Schrödinger’s rally
Schrödinger’s rally
Erwin Schrödinger’s famous thought experiment described a cat locked in a steel chamber, wherein the cat’s survival was dependent on a radioactive atom. According to the Copenhagen interpretation of quantum mechanics the cat is both dead and alive simultaneously up until the point when its state can be observed.
Schrödinger felt that a theoretical feline being in a quantum superposition was not very representative of the world we live in, which is why he questioned the sanity of the interpretation. It seems that quantum mechanics is not the only field of study where quantum superpositions seemingly appear.
In the world of financial economics there is a very strong belief that free markets are pricing financial assets correctly all the time, because all available information is already reflected in the price and only new information can change this. This line of thinking has been advocated by many, but perhaps the most famous one was Eugene Fama, who built the theoretical framework around the Efficient Market Hypothesis, EMH for short. In this model open markets are always right about price and excess returns are impossible to achieve on a risk-adjusted basis. In today’s modern markets where transactions are executed within seconds, new information adjusts prices almost instantaneously. This makes arbitrage impossible, because only new information can change the price of an equity asset, specifically in this case, the price of a stock. Let’s hold that thought and apply it to the current situation as it is in August 2020.
“Since economic theories don’t serve us in abnormal times, leaders need to apply alternative tactics in guiding their organizations”
As you probably know, reading this from home, in March 2020 the world was struck with a highly contagious virus that forced governments around the world to restrict physical contacts between people to contain the spread of the virus. Covid-19 has had an enormous negative economic impact around the world, leaving companies fighting for survival, raising capital, laying off employees, halting or reducing production and reducing investments. Generally, the virus and the ensuing lockdown was bad for most industries, which is also reflected on companies’ stock prices. Around the world stocks dropped around 30%, in some places more and in some places less, but drop they did just like they should according to EMH. Fast track a couple of weeks into April the situation was as follows; the world was on fire, countries were in lockdown and businesses started to really feel the pain, but governments and central banks announced unprecedented stimulus packages for people and businesses creating hope into the markets. New information had entered the markets and stocks reacted accordingly.
Jumping to July, most European countries have the virus under control, but the economic activity is nowhere near the level that it was before the virus and won’t be for the foreseeable future. The prevailing logic in the United States seems to be ¨there can’t be a second wave, if the first wave never ends¨ and in Latin America the virus is starting to really pick up speed. With this kind of outlook on the world and the virus, it wouldn’t be unreasonable to say that in terms of business we are worse off than before the lockdowns. Analysts around the world expect companies to report losses on almost all sectors of business. Even with government support and central bank money, businesses are fighting for survival for the next years. Everybody is talking about a depression not witnessed since the early 30’s, but still the stock prices are almost at pre-virus levels. Why is this?
Securities traders often look for patterns in price movements in predicting near-term future price levels. One of these movement patterns is called a dead cat bounce. It’s called that, because even a dead cat will bounce when you drop it hard enough. In this pattern, typically an event happens that makes the underlying asset lose a part or all of its value, thus rapidly going down in price. After a drop in price, the asset’s risk-adjusted profile can become attractive to traders who can tolerate more risk and who haven’t noticed the deterioration in value that happened because of the event. This stops the price fall of the asset and usually sets it on an upward price trajectory. At this point more traders jump in on this rally, because they think the asset is trading at a discount causing the price to rise significantly or even recover completely. Once the majority of the traders trading this asset observe that the underlying asset is in fact worth less than its original price because of the event, the price will plummet again causing everybody who jumped in on the bounce to lose their money.
Dead cat bounces happen with some frequency in stock prices and are very hard to predict. However, they usually don’t happen on a market-wide scale. Theoretically they could happen, if entities with enough financial power (say governments and central banks) would shovel mind-boggling amounts of money into the markets without consideration to the asset’s underlying value. That kind of financial stimulus would effectively kill the function of financial markets. Fama is incorrect about new information being the only factor that changes prices trillions of dollars of aid change them just as much. Not only will that amount of money make the cat bounce, it would make it fly!
As of right now, nobody knows when the pandemic passes and businesses can go back to normal, or how governments and businesses are ever going to pay their debts and survive after the pandemic. Endless printing and borrowing money have their consequences, we just don’t know yet what these consequences are. Eventually economic realities win, meaning that in the short-term the market may be a voting machine, but in the long term it’s always a weighing machine. With all this uncertainty in the air and possible outcomes, one could say that the markets right now are in a quantum superposition, where they are both alive because of unlimited financial support and dead because of diminished underlying assets. Unfortunately, I must agree with Mr. Schrödinger on the point that in real life the cat can’t be both dead and alive simultaneously, and neither can the markets.
Since economic theories don’t serve us in abnormal times, leaders need to apply alternative tactics in guiding their organizations. That is why we at Alumni are working day and night searching, coaching, sparring and assessing talent, so that our clients can make the right decisions in these exceptional times and come out stronger on the other side.
*The writer of this article does not hold any short positions of any publicly traded equity securities and stands in no position of gaining financial benefit from a market decline.
Jyri Ursem
Researcher
