Tesla and the Fear of Missing Out
By far, the most talked about stock in financial circles is Tesla (TSLA). For those unaware, the maker of electronic vehicles and its <insert your own adjective> front man, Elon Musk, has a borderline religious following and an equally large and very vocal opposition. In the last year, the bulls have certainly had their way. The stock has returned almost 500% in that time which has left many on the other side wondering when will price ever come back to Earth like one of Musk’s Space-X rockets. The interesting thing about Tesla is that its gravitational pull is strong enough to involve those with no money currently at stake. The Fear of Missing Out (FOMO) is a powerful force that can disrupt even the smartest and most logical minds.
Immediately, both groups break what should be Rule #1 for most investors: don’t get emotional about an investment. In an ideal world, an investment should just be about math. When one buys a share of stock, they are purchasing a small piece of the equity of that company. On paper, the amount of equity to be divided amongst the shareholders is simply the total assets less the total liabilities. The amount that an investor pays for that one share should be some calculation of future value along with some sort of probability that this future value comes to fruition. This is where it gets tricky. A common method of determining how much to pay is to look at the earnings per share of a company and then pay some multiple of those earnings (AKA the price-to-earnings ratio). Over the last year, Tesla has lost $0.89/share and as you might remember from 4th grade arithmetic, you can’t divide by a negative number. Well, say the bulls, you aren’t paying for what is happening now, you are paying for what will happen in the future. Fair enough.
Does it sound implausible that a company with negative earnings and (maybe?) questionable accounting practices is worth $1,500/share? Enter the short sellers. In general, short sellers are a pessimistic and skeptical bunch, but it seems especially to be the case with Tesla. Not only do they not believe it is worth $1,500/share, they would most likely tell you it’s worth $0/share. For starters, short selling is the act of borrowing a share of stock to sell it and hopefully buying it back at a lower price. It is buy low and sell high, just in reverse order. What we have seen play out in the last year is a byproduct of a large amount of investors selling a stock short. It’s like gasoline on top of kindling in the middle of a drought. Any spark that moves the price upward causes a chain reaction of investors buying the stock at a higher price because they owe it to the entity from which they borrowed it. The more stock is bought to cover a short position, the higher the price goes which causes more short sellers to buy to cover, and so on. As you can see on the chart below, there were 42 million shares sold short vs 179 million outstanding one year ago. God bless those liable for those remaining 14 million short shares if they have been short this entire time.
Those who have been watching from the sidelines see this meteoric rise and will typically go through three phases: curiosity, doubt, and capitulation. It is a story that has played out numerous times throughout hundreds of years of history. Early investors who start making money hand over fist are typically not ones to keep this sort of information quiet. Maybe one of your friends or coworkers made a quick buck on Tesla, or Bitcoin, or whatever. If you are a good friend or coworker, your first reaction should be, “Good for them. They made some money.” Now the hook gets set. You add the ticker symbol to your Yahoo Finance app and turn up the volume on the TV when the anchor talks about the stock—the whole time thinking about getting in when the price pulls back. You watch with disbelief as the price climbs higher and higher. Finally, capitulation. You can’t stand the thought of not making money that is freely available so you call your investment professional and buy some.
Don’t feel bad if you get caught in a speculative mania. Sir Isaac Newton fell victim to these same impulses. In the early 18th century, there was a bubble in shares of the South Sea Company. As you can see in the chart below, he initially made some money on the stock, but bought back in at higher prices as it appeared the stock would never stop going up. What comes next is what could be referred to as gravity (sorry, couldn’t resist). He is reported to have said he “could calculate the motions of the heavenly bodies, but not the madness of the people.”
In the classical sense, making money on an investment is a function of participating in the growing value of a company through their revenues, earnings, profit margin, etc. The price at which a stock is currently trading represents the equilibrium of the collective opinion of all market participants. If the entirety of market participants were comprised of clones of Spock from Star Trek, the market would be a fairly boring place of mathematical calculations. Instead, it is comprised of irrational humans whose decision-making is driven by fear and greed. It is so important to resist getting fascinated by the green and red arrows on the screen and instead focus on why you would like to commit hard-earned money to an investment. If you like Tesla at $1,500, why not at $178 a little over a year ago? Could it turn into a company that revolutionizes the world and justifies the current valuation? Absolutely—anything is possible. Just realize that the higher the price paid, the lower the margin for error–this applies to any investment, not just Tesla.