The efficient market fallacy

Jeremy Grantham, the Founder and Chief Investment Strategist of the investment manager GMO, released a note this month entitled The Race of Our Lives Revisited. The note itself is worth reading, touching upon the issue of climate change for humanity as a whole and for an investor.

What struck me was a paragraph towards the end of the 35 page note in which Grantham notes:

There is, however, one more economic argument in favor of divestment: that the Energy sector will be the first example of much more significant mispricing than any sector in the past…why would the market not do its usual remarkable job of forecasting this? Because this is the first time in history, I believe, where a significant chunk of the US investment community does not believe in the most important factor that will affect this sector — climate change.

Grantham goes on to note:

Why? Because we have had a 30-year, well-funded program to make the problem of climate change seem vague, distant, and problematic, the end result of which is that we have a Republican Party wherein 60% of the people don’t believe a word of the facts I have showed you. Some of them, presumably, are in the stock market. How many of these deniers does it take to distort the price…There certainly should be more mispricing than normal and that might just allow for unexpected long-term underperformance of Energy (and perhaps some chemicals).

Grantham is essentially noting that the market is not performing efficiently because the investor base don’t understand the issue and they don’t know which experts to believe. This leads to mispricing across the entire sector.

It’s a really interesting point, and one I believe has relevance to crypto, albeit on a smaller and more immediate scale. Grantham more eloquently explores a point that I tried to make in my piece on the Crypto Knowledge Gap, in which I discussed the divorcing of prices from reality:

I am not merely restating the common observation that valuations as a whole exceeded any realistic potential valuation, but rather that a subset of cryptoassets exceeded the trends of the wider market. They became (and many still remain) divorced from any realism and were instead traded by a majority of people who did not understand them, did not understand the market and did not understand the components needed to even begin to value them.

A particularly egregious example is that of Verge, which soared in price following the ‘recommendation’ by John McAffee to buy it on Twitter.

However, it is not the rise that I’m particularly interested in — speculation was rampant across the board, so I’m not going to single any particular cryptoasset out for that, even if its rise was particularly noticeable.

What I did find interesting (even at the time) was the reaction to the price of Verge (XVG) when it got hacked twice in quick succession in April and May. The first hack was bad, a 51% attack on the network, but the May attack was disastrous as it was effectively a repeat of the first attack. To err is human, to get 51% attacked twice is ludicrous. I’m not even going to bother going into how the attacks were resolved or the wider farcical events surrounding Verge at the time; rest assured it was awfully handled and should have inspired no confidence in the team’s ability to make future progress.

Now let’s look at the price on April 4th, the day the first attack was uncovered. The price dropped slightly, from $0.065 to $0.055 24 hours later. A fortnight later the price was at $0.11, or nearly double what it was before the hack. Against BTC it would drop c. 20% before recovering all losses within four days and being up nearly 40% two weeks later.

On May 22nd, the day of the second attack, the price was $0.051. The price would fall to $0.041 within 24 hours, dropping roughly 11% against BTC.

Now let us compare that performance against the market. From April 4th to April 17th, the same dates as Verge above, the market rose from $282bn to $331bn, a 17% increase. Verge significantly outperformed the market following being hacked.

Following the second hack, Verge dropped c. 14.1% in the 48 hours after the hack. The market dropped 13.8% in the same period.

By contrast, when the DAO hack occurred the price of ETH fell by c. 50% within 48 hours. You could argue the DAO hack was more serious due to the sheer amount of ETH that was locked up by the attacker and the issue it presented to the very future of Ethereum (even if the network itself was not the subject of the attack), but Verge got attacked twice using basically the same exploit and the price barely responded.

As discussed, a large reason for this is because most didn’t understand what it was they were investing in and many of those all invested in the same narrow set of coins which were promoted by the likes of John McAfee.

The difference in how the Verge hack was greeted as opposed to the DAO hack was striking to me. I remember the Ethereum and Ethtrader subreddits as well as the wider crypto community on that day (I actually remember exactly where I was when I saw the news come through as I then spent half an hour on my phone trying to desperately log in and execute a trade on Kraken, a site which barely stays up at the best of times) and I spent the entire day reading the fallout. People knew how bad it was because by and large early investors were more well-informed.

By contrast, I think many will have seen the XVG hack and thought “well it’s only $1m that’s been stolen, that’s nothing for a $700m+ market cap” without realising all the other problems that such an attack means for a network.

Extending upon this slightly, I think that CoinMarketCap has a role to play in this. It is a useful tool, but many assume that the biggest cryptoassets listed are legitimate as a result. This is a site that had BitConnect, an actual and obvious Ponzi, regularly featuring in its top 10. Market cap has nothing to do with legitimacy. I think many assume because a project is large it is bound to survive. The rise of crypto ‘influencers’ also plays into this.

Furthermore, the propensity for those in crypto to label everything as FUD even when the news is actually just plain bad news also plays its role. Grantham’s assertion that “60% of the people don’t believe a word of the facts I have showed you” could be quite easily amended to something akin to “90% of XVG holders wouldn’t believe a word of the facts that were shown to them”.

It becomes an us against them situation, where the hordes of outside forces are trying to tear down the besieged honest community. All a project team needs to do is keep repeating “Verge fam” and people believe everything is fine. In many ways this resembles the increasingly tribalistic nature of politics and identity groups worldwide. The actual issue gets shoved aside.

Finally, the actual news reporting around the situation was also a problem. I have no issue with objective reporting but that doesn’t mean simply parroting the lies being told by the team, as many reports did. We don’t have to give equal weight to a lie.

Returning to Grantham, I believe the Verge attacks are an example of severe mispricing across the crypto space which has not been eradicated in this bear market.

There are a whole bunch of cryptoassets which were rampantly speculated upon and soared to valuations which are multiples ahead of where they should have been relative to other cryptoassets. These are the sort of assets to avoid being in now, because the short term speculators will likely not return to the same tokens again. Even if they’ve fallen 80, 90, 95%, do not assume they can’t fall further (or at least significantly underperform) even if the wider market starts to recover, because they are falling from an artificially high ceiling.