020 in the U.S., China, euro zone, Japan and eight other developed economies. “Stocks only go up” isn’t just a wry catchphrase: Essentially it’s been the lived experience of young investors this past decade. And so they ignore nosebleed valuations and buy the dip.

But something’s changed too in the culture of investing. It’s no longer enough to admire a company or asset and buy the stock or token. Some of the biggest investing trends have become an extension of personal identity, akin to your religion or your sports team. Sometimes that connection is overt: From Christmas Day the home of the L.A. Lakers will be renamed the Crypto.com Arena. Footballer Tom Brady has launched his own NFT collection.

These movements can be fun and empowering, but financial super-fandom can quickly become toxic. I worry that the same forces diminishing modern politics — partisan divisions, pervasive distrust, social media echo chambers, misinformation, cancel culture and conspiracy theories — are seeping into the investing world, where they’re warping capital allocation, inflating a series of bubbles and challenging the ability of regulators to protect investors and the markets.

In some respects, this time really is different. Easy to use, commission-free brokerage apps like Robinhood have given millions of neophytes the tools to play at being a Wall Street trader.

Instead of sticking their money in a boring index fund, young investors are making concentrated bets on single stocks and using cheap short-dated out-of-the money call options (speculating the price of the stock will quickly increase before the option expires). It’s the financial equivalent of buying lottery tickets.

It can be an effective way to squeeze the underlying shares higher (because option sellers hedge their position by buying the stock). It often attracts momentum-buying from hedge funds and other institutional investors, which magnify the price moves. And options are also a huge money-spinner for digital brokerages. Problem is, inexperienced retail investors may not fully understand the risks, until it’s too late.

“It’s much more like gambling,” says Bloomberg Intelligence market structure analyst Larry Tabb. “The options premiums might seem pretty small but you can easily end up losing your entire investment.”

Speculative assets have evolved, too. In 2000 investors could easily comprehend the business model of a Pets.com, say. There’s now a much higher degree of financial abstraction: Think SPACs, NFTs, Web3, DeFi ( “decentralized finance”) and the metaverse. This abstraction excites intellectual curiosity but the harder something is to explain, the easier it is for promoters to hype it to people lacking a financial or technical background.

Fearing they’ll be accused of stifling innovation or capital formation, regulators have mostly allowed the party to continue. Digital assets typically aren’t registered and regulated as financial securities. Crypto trading often happens on opaque, offshore exchanges. SPACs can publish fantastically optimistic financial projections, which traditional IPOs avoid due to liability risks. It smacks of regulatory arbitrage on a grand scale.

Another important check on speculative excess, the short-sellers who think a stock is overvalued, had a difficult year. That’s not to say they didn’t enjoy some successes — former SPACs have been particular fertile ground for the shorts — but the market’s relentless rise and the danger of being caught up in a GameStop-like squeeze convinced some to give up the game entirely. To cap it all, much to the delight of the Reddit crowd, short-sellers now face a U.S. Justice Department criminal investigation into their activities.

The GameStop saga and similar events also torpedoed a key theoretical foundation of Wall Street — the notion that markets are efficient. Securities prices are supposed to reflect all known information and the discounted value of expected future cash flows. If prices rise more than is justified by financial fundamentals, more sophisticated investors should sell.

An emerging theory, the Inelastic Markets Hypothesis, postulates that retail buying is able to warp prices for prolonged periods because so much of the market is now passive, not actively managed, and is therefore insensitive to changes in prices.

“Demand shocks and inelastic markets are the tissue that connects the meme stocks, Tesla and even crypto” says Philippe van der Beck, a researcher at the Swiss Finance Institute.² “Bitcoin can be seen as an extreme version of today’s stock market: it’s almost entirely detached from fundamental value as there are no cash flows for investors to discount. People are just betting on how they think demand for the asset will change in the future”

When flows trump fundamentals and financial prophets, not accounting profits, drive investment decisions, attention becomes the only trading currency that matters.

True, retail investors are a heterogenous bunch, and include green eyeshade value investors who pore over spreadsheets. But increasingly, the hallmarks of the retail investing world have been dizzy-eyed techno-optimism, tear-it all-down nihilism and cult-like fanaticism.

This transition shouldn’t come as a surprise. Not only have markets been roiled by the same events and forces that stoked fear, division, turmoil and mistrust in society at large, but the 2008 financial crisis set back a generation’s earnings prospects and engrained a feeling that Wall Street always wins. Politics appears irredeemably broken, mainstream media is no longer trusted, and technology upstarts that once promised a better and more equitable world have become impregnable behemoths.

And that was before Covid hit.

Young people are starting careers with massive student debts and housing has again become crazy expensive: It’s no wonder they dumped their stimulus checks into the stock market and gamble to keep up. The FOMO is real.

Those who now proclaim a new financial dawn find a receptive audience. Hence the excitement around decentralized finance (who needs bankers?!), and the collective elation during the GameStop phenomenon: Ordinary investors suddenly feel incredibly powerful. “Professional investors would never have paid attention to Reddit boards two to three years ago,” says Tabb. Now they do.

Of course it’s hard to fully rationalize buying a joke dog token or one named after a coronavirus variant — but you only live once (YOLO). And as long as the prices go up, who cares why?

Memes and in-group language foster a feeling of togetherness that people have missed during an insolating pandemic.

Online forums like r/wallstreetbets help day traders to share sophisticated ideas, champion the little guy (it’s often men) and humorously commiserate about spectacular losses.

Users of YouTube, TikTok, Discord, StockTwits and Twitter also push out a wealth of financial information that theoretically enables better investment decisions.

But there’s a catch. The retail investor commandment to “do your own research” sounds responsible, but financial influencers often hold positions in the assets they’re touting. A lot of digital financial content is little more than shilling.

Retail investors can also end up in digital echo chambers and fall prey to confirmation bias. “It can affect the information you see. A Tesla bull may only see positive news about the company whereas on the same day a Tesla bear’s news feed will tend to have much more negative news in it,” says Tony Cookson, an associate professor of finance at the Leeds School of Business, University of Colorado, who has researched this phenomenon. “It’s financially costly to selectively read things that reinforce your existing views.”

Moreover, some of the year’s defining financial obsessions pretend to be egalitarian and freewheeling but at their core are highly dogmatic. Don’t just take my word for it. “These days even the most modest critique of cryptocurrency will draw smears from the powerful figures in control of the industry and the ire of retail investors who they’ve sold the false promise of one day being a fellow billionaire. Good-faith debate is near impossible,” the co-creator of Dogecoin, Jackson Palmer complained in July. (Dogecoin is a joke cryptocurrency that became a $23 billion meme sensation when Musk touted it to his followers.) Palmer wasn’t done:

The cryptocurrency industry leverages a network of shady business connections, bought influencers and pay-for-play media outlets to perpetuate a cult-like “get rich quick” funnel designed to extract new money from the financially desperate and naive.

— Jackson Palmer (@ummjackson) July 14, 2021

True believers seek to reinforce these financial echo chambers, by attacking even mild “fear, uncertainty and doubt” (FUD). And rather than engage with them, they often block out or cancel critics.

There are guides on how to troll “no-coiner” journalists like me — “have fun staying poor!” is a common refrain — and they emphasize the importance of getting information only from like-minded crypto people.

In this climate, scams and misinformation proliferate. New coins are pumped and then dumped by their creators. Retail investors are encouraged to HODL (never sell) and have “diamond hands,” even though if the price collapses they’ll be left holding the bag. “It’s typical of mania environments that the crowd is no longer capable of distinguishing the predators,” says Peter Atwater, president at Financial Insyghts LLC and an expert in social psychology.

A common enemy, real or imagined, disciplines the herd so investors don’t get bored and take their money elsewhere.

Bitcoin “maximalists” argue all other coins are inferior: In their laser-eyed view of things, central bank money-printing will end in ruin and Bitcoin is destined to become a new global reserve currency.

Goldbugs have been obsessed with sound money for decades, but their philosophy has now been more effectively weaponized. With crypto “we’ve decided to do the most American thing ever, to commoditize our rage at the financial system into a financial product,” writes the software engineer and crypto critic Stephen Diehl.

After raging against hedge funds that shorted GameStop, the “apes” shifted their ire to discount brokerage Robinhood Markets Inc, claiming it conspired with market-maker Citadel Securities to restrict their trading. “There are those who still refuse to believe an American landed on the moon,” Citadel tweeted in September lambasting “internet conspiracies and Twitter mobs” for ignoring the facts.

Similarly, hardcore AMC shareholders are obsessed with the idea that the mother of all short-squeezes (MOASS) will propel the stock to new, incredible heights. The stock has fallen more 50% since the June peak. Salvation must wait.

No wonder it’s hard for members of the financial elite to come across as authentic to retail investors — witness this cringe-inducing endorsement of Crypto.com by the actor Matt Damon.

Attracting ordinary investors can also backfire, as billionaire hedge fund manager Bill Ackman discovered this year when his $4 billion SPAC, Pershing Square Tontine Holdings Ltd., announced and then abandoned buying a stake in Universal Music, much to Reddit’s chagrin.

But that hasn’t stopped establishment figures from trying to co-opt the retail wave for their own purposes: After all, the rewards can be huge.

Nobody has pulled this off better than the crypto-touting, master of memes Elon Musk. “If you drew a Venn diagram of every major financial theme in the past decade then you’d find Musk in the middle,” says Atwater. “Normally you can’t be folk hero and the richest person in the world, but he’s done a masterful job of selling people the dream they wanted to buy, at least for now.” And Musk seems very aware of his power.

thinking of quitting my jobs & becoming an influencer full-time wdyt

— Elon Musk (@elonmusk) December 10, 2021

AMC boss Adam Aron embraced the “apes” and saved his company by selling more stock. Since then the cinema chain has jumped on seemingly every populist investing trend, from accepting meme coin Shiba Inu (SHIB) as payment to issuing NFTs.

Cathie Wood’s futuristic pronouncements made her a star on social media and sucked more cash into her risky Ark Investment Management strategies.

And former Facebook executive Chamath Palihapitiya parlayed anti-establishment rhetoric into a portfolio of SPACs — the “poor man’s” private equity, with as many egregious fees.

Politicians are catching on too. Donald Trump’s digital media venture struck a SPAC deal that seeks to harness the same tribalism he nurtured and exploited as president. So far, the price has risen five-fold. El Salvador’s “millennial authoritarian” president Nayib Bukele was embraced by the crypto crowd after he declared Bitcoin legal tender. When crypto prices crashed in early December, the head of state informed his social media followers that El Salvador was buying the dip...

As we neared the end of 2021, crypto, unprofitable tech and the meme stocks have all sold off, hurting retail portfolios. With persistent inflation bringing forward expectations of interest rate hikes, Wood’s Ark funds and Palihapitiya’s SPAC bets were among those caught in the downdraft.

These bubbles may not have burst for good; retail investors may just have shifted their attention once more. They began feverishly buying Apple Inc. call options, for example, helping to push the iPhone maker’s valuation toward a mind-boggling $3 trillion. Shares of new Reddit favorite Ford Motor Co. have lately outperformed Tesla.

Speculative excesses aren’t all bad: Some of the cash that’s poured into markets into 2021 will fuel real innovation — Musk’s technological achievements are impressive.

However, the longer manias persist, the more capital is misallocated and the greater the risks for financial stability. The implosion this year of property giant China Evergrande Group, family office Archegos Capital Management and U.K. fintech Greensill Capital revealed fragilities that ever-rising markets conceal, as well as the dangers lurking in leverage, derivatives and concentrated exposures. Moreover, today’s most speculative assets are often interconnected — people who own Tesla also own Bitcoin³; indeed Tesla owns Bitcoin!— amplifying potential volatility.

So I’m glad Gary Gensler, the new head of the U.S. Securities and Exchange Commission, has outlined an ambitious policy agenda, spanning the “gamification” features of trading apps, SPAC financial disclosures and “Wild West” crypto markets, including lending and so-called stable-coins (the most important of these, Tether, is supposedly fully backed by dollar financial reserves but not everyone’s convinced).

Here’s my non-virtual two cents: I think we need greater oversight of crypto trading platforms and more digital assets should be regulated as financial securities. And I’m in favor of tightening access to options trading to prevent inexperienced investors losing their shirts.

But let’s face it: Regulators can’t turn back the clock. It’s not their job to heal societal divisions and they can’t police everything investors do and say on the internet. Democratized finance is here to stay. We must learn to live with it.

In a world of social media hype and increasing financial abstraction, teaching basic financial literacy and how to find unbiased investing advice will be vitally important.

Sadly, I fear the current generation of young investors may have to learn the hard way. Eventually people will tire of phony financial prophets and pump-and-dump markets. And then, as everyone makes for the exit, of the losses that pile up in their Robinhood accounts.

¹Intradaypeak compared to the start of 2021

²His papers "The Equity Market Implications of the Retail Investment Boom" and "Flow-Driven ESG Returns"are worth your time, as of course is "The Inelastic Markets Hypothesis"paper by Gabaix and Koijen

³As pointed out by Viktor Shvets, a Managing Director at Macquarie, in this Odd Lots podcast episode

Bloomberg News provided this article. For more articles like this please visit bloomberg.com.

Read more articles by Chris Bryant