Tesla's human error

Why computers are the first and best defense against people doing dumb things in the stock market

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And now: Tesla.

Can Duruk at The Margins introduced a compelling new framework for sorting out just how tech-y a company really is.

It’s called, the Zombie Apocalypse Scale. 

Here's the idea: Instead of looking for a binary outcome for this question, let's agree that tech-companiness is a spectrum. There are probably some discrete stops, but let's ignore that for now. And then, let's establish a quantifiable metric, something that we can compare companies across.

I call this scale the Zombie Apocalypse Scale. It is a measure of how many days a company could run for if all its employees were turned to zombies overnight. The more days you can operate without any humans the more of a tech company you are. Among many other things, I am obviously assuming here that most zombies would not be able to perform any duties.

The scale goes from Google to McKinsey. Google is the tech company. McKinsey is the human company.

And this frame got me thinking about the stock market and where the market falls on the apocalypse scale, because in the stock market this week there was one particular stock that seemed possessed: Tesla.

On Thursday, Matt Levine wrote — as he often does — the definitive overview of what happened with Tesla this week. I would encourage everyone who has not done so already to read Matt’s piece.

For those who do not want to do that, this excerpt will suffice as an overview of what happened with Tesla shares last week. 

Tesla’s stock finished January (that is, last Friday) at $650.57, up 55.5% from its December close of $418.33, which was itself up 26.8% from November. On Monday, the stock ripped up 19.9% to close at $780. On Tuesday, it got as high as $969 before falling over the last 12 minutes of the trading day and closing at $887.06. Yesterday it fell 17.2% to close at $734.70; it has remained pretty wild today, to the point that I am not going to risk typing a price here. Tesla’s 10-day realized volatility is 170.

When the dust settled on Friday, the stock closed at $748.07. The stock was up a little over 9% this week. A good week for any stock. But a rally that I think belies the true chaos of Monday-Tuesday-Wednesday.

Year to date, Tesla shares are up 73%.

This 👏 is 👏 not 👏 normal 👏

For a company as large as Tesla — as of Friday’s close the company is worth just under $138 billion — this kind of volatility is not normal. In fact, you don’t expect to see trading like this in any public company unless there is some incredible news flow pushing the stock all over the place (see: PG&E) or the stock is being manipulated. Like, for instance, Long Blockchain. Or Cynk. 

The easiest, you-don’t-even-have-to-look-anything-up sort of explanation for what happened with Tesla shares is that it was a short squeeze — lots of people had bet shares of Tesla would go down in price so when the stock rises they are forced to buy back their position, thus pushing the price of the stock higher.

The problem with this theory is that the number of outstanding bets against Tesla has actually been decreasing.

And while short interest in any heavily-shorted stock will fall when the price of that stock goes up sharply, the current decline in the percentage of the float being sold short is in-line with previous positioning flips in the stock’s history while the rally in the stock is... not.  

Elsewhere in “what is up with Tesla,” Tom Lee of Fundstrat was on Yahoo Finance on Tuesday and offered a theory that the rally in Tesla was being fueled by fund managers benchmarked to the Russell 1000 Growth index who were underperforming their bogey because of the outsized impact Tesla’s surge was having on that index. 

Tom noted that Tesla had just a 0.7% weighting in the Russell 1000 but was responsible for 15% of the index’s year-to-date gains (through Tuesday, at least). So the way for these managers to keep pace with their target benchmark is to buy the stock doing most of the work and causing them most of the pain. 

My friend Luke Kawa at Bloomberg also had an article that outlined how option-market arcana was likely a big part of this rally. The basic outline is that option market dealers who sell calls — a contract to purchase a stock at a certain price in the future — hedge these sales by buying the underlying stock outright.

In this case Tesla.

As Matt noted, r/wallstreetbets took Luke’s article as evidence Tesla shares could be pushed infinitely higher if they, r/wallstreetbets readers, just bought enough calls and forced dealers to continue purchasing more Tesla stock at ever-higher prices. Like a cheat code. It is a creative interpretation. There are also some (many?) legal questions around any concerted efforts to employ this strategy.

The common thread in the performance-chasing and the dealer-hedging narratives around what made Tesla’s stock go nuts this week, however, is that they make the stock market look a lot more like a McKinsey operation than a Google one. 

I think most people believe there has been a Googleficiation of the stock market on the Zombie Apocalypse Scale that imperils the “integrity of the market.” All of this just being short hand for: I didn’t like the way stocks traded [insert any day here] and if there weren’t so many computers I would’ve been right.

And given that algorithms are blamed for every bad thing that befalls the stock market, the McKinseyness of this Tesla situation is somewhat surprising.

Using a computer is not technology

Now, technically speaking, pretty much all trading in the market is done electronically. Like, even the guys on the floor of the New York Stock Exchange use a tablet to execute the trades they are responsible for. The stock market is pure technology in as far as there is literally not a single trade that happens without the help of a computer. Even if a human is pushing the buttons.

When some bad news happens and Finance Twitter congregates on a Sunday night to see what futures will do, the jokes take the form of: “Turn on those machines!” The joke is not, “Get ready to answer those phones!”

But “using technology” — as many companies that have recently gone public learned — is not sufficient for being treated and valued like a tech company. At least not anymore. (This is also the point of Can’s post, more or less.)

Offering companies flexible short-team leases for office space isn’t “tech” because you have an app. You are, in fact, a real estate company with a horrifying asset-liability mismatch. And no one thinks the “Sleep Economy” is a thing you have created because you use the internet to fulfill orders and the bed comes in a box. Instead, everyone thinks you are a mattress company. 

So the execution of trades via technology isn’t really a compelling way to judge, one way or the other, whether the stock market is more Google or more McKinsey.

What does seem apparent, however, is that the bizarre behavior in Tesla shares touched way more human hands than the average stock transaction. If “tech” is the boogeyman for investors who think something is wrong with the market, it seems like the wrongest things are actually happening because of what humans do.

So, what would’ve happened to shares of Tesla if there were no humans? If the apocalypse hit last Monday night and the rally in Tesla was really about dealer hedging, would programmatic trading in Tesla’s options book have pushed the stock to infinity? Or would the stock have mostly stopped doing weird stuff after everything settled up at Monday’s close? Would the price actually go down? 

It’s harder to say than I initially expected it to be. And I still don’t really know the answer.

When I started this thought experiment my stylized post-zombie apocalypse stock market left us with a world in which HFT algos, passive retirement flows from Vanguard, and Renaissance push around stock prices. And when you say it like this the immediate question most people would ask is — and this is different how? 

Free markets? You got ‘em.

So but the way Can ultimately arrives at the scale of zombie apocalypse survivability is by asking how long it would take until the thing being run by whatever systems don’t get turned off when the apocalypse hits breaks. 

In the Google example, search is probably fine for a few weeks. In the McKinsey example, when no one shows up to do whatever it is consultants do the client notices on day one. (I think the proper joke, however, is that the client wouldn’t notice because, again, it’s not clear what consultants do. The client might actually be relieved!)

The stock market, at least when examined through the lens of why it seems like what happened to Tesla stock happened to Tesla stock, is a lot more McKinsey than Google. 

But! The McKinseyness of the market in dealing with Tesla’s volatility also gestures towards none of this having happened if there were just no humans in the first place. 

And without doing the entire reductio about how humans write the programs that carry out the algorithmic trading which means there is always a human element to all stock trading and so on, the trend towards passive investing and the efficiency with which capital is allocated in public markets as a result has happened because the market is Googlefying itself.

Passive investing — which we can broadly define as automatic contributions to low-cost funds designed to track broad asset classes like the S&P 500, the Barclays Bond Agg, Emerging Market stocks, and so on — is essentially one big prepper trade from a class of retirement savers increasingly aware of how futile their efforts are to beat the market. 

There is no grand conspiracy blue-pilling investors into using low-cost index funds. It’s just that a couple decades of underperforming the market and getting charged an arm and leg for the privilege has created a financial education industry obsessed with emphasizing one thing: keep costs low. Don’t try to win, just ensure you lose less.

And all this really shouldn’t be a surprise. Because if we’re to believe the stock market and financial capitalism really is efficient then any trend other than increasing the market’s survival rate in a zombie apocalypse would reveal a broken market.

A market that would be broken not because of your priors about Fed policy and social justice, but broken by the thing itself, broken by inefficiency that isn’t rooted out by the competitive forces this system is purportedly best-positioned to unleash.

And so the whole Tesla situation reveals a market that isn’t broken, but in fact works so well it took a few days to realize someone let McKinsey log back on.