Majority opinion is irrelevant in the markets. Here’s what really matters

US markets are closed for Martin Luther King Jr. Day, but as you know the city never sleeps and Dow futures are pointing down 600 points (5%). We were in for a long trading day – it started with the Nikkei down 4%, the FTSE100 followed down 5.5% and the CAC and DAC cracked 7% each. Unbeknownst to the financial news journals that reported that markets were reacting to a possible recession in the United States, a strange story was brewing.

Jérôme Kerviel had joined the middle office of a Parisian bank, Société Générale (SocGen), in the summer of 2000 to work in its compliance department. In 2005, he was promoted to the bank’s Delta One division, which handled the trading program, ETFs, swaps, index funds and quants. From compliance guy to business geek, Kerviel was on a roll; Christian Noyer, Governor of the Banque de France, called Kerviel a “computer genius”.

This aura faded on January 18, 2008, when SocGen discovered that Kerviel had taken massive market positions that far exceeded his remit. In total, the size of this so-called “unauthorized” position was close to 50 billion euros, greater than the market capitalization of SocGen at the time. SocGen’s board decided over the weekend that he could no longer continue in the position; they began liquidating on January 21. It took them three days to execute and ended with almost 5 billion euros in losses, and we had another “Black Monday”.

The claim that a person acting alone, without anyone’s control, has accumulated a position greater than the total market capitalization of the bank is strange. Stranger still is the fact that an attempted liquidation of a €50 billion transaction resulted in nearly $3 trillion in equity losses worldwide ($30 trillion in the global stock market at the time). In other words, 0.2% of a sell order (€50 billion traded in a $30 trillion market) that was to be executed regardless of price, triggered a reaction that ultimately wiped out nearly 10% of the entire global stock market.

Markets are not really a sum of what all of its participants think. A large majority of global equity holders during those three days (January 21-24, 2008) might not have believed that now was the time to sell. Their opinions didn’t matter. With markets, prices reflect the activities of the marginal/most motivated buyer and seller, not those of the majority. Consider the case of 100 shareholders of a hypothetical company. Of this number, 99 may believe that now is not the time to sell, but a shareholder faced with possible bankruptcy is forced to sell at all costs. The quoted price of our hypothetical company will drop and drop dramatically if no buyers come along. Until one (or a few) of those 99 decide to turn themselves into marginal buyers, their opinion is worthless.

Nassim Taleb writes in his book
skin in game that like markets, this phenomenon is how science has thrived in our generation. Once something is scientifically debunked, it’s wrong. Everyone must now converge on this new line of thinking. Taleb writes that if science had operated by majority consensus, we would still be stuck in the Middle Ages and Einstein would have ended up as he began, a patent clerk with unsuccessful side-hobbies.

As consumers, we continue to benefit from science; but we as investors can also benefit when markets follow a similar path.

How, you might ask? Take the case, say,

. Its listed share price, between October 2021 and June 2022, fell by almost 20%. The reason? Foreign Institutional Investors (IFIs), given rising US interest rates and the Russian-Ukrainian conflict, decided to sell emerging market stocks (including Indian stocks). I’ve written before that financials form six of the ten largest overweight FII positions in India. Read here

As of June 2021, FIIs owned over 48% of ICICI Bank shares; this percentage fell to less than 44% in March 2022. FIIs were not the majority in ICICI Bank; mutual funds, institutions and individual shareholders did (and they were buyers when the FIIs were sold). But since FIIs were the most motivated sellers, their opinion was what mattered, not the majority.

Let’s build on it. Of the 51 analysts covering ICICI Bank, an overwhelming majority of 50 had a Buy rating (1 had Hold, and zero had Sells). Since October 2021 (chart below), when all analysts were shouting to buy and raised the target price by 20% in anticipation of improving fundamentals (ICICI bank’s net profit would rise from INR 47 billion in June 2021 to INR 74 billion in June 2022), the shares fell by 20%!

Agencies

And as often happens, post hoc justifications started pouring in – banks are not doing well in the rising interest rate scenario, the rise of the fintech industry will destroy the terminal value of the banking sector, and of course others.

The confluence of these events, in my view, presents an incredible opportunity. Imagine if we knew in October 2021 that in the next six months the rate of credit growth in India would hit multi-year highs, ICICI’s earnings would almost double next year and its earnings commentary would be at its strongest for many years. And then being presented with the largest cohort of owners (FII) forced to sell their position for technical reasons!

Do not mistake yourself; it is not a recommendation for you to buy ICICI Bank. But I believe that our investment experience will be much richer if we are aware that the most motivated buyer or seller (and not the majority) determines prices in the markets. That way, we might be able to put capital to work better instead of focusing on post hoc rationales as to why stocks that are down deserve to be down.

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