The third body
The last two posts in what is turning out to be a sort of mini-series have been about the emergence of sentiment as a principal driving force in 2020 financial markets. The first, The most basic fundamental, lays out the initial argument and identifies some key resulting market aspects in such an environment. The second, The biggest risk, outlines the ways in which financial value metrics are being gradually displaced by pure sentiment, which unlike traditional reference points is difficult to quantify and even more so to predict. In short, the current market context calls for a new look at market drivers and parameters, established during times and markets that reflected greater structure, or a structure that was perhaps more conducive to methodical assessment.
The present installment continues on this path, taking a cue from IPOs of the past week, the “mispricing” of which has caused sufficient stir to prompt the next in line to pause before continuing with this “broken process”. Below are headlines that depict the building tumult:
While much of the debate has centered around the notion of a price that was set too low by underwriters — a notion presupposing a correct and ideal price, a price that offers a sufficient upside for the markets to become excited in the after trade, though not so much as to adversely impact the issuer’s treasury or selling shareholders in too noticeable a way — these debates seem largely to be shaped by a perspective founded in the way things were. Which is to say, before sentiment took over as dominantly as it has.
But sentiment is fickle, it’s contagious, it can move (or not) in ways that the best of specialists can’t easily predict. And in a market ruled by sentiment, the place to catch one’s bearings may not be the S-1 filings and related analysis, which aren’t read as carefully, I don’t think, as the breathless headlines that preceded the IPO… For instance, the most recent, which is typical:
There have been countless such in the decade past, regarding countless startups in countless private rounds — the billions raised, the tens if not hundreds of billions in value recognized for companies only a few years old, the unicorns, the unicorns!, the growing size of venture funds supporting all the growth and booming opportunity. The never-ending flow of headlines of this type has fed and keeps on feeding sentiment, which builds and grows.
The articles below the headline (such as the one depicted) don’t necessarily provide a careful summary of the described transactions — the subject being private, after all, and the terms of the transaction not disclosed — but had the average reader dug that deeply in (a tall order, to be fair, in light of the barrage of content that is shared at every turn), one would have noticed that the private offering in question had been preferred stock, ranking high above the common in the pecking order of the balance sheet. And one might have further noticed that there was a liquidation preference involved, which safeguards a minimum return of capital to the preferred investor. Had one taken note of some such things, one would have (correctly) concluded that the resulting unicorn-plus valuation was in actuality a sort of gimmick in the circumstance. The deal was for a long-dated call option, in modern day-trader’s parlance, with an almost assured recovery of the option premium in a downside scenario.
Had there been a clearer reference to these things and more, and had these features been properly digested and internalized, maybe then the excitable predisposition of sentimental traders to participate in the trajectory would have been less pronounced. Perhaps the IPOs would not have been “mispriced”, and the expectations of the venture backers and company executives may have more closely matched the outcome… Perhaps.
It’s very difficult to know for sure, as it is difficult to know anything for sure when one is moved by sentiment, let alone when this involves a market filled with it. But there is something we do know, it seems, because it’s proven out in mathematics: When a pair of bodies is joined by yet a third, what was a stable and predictable relationship between the pair devolves in chaos (Wikipedia: Three-body problem).
The public stock markets for the longest time were dominated by two bodies — the marketers (brokers, bankers, analysts, sales & traders, indexers and ETFers) and their institutional investment counterparts (hedge funds, mutual funds, pensions, sovereigns, etc.) — as for the longest time the retail trade was quiet, passive, and diminutive in the shadows. When this third body, suddenly now active, large, and highly sentimental, joins the mix, the result is, as they say, what it is.
There was no IPO “mispricing” and the system isn’t “broken.” There was no way around the surprising outcome because the stage had been previously set. The market is, by definition, right, and it wants to be accepted on its terms. These days, this means, the market needs us to be versed in sentiment and the third body, and to refresh our familiarity at every moment while the moving bodies move.