Tuesday, June 10, 2014

The Stock Market Is Like a Fish Tank

Now that the majority is tightly packed into a market devoid of yield/alpha, this concentration sets up the inevitable collapse of valuations perfectly.

I recently had the pleasure of visiting a state fish hatchery. Those of you who fish know that the hatcheries are responsible for raising sports fishing species such as trout and salmon and then releasing them in lakes and rivers to bolster native stocks.

The fish are kept in large concrete tanks where the water temperature and feeding are carefully monitored and controlled. In this particular hatchery, the public is invited to buy a small handful of food pellets (25 cents) to feed the fish when they reach a certain stage of maturity. (Proceeds go to maintaining native fisheries.)

The fish are milling about semi-randomly, seeking whatever food might appear. In the stock market, investors and punters are also milling about semi-randomly, seeking yield and above-average returns (alpha).

When a few food pellets are randomly tossed into the tank, the first fish in the vicinity to respond to the splash get the pellets. In the stock market, the pellets are yield and alpha.

The fish milling around in the tank are highly attuned to the actions of their mates, and those nearest the first fish quickly follow them to the source of the food. This makes good sense, as the food (yield/alpha) might be plentiful and the second wave of fish would be well-rewarded for being second.

These fish attract the attention of virtually every other fish in the area, and within a few seconds the water where the few pellets landed is boiling with fish seeking pellets (yield/alpha).

This pattern can be repeated until one runs out of pellets: toss a few food pellets in a sparsely populated area of the tank, and watch how quickly the majority of the fish rush to the spot where the food has already been consumed.

The few fish wandering around the edges who did not join the majority speeding to the place where the food (yield/alpha) has been exhausted are the likeliest to be closest to the next semi-randomly tossed pellets.

In effect, those who join the majority thrashing around the spot where the food has been consumed are guaranteed to go hungry. I submit that the stock market is like a fish tank, and the majority are thrashing around precisely where the yield/alpha has been consumed and the risk of starving (losing money) is greatest.

The same can be said of the residential rental market, and every other asset class where the majority of participants and betting capital that the food pellets are limitless, when the reality is the yield/alpha in the market has already been consumed by those who got there first and second--those who responded first when no other participants noticed the splash of opportunity.

Now that the majority is tightly packed into a market devoid of yield/alpha, this concentration sets up the inevitable collapse of valuations perfectly.

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