Saturday, January 13, 2018

The Feedback Loop and Why It is Dangerous

When a system is nearly 100% feedback, it is dynamically unstable.

Feedback.   We've heard it on amplifiers at rock concerts or church receptions - at least back in the old days, before electronic circuitry filtered it out.   The sound from the speaker goes into the microphone and an ear-splitting squeal results.  Ouch!

Feedback works in the financial sector as well - in both "legitimate" and con-game investments.  Take the penny-stock swindle, for example.   A few years ago (decades now, I guess) a teenager in New Jersey figured out that he could buy an e-mail address list for a few dollars.   He found some penny stock with a name that sounded technical (or similar to another stock that was in the news) and sent out a SPAM e-mail to the address list, saying that this stock was "going places".

Of course, I am missing a step here.  Before he sent the e-mail, he bought some of the stock or better yet, a stock option on the penny stock, at a very, very low price.   The e-mail he sent goes to thousands, tens of thousands, or even millions of mailboxes.   And of those, even if only a few people act on it, the stock price goes up.   Thinly traded penny stocks are very susceptible to even small deviations in supply and demand.

Actually, just about any commodity changes prices dramatically in response to supply and demand.  A 1% increase in the supply or decrease in demand can cause a 10% swing in prices - easily.  And the thinner the item is traded (smaller volume) the more pronounced this swing is.  So even a few people buying a penny stock Over-The-Counter (OTC) can cause a price swing of 10-20% or more - maybe far more.  After all a stock that costs a few cents can easily double in price, and people don't really care much.

And here is where the trouble begins.  Say you are an unsophisticated investor (no shame there - welcome to the club!) and you get this penny-stock e-mail.   You go online and look at the stock price, and sure enough, the price has been going up as of late!  Maybe this teenager in Secaucus, NJ is on to something (of course, you don't know he is only 15, but that's the beauty of the Internet - all of our opinions are of equal weight!).

So you figure, "Hey, I can afford to gamble a few hundred bucks on this!" And that is a warning sign right there - anytime you say, I can afford to gamble, you should step back, think about it, and then hit yourself with a stick, hard, several times.   You can't afford to gamble, period.   So stop gambling.

And you throw $500 at WillGrowCo penny stock and figure, "Why not?  Maybe my ship will come in!"   You might as well buy lottery tickets.

And this is where it gets weird.   Your very purchase of the stock causes the price of the stock to rise.  In a way, it is like a law of physics - you cannot measure something without affecting the measurement.  The very act of buying a thinly-traded penny stock affects the price itself!

Heisenberg and Schrödinger get pulled over for speeding. 
The cop asks Heisenberg "Do you know how fast you were going?" 
Heisenberg replies, "No, but we know exactly where we are!" 
The officer looks at him confused and says "you were going 108 miles per hour!" 
Heisenberg throws his arms up and cries, "Great! Now we're lost!" 
The officer looks over the car and asks Schrödinger if the two men have anything in the trunk.
"A cat," Schrödinger replies. 
The cop opens the trunk and yells "Hey! This cat is dead."
Schrödinger angrily replies, "Well he is now."

And so it goes in real life.   What's worse, is that other people respond to the e-mail and buy the stock, and the price goes up even further.   Your opinion that the stock was a good buy is immediately validated.   Meanwhile, the teenager in New Jersey has sold out - likely to you, as he was the only one with stock that was being offered for sale, and he set a fairly high price on it.   For a few hours work, he made a few thousand - or tens of thousands - of dollars.   Meanwhile, you are out $500, which you shrug off as "bad luck" and move on to the next scheme.

We saw the same thing happen - again an again - in more "legitimate" markets.   In 1989, the Real Estate market crashed.  Why?  Well, in the 1980's, interest rates started to drop and housing prices went up.   People started investing in Real Estate - nothing like the bubble of 2008, of course, but a bubble nevertheless.   Prices went up because more people started buying.  And more people started buying because prices went up.   A perfect feedback loop situation.

But eventually, feeback loops blow up.   If the amplifier at the church supper is left in feedback mode, everyone will be deafened by the squeal and eventually the amplifier will overload and burn out.  Usually someone intervenes before that happens, or you hope a fuse blows before the amp catches fire.  And that is what happened in 1989 - the market blew up, prices overnight collapsed, and people lost a lot of money - well, a lot of little people lost a little money each.   For example, a friend of mine lost $10,000 on his condo - he had to borrow ten grand from his 401(k) to sell the place in 1992.  That's a real loss, painful, but not bankrupting.   Now multiply this times a million people and you see it can be a lot of dough.

The dot-com thing was similar.   Some companies started to soar in price as we embraced this new "online" world.   And some companies were actually making money.   But as with today, folks threw money at anything with "dot com" in the title - much as people are throwing money at Kodak (really?  Kodak?) today, as there is some sort of tangential rumor they are getting into "crypto".   Here's a clue for Sears and Radio Shack - put the words "block chain" in your next quarterly report or mention them in a conference call.  I can just see Eddie Lampert in a call with investors, saying, "Shop Your Way will now be enabled with block chain!" and the share price doubling the next day.  Good idea, Eddie - feel free to use it.  Buy me lunch sometime.

The price of dot-com stocks went nuts as everyone was buying.  And this validated their purchase as being a wise decision, and moreover made them reluctant to sell off a "winner" while "everyone was making money."

By the way, here's a "rule of thumb" I use with a stock shoots up.   I sell half of it right away.   Or at the very least, I sell what I have invested in it.   This way, I get my money back and still can speculate on the remainder - sort of best of both worlds.   When my friend started a bank, I invested $10,000 in it.  When the stock doubled in value, I sold $10,000 of it and got my money back.   I went and did this five more times and did very well, thank you.   Yes, I could have left all my money in and made far more.   Pigs get fat, hogs get slaughtered.   I am content to have quintupled my money and cashed out.   We should all be so content.

Eventually, though, the feedback loop on dot-com overloaded and burned out.   And what burned it out was the realization - which can be very sudden - that many of these companies weren't making money.   Overnight, companies went out of business, and then this started a panic sell-off mode which took down even some profit-making companies, at least in terms of stock price.   If you buy with the herd, you sell with the herd, and herds can be spooked and run wild.   And the grass in the center of the herd is generally matted down and pooped on.

But of course, to anyone who has studied catastrophe theory this is old news.   For example, I was watching this Netflix series on toys, which is pretty interesting, and they had an episode on "He-Man" which was a slightly homoerotic toy for young boys in the 1980's.   The toy took off like a rocket, once they created a cartoon to go with it (today, they do this in reverse order - the cartoon is just an ad for the toy).   It sold well over $100 million a year in action figures and accessories and then..... dropped to seven million.   Mattel almost went bust.

What the heck happened?  Teenage Mutant Ninja Turtles is what.   The episode did not address this, but I suspect what happened is that elementary school fashions changed overnight.   Suddenly, it wasn't "cool" to be playing with "He-Man" who, let's face it, was pretty gay. My nephew had the whole collection - and Castle Grey Skull, complete with "Jaw Bridge" and played with it for hours.  And then one day - it went into the closet (or maybe back into the closet) and was never played with again.

His younger brother dug it out and used the castle (but not the action figures!) with his Ninja Turtle collection.  It was interesting to me to watch, as the figures were really about the same, if you think about it, the only difference being that the names and characteristics of the characters.   The fact that he had no trouble turning Castle Grey Skull into a Ninja Turtle hideout was telling.  It was the same damn thing, with a different name.   And yes, the Ninja Turtles were the hot toy to have for a while and just as suddenly, they vanished (but of course, have been the subject of several reboot attempts).

These fads come and go, and really, investing in a fad is no different than buying He-Man or Ninja Turtles, or whatever toy is "hot this season".   People are sheep - they are cows.  The travel in herds and look to one another for validation.  It is a human thing.

And so it is today - after two real estate meltdowns, at least two dot-com meltdowns (including one in progress - how's that Groupon stock doing, fellas?) and the gold bubble bursting (or at least deflating) we are now seeing the exact same hysteria and feedback loop with crypto-currencies.   And everyone is saying its a bubble, and no one is listening.  This will not end well.

Combine this with an overheated stock market, a slightly unhinged President, and, well, things could get really ugly in a real hurry.

Unload those He-Man figurines, before it's too late!