The old investors sneer when masses of investors pay two dollars for a dollar in the market, and sometimes they even briefly get on the train of madness themselves, if it seems to them that it can temporarily reach three dollars. But pricing anomalies can be a hint of a bubble for the broader market.
In the most recent and well-known example, MicroStrategy’s stock price implies the value of its main asset—a vast pool of Bitcoin—is more than double the price of Bitcoin on the open market.
In an even more extreme example, a closed-end mutual fund called Destiny Tech100 recently traded at 11 times the fund’s net asset value, or NAV, as of Sept. 30, down from 21 times earlier this year. Investors rushed to buy shares of the fund, best known by its ticker symbol DXYZ, because it owns shares of Elon Musk’s SpaceX and other minority-owned technology companies. Individual investors don’t have many other ways to gain exposure to them.
Is this a new phenomenon? Absolutely not. There are no new stories, only new investors, as they say. However, these situations are strange and should be carefully examined, since they violate the principle of the “law of the single price”, which states that identical products have identical prices. They can also be a symptom of speculative euphoria in the stock market, although there is no telling how long the mood may last or if it will intensify.
“Strange things can happen without bubbles, but bubbles can’t inflate without strange things,” says Evan Lamont, portfolio manager at Acadian Asset Management, who has studied such anomalies for decades, dating back to his days as a Yale finance professor. “When there are optimistic retail investors, they will pay too much in all kinds of crazy ways, and it won’t always be possible to tell. But you can tell when there is a substitute that they are ignoring.”
The stock market has a long history of such ‘deviations’. Eventually they disappear, one can hope, but it may be dangerous in the short term to try to take advantage of the price inefficiency by selling the overvalued asset short, and buying the undervalued asset. Wild excesses can get even wilder and stay that way for a long time.
Sometimes there is no practical way to take advantage of price differences through arbitrage, which may explain how the deviation is possible. You will not be able to buy shares of SpaceX on a public exchange, for example, because it is not traded.
History has provided some instructive examples, some of them memorable.
1923: Short on GM, long on du Pont
Benjamin Graham – who taught Warren Buffett how to analyze securities – told in his memoirs the story of the investment company he founded in 1923 and its first trading procedure: the purchase of du Pont (the chemical company), and shorting General Motors (the car manufacturer, GM ), in which du Pont had a large stake.
“The first thing I did was buy some shares of du Pont and sell 7 times as many shares of General Motors short against it,” he wrote. “At that time, du Pont was not usually sold for more than the value of its holdings in GM, so the market didn’t really value all of its chemical businesses and assets. That’s why it also traded very low compared to GM’s market price.” This doubles match was successful and Graham won.
1929: Funds closed
A surge in closed-end fund issuance was a hallmark of the 1929 bull market that preceded the stock market crash in October of that year. The highest recorded premium to NAV for a closed-end fund was 1,235% in a fund called Capital Administration Co. According to a 1991 paper by Bradford DeLong and Andrei Shleifer, who were both economics professors at Harvard at the time.
In a 1940 Senate hearing on new legislation concerning investment companies and mutual funds, the chief counsel of the Securities and Exchange Commission recounted asking Goldman Sachs senior partner Sidney Weinberg about the closed-end funds he was setting up, and specifically, “Why are you setting them up so fast?” ?” According to him, Weinberg replied, “Well, the people want them.”
Late 1980s: ‘One Country’ funds
This mania was among the stupidest ever. Investors flocked to the device called ‘single-country’ funds listed on the New York Stock Exchange, with names such as ‘Germany Fund’ and ‘Spain Fund’. They fetched huge NAV premiums even though the securities they owned were easily accessible to foreign investors in the relevant countries. In 1989, the average price of a ‘One Country’ fund’s share rose by 102%, more than double the increase in its underlying NAV, according to an article in Barron’s magazine the following year.
A combination of events helped fuel the surge. The Berlin Wall came down that year, just as the property price bubble in Japan was peaking. A September 1989 Wall Street Journal article reported that the ‘Spain Fund’ posted a 45% gain in one day, “the biggest gain for any stock on any exchange” that day, “fueled by strong and sustained buying by Japanese investors”. Its premium was then 165% of NAV, which was made up of Spanish stocks, and the frenzy spilled over to other ‘one country’ funds.
For a while, the hot trading trend was to sell short the funds of ‘individual countries’ and buy the stocks they own, with the aim of profiting when the values equalize. Eventually they did.
3Com/Palm: The pair trading classic
During the 1990s and early 2000s, the Palm-Pilot was a hand-held device that came with a touch screen and pen, which served as a personal assistant. Palm was the largest maker of hand-held computing devices, with a 70% market share, and it went public in March 2000, about a week before the Nasdaq Composite’s weighted peak during the dot-com bubble.
Palm stock jumped 150% on its first day of trading, giving Palm a market capitalization of about $53 billion. Palm was still owned by the parent company Com 3 (94%) at the time. However, on Palm’s first day of trading, 3Com stock fell 21%.
The funny part: According to the stock market, 3Com was worth about $23 billion less than the value of Palm’s shares owned by Com 3. That didn’t make sense, yet valuations remained in disarray for months. Over time, both stocks fell to earth, sanity prevailed and the world eventually moved to smartphones.
Arbitrage has landed in the Planet of the Apes
In August 2022, AMC Entertainment, which skyrocketed during the coronavirus pandemic as part of a legendary short squeeze, said it would give its owners one share of newly issued preferred stock, with the ticker symbol APE, for each common share of AMC (fans of AMC shares called themselves apes – apes). The preferred shares did not pay a dividend, and economically they were almost identical to the common shares. As the Journal reported at the time, many investors thought the reason AMC did this was because it couldn’t get permission from shareholders to sell more common stock.
Despite their virtual identity, the two stocks had different prices. An October 2022 Journal article noted that AMC was trading at $6.97, while APE was only $2.71.
Even though there were loan costs involved, the arbitrageur was supposed to be able to short AMC shares (by taking a loan and selling the stock), buy an equal number of APE units, and profit when they equalize – which indeed happened in the end. The sure thing is that everyone who participated in this maneuver needed nerves of iron. APE units ceased trading in August 2023 when the company converted them to AMC shares.
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