Prices Don't Glide... They Leap

Feynman's place in history... Teaching children about friction... Talking-head word salad... Prices don't glide ‒ they leap... Meta Platforms' two-day plunge... Russia's small stock market...

Editor's note: Before we get to Dan's regular Friday essay, we want to give you an update from on the ground in Ukraine, where yesterday Russian forces invaded the country.

As I (Corey McLaughlin) wrote about in yesterday's Digest, Stansberry Research analyst Bill McGilton has lived in Ukraine's capital city of Kyiv (Kiev) on and off for the last 15 years... And he has been hunkered down there the last few days with his family.

This morning, Bill recorded a brief video from his view in Kyiv. You can watch it here. At the time, you'll see things were calm, but Bill was expecting Russian troops to arrive soon...

Sure enough, and not long after, Bill told us he and his family were leaving the city, as both the Russian and Ukrainian military presences were growing on the streets of Kyiv in advance of what looked like a fierce battle to come. Bill told us...

I'm making a run for a village toward the Polish border. Seems like there's going to be a heavy tank battle in Kiev soon. Both sides are moving heavy equipment in.

This is a kind of armed conflict not seen in Eastern Europe in decades. And from what Bill has reported to us so far, the Ukrainian military has been putting up what could be considered an unexpectedly strong defense of the country. Late yesterday, Bill told us...

The Ukrainians have packed the airport runways with cars and threw away the keys – very smart, extremely hard to move – slowing the Russians down, but they're still on their way. They're on the outskirts already flying huge Antonov cargo planes in with equipment.

Bill promises to keep up posted, and we'll continue to share updates from him as we can. Of course, our thoughts are with him, his family, and all the people caught in the crossfire of this terrifying and sad geopolitical conflict.

As we mentioned yesterday, we're also planning a special Town Hall event about the impact of the conflict in Ukraine on the markets. Several of our editors will be gathering together on Monday for a special broadcast for all Stansberry Research subscribers.

We will share a link to watch this Town Hall event and more details in the Digest as soon as they are available.

In the meantime, here's Dan's latest Friday essay, which in part touches on how the Russian stock market has reacted (more accurately, crashed) in response to the Kremlin's invasion of neighboring Ukraine and ensuing sanctions put on the Russian economy...

Before we discuss investing today, let's talk about science...

We'll start by talking about a horrible disaster in American history and the brilliant man who figured out what caused it...

The man was Nobel Prize-winning theoretical physicist Richard Feynman (pronounced "fineman")...

If you've never read one of his books, the discovery you're about to make is wonderful...

Some of what I (Dan Ferris) will discuss in today's Digest was inspired by Chapter 8 of The Pleasure of Finding Things Out, a collection of Feynman's speeches and other short works. I highly recommend it...

Feynman won the Nobel Prize for physics in 1965 (along with two other physicists) for his work on quantum electrodynamics (don't ask)...

But he is most famous for figuring out what caused the Challenger space shuttle disaster on January 28, 1986. Challenger, you no doubt recall, exploded less than two minutes after liftoff... killing all seven crew members on board.

I won't get into the nitty-gritty of the space shuttle or Feynman's investigation of it. I'll just discuss the simple demonstration Feynman used to show everyone what happened...

He showed how a critical rubber seal failed to perform properly at freezing temperatures...

He did this with a simple demonstration...

He got a piece of the rubber seal used on the shuttle, a cup of ice water, and a clamp...

Feynman clamped the rubber seal and soaked it in the ice water. Then he pulled it out and removed the clamp, revealing that the rubber had lost its elasticity and failed to return to its previous shape...

That happened on the Challenger space shuttle, causing a leak in the solid-fuel rocket booster, triggering the massive, deadly explosion. (There's a short video clip of the demonstration here.)

Feynman was a maverick who reluctantly accepted his appointment to the Rogers Commission, formed to investigate the disaster. He became so critical of NASA that the chapter he wrote for the commission's report was relegated to an appendix...

Nevertheless, his simple demonstration made headlines and assured his place in history... Feynman died two years later, but he'll always be known as the guy who figured out what brought Challenger down.

Feynman's demonstration was a perfect expression of his views on how science should be done and how it should be taught... He believed in simple, useful explanations, uncluttered by needlessly complex jargon.

He especially didn't like the idea of teaching science to children by telling them how to use words like friction, energy, and gravity... words that were meaningless to them.

For example, if a child asks why their sneakers wear out, the answer is not "because of friction." A real answer – a Feynman answer – might be something like... "Your sneakers wear out because with every step you take, little pieces of concrete sticking up from the sidewalk rip little pieces of shoe rubber off your shoe. Over time, your shoe has less and less rubber on it, so it wears down."

That is a real explanation...

That is science.

It irked Feynman that teachers seemed to be more concerned with telling children to parrot the words of science than helping them learn how to do scientific inquiry.

I feel the same way about the word liquidity as Feynman did about words like friction and energy... To say that markets move based on liquidity is as useless as telling a child that things move because of energy.

You need useful insights, not another useless word to throw around at cocktail parties.

Unfortunately, much of mainstream financial media's output is little more than "word salad"...

And most talking heads using words like risk and liquidity have no useful insight or understanding to share about the real concepts those words represent...

If you can't read what we publish and use it to make more money as an investor, we're useless... I don't want to waste your time and mine tossing up the same useless, meaningless word salad every week.

So let's start by providing a definition of liquidity...

We will use a definition that's more like that image of concrete catching on little pieces of shoe rubber, causing shoes to wear down.

The primary meaning of liquidity for most folks is the ability to buy and sell assets very quickly without worrying about big price movements occurring between the moment you place your order and the moment it is executed... It also includes virtually instantaneous execution for market orders.

If you trade stocks, bonds, options, futures, or other securities or derivatives for short-term profits, you're doing so under the assumption that you'll easily be able to buy and sell them without moving the price... That's what we mean by a liquid market.

For most folks, liquidity is like the air they breathe... They don't think about it unless it's suddenly not there. It's an ever-present bid for whatever you want to sell and the ever-present offer of whatever you want to buy.

The importance of mitigating liquidity risk is either implicitly or explicitly taken into account with every buy and sell recommendation every editor makes... Most, if not all, of the trading and investing services under the Stansberry Research banner have liquidity guidelines... or at least keep it solidly in mind when making recommendations.

For example, when Mike Barrett and I make recommendations to Extreme Value readers, we stay away from stocks of companies under about $500 million in market cap... though we've made a few exceptions over the years. We also prefer stocks that trade several million dollars of volume per day, on average.

The reason?

Because the smaller a stock's market cap is and the fewer shares that trade, the more likely our readers are to move the price substantially when we recommend it... The act of trying to buy or sell at a certain price can change the price of the stock.

In brief, liquidity tends to fall with market cap and trading volumes. Less liquidity raises the risk that you'll wind up selling at a price far above or below a recommended buy or sell price.

I don't mean to imply that liquidity risk is only present for small-cap stocks... Not at all.

Liquidity risk is higher than you might guess for mega-cap stocks...

And even entire markets...

When a stock instantly moves to a huge loss with no trades at many prices in between, it's the market saying... "There were no bids at all those price levels between the last trade price and the one immediately following."

I've occasionally warned investors that liquidity risk can and does happen to the biggest, seemingly most liquid stocks in the market...

In my talk during the 2017 Stansberry Conference in Las Vegas, I warned that this could happen to the biggest-cap stocks of the greatest businesses in existence. I included Meta Platforms (FB), then called Facebook, in that list. Since then, the stock has sustained large one-day losses three times, as shown in the table below...

Meta's market cap was $630 billion the day before it lost 19% of its value ($121 billion) on July 26, 2018... It traded between 10 million and 30 million shares per day in the weeks prior to that day.

It was as highly liquid as you could ever want. Nobody was thinking about liquidity risk with Facebook... Nobody thought it could lose $121 billion in market cap until it did. It was the biggest one-day market cap loss in recorded history, until a few weeks ago...

On February 3, 2022, Meta Platforms lost $252 billion of market cap in one day ‒ now the largest one-day market cap loss in history. The two-day intraday price chart below is dramatic...

The stock fell almost instantly in after-hours trading on February 2... It opened down 25% the next day, February 3.

Whether you trade after hours or not, the loss was fast... too fast. You couldn't have escaped it.

In effect, there was zero liquidity in the area where that loss occurred... meaning that, after hours on February 2 and all day long on February 3, it was impossible to execute a transaction at a price near the February 2 regular session closing price recorded at 4 p.m. Eastern time.

Imagine holding a stock that's trading around $322 a share... and in the next instant, it's trading at $246. There were zero bids – zero liquidity – at all the hundreds of price levels in between those two prices...

That is what liquidity risk looks like in a mega-cap stock...

It's as if you were rowing a boat across a smooth lake, and suddenly the water drained away and left you sitting on the lake bottom with fish flopping all around you...

Perhaps you're thinking that Meta's fundamentals were suddenly poorer than expected, and the market reacted more violently than anyone expected... So maybe you think that I'm wrong to label such an event as an example of liquidity risk.

But it doesn't matter why liquidity suddenly evaporates... My point is that the assumption that it won't evaporate instantly is a flawed one. Don't be surprised if you see more such events, not fewer.

And as I said a moment ago... it's not just mega-cap stocks. Liquidity can dry up for entire markets, sending dozens of stocks plummeting faster than you'd ever expect...

The classic example of this is the one-day 22% drop in the Dow Jones Industrials Average that occurred on October 19, 1987... sometimes referred to as Black Monday.

When a market is in freefall like that, it means there aren't enough bids for the many shares being offered for sale, pushing the balance between the supply of shares offered and the demand for those shares ever lower.

If you try to sell into such a market, you might find it difficult to get limit orders filled, because the market will keep moving down while you're entering your order...

If it moves fast enough, your limit will never be reached... If you use market orders, you will almost certainly lock in much bigger losses than you anticipated, as prices spiral out of control...

A market in freefall is a market in which it is very difficult to execute transactions at any given price level... no matter the fundamental cause of the event.

The most recent example of an entire market in freefall is the Russian stock market...

The MOEX index represents Russia's 50 largest, most liquid stocks... The index fell 44% in its last five trading sessions through yesterday. Take a look at this chart below...

It's hard to miss the downward gaps that preceded the opening of the last two sessions. Again, the gaps represent zero liquidity – no bids – between the closing and subsequent opening prices...

Perhaps you object on the grounds that Russia's whole stock market is worth just $600 billion today... with a peak value of about $913 billion last October, according to data compiled by Bloomberg.

It's in the same market-cap ballpark as the Meta Platforms example.

Yes, it is in the same general market-cap range... But the MOEX contains the 50 largest companies in the most populous country in Europe.

The index does not contain just one company's share price, which has recently fallen due to information specific to that business the way Meta did earlier this month... No, the MOEX contains the share prices of 50 companies, responding to an event not specific to their businesses and far outside their control.

The Russian invasion cuts into every aspect of the entire country... and it affects the (mostly foreign) investors who own most of the stocks of the companies in the MOEX Index.

Sanctions against Russia and Russian companies are certainly on investors' minds right now... It seems safer just to sell and wait it out than stay in and lose more money.

But the broader point is this... It's foolish to believe something similar can't play out in the S&P 500 in the exact same way... The belief that what has happened elsewhere in the world "can't happen here" is at best naïve and at worst reflects too great an ignorance of history...

The bottom line is...

Public securities markets are risky... Those big instant price leaps are normal...

These two assertions make up two of the "10 Heresies of Finance" listed in Chapter 12 of mathematician Benoit Mandelbrot's 2004 must-read classic, The (Mis)Behavior of Markets. As Mandelbrot put it...

Markets Are Very, Very Risky ‒ More Risky Than the Standard Theories Imagine

Prices Often Leap, Not Glide. That Adds to the Risk.

During my lifetime, we've witnessed the single biggest downward price leap in history... Black Monday, October 19, 1987.

I believe it can happen again... which is in direct contradiction to what market professionals will swear today is an absolute impossibility. In fact, one of them did so recently on the Stansberry Investor Hour podcast.

They'll tell you that the stock exchanges today have circuit breakers. If the S&P 500 falls 20% in one day, gatekeepers automatically close the exchange. So there's no chance we'll see another Black Monday... Or so they say.

But regular readers know I don't subscribe to the conventional view of markets as a "linear, continuous rational machine," as Mandelbrot put it (and neither does he)...

In my view, humans didn't invent markets. Markets happened to humans. Humans are in markets the way fish are in water... And fish don't control anything about water.

Likewise, humans have far less control of markets than they pretend to...

Markets are a complex derivative of countless unfathomable human interactions... Nobody truly masters them. The only thing you can do is learn to live with them.

Normally, this is where I'd tell you how you might do that, but according to Mandelbrot, you already know how. More from his book...

A typical broker's recommendation, based on Markowitz-Sharpe portfolio theory, is 25% cash, 30% bonds, and 45% stocks. But according to a study by the Organization for Economic Cooperation and Development, most people do not think that way. Japanese households keep 53% of their financial assets in cash, and barely 8% in shares (the balance in other asset classes). Europeans keep 28% in cash, 13% in shares. For Americans, it is 13 % cash and 33% stocks. Unlike a broker, most investors do not care about "average" returns. For them, the rare, out-of-the-average catastrophes loom larger.

Mandelbrot was writing in 2004, and savings rates can change over time...

But it's enough to observe simply that investors generally don't care about academic studies like Markowitz-Sharpe... or average returns over the long term. They more likely allocate assets based on their own feeling of what amount of risk they can tolerate than the prescription of some academic.

And yes, sometimes they go overboard ‒ like near market tops ‒ and sometimes they're too scared to invest at all ‒ like near market bottoms. But the point is, you go your own way, and there's as much data out there to show that as anything else...

That's a good thing... Theoreticians have mostly misled us.

They've failed to figure out that finance isn't physics... Physics and the mathematics it employs rely heavily on the idea of continuity. Gottfried von Leibniz, who invented calculus, expressed his strong belief in a "principle of continuity."

Calculus was designed to study continuous change. The math used by financial theoreticians like Bachelier, Markowitz, Sharpe, Black, and Scholes assumes continuous changes in prices...

But real market prices leap all over the place, so the theoreticians' assumptions are wrong... and the math is largely useless.

What's useful is simply keeping enough of your assets in cash...

You already know that... and perhaps precious metals, too... so that when the inevitable massive market dislocation arrives, you are both unharmed and ready to exploit it to the fullest.

If you've taken my consistent advice to hold plenty of cash and plenty of gold and silver, the unpleasantness in the market so far this year hasn't fazed you... or at least it has made less of a dent in your portfolio than if you weren't holding those assets.

And that will allow you to wait more patiently for the massive opportunity that always lies on the other side of the worst market volatility, which you and too few others will be well-equipped to exploit for maximum gain.

New 52-week highs (as of 2/24/22): Cheniere Energy (LNG), United States Commodity Index Fund (USCI), Viper Energy Partners (VNOM), and Zeta Global (ZETA).

In today's mailbag, Stansberry Research analyst Thomas Carroll responds to comments on his Wednesday Digest... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"I love you all so very much, but I checked VAERS ("Vaccine Adverse Event Reporting System") on the COVID vax numbers. Thomas said...

As of now, it is expected that researchers will not find anything really bad that happens to more than 1 in 500,000 people... The odds say there is no or little reason to fear this vaccine.

"VAERS says there were 10,909 deaths in the U.S. from the vax (as of 18 February 2022). You said 214 million in the U.S. have been vaccinated. The simple math says that equates to more than 1 in 20,000 die. This isn't the adverse reactions number; we are talking the most extreme outcome.

"There is more that I disagree with, but this one was low hanging fruit and important enough to write in. You can do better. Still, with much love." – Paid-up subscriber Garry M.

"I do not think a platform for investment should be giving out medical advice especially when the real truth is still to be determined. Especially noted was the safety of the new vaccines which it is too early to really know what we are dealing with." – Paid-up subscriber Debra C.

"Just wanted to take a moment to let Tom Carroll know that I was sorry to hear about his dad. I haven't lost any parents yet but know that I will one day. I was sad to hear that." – Paid-up subscriber Trevor P.

Thomas Carroll comment: Thanks very much for all the feedback. I welcome discussion and debate about the things I research, especially in health care as it is the most important asset we own. Here are some follow-up thoughts...

First, I won't quarrel about math. Everyone has the right to analyze data as they wish and draw conclusions. However, the data that is used and how it is applied is paramount. Regarding VAERS data – which has become a lightning rod item in the media – the system absolutely, cannot, without a doubt, be used the way many folks are applying it...

VAERS is self-reported by doctors, patients, parents, manufacturers, etc. One of the main disclaimers posted by VAERS states that its data is not to be construed as cause and effect. A death reported to VAERS does not necessarily accurately reflect what caused it.

Federal law also requires doctors to report post-vax outcomes regardless of whether the doctor thinks the vaccine was responsible for the event. In other words, if Joe gets a vaccine on Tuesday and gets killed in a car accident on Wednesday, this must be reported to the system.

That said, the VAERS is one of the best systems in place to survey the masses despite its big shortcomings. It's hard enough to get doctors to talk about bad stuff given medical litigation in the U.S. (As an aside, read Dr. Marty Makary's book Unaccountable for more on this). Conversely (and continually to my amazement), doctors can and do use the system to drive their own agendas.

Quite simply, I believe there is no chance that 10,909 people have died directly as a result of the vaccine.

On the issue with me giving out "medical advice" via an investment-focused organization, I understand that. However, I do not believe this is medical advice. I'm pulling information together and drawing a conclusion about COVID-19 restrictions.

At the end of the day, my point is hundreds of millions of people are vaccinated and millions more have had COVID-19 (creating the best protection of all). We as a society have reached a point where restrictions and mandates are unwarranted, irrational, and even being used for political gain. That is not medical advice.

Thankfully, it looks like we're getting closer to a world without heavy-handed COVID-19 restrictions.

As I write, the U.S. Centers for Disease Control and Prevention is reportedly preparing to announce that it's essentially ending indoor mask-mandate guidance... saying that most people don't need to wear masks in indoor settings anymore, for COVID-19 infection prevention at least.

Two more things...

Trevor P., thank you very much for the time you took to write in about my dad. It is very appreciated. He was a good American, veteran, husband, father, and sibling. He relished his freedom. He made his own decisions like many others. Unfortunately, despite my best efforts, misinformation led him to what I believe were poor decisions. He paid the ultimate price for that.

Lastly, in an effort to encourage more health care learning, if anyone is looking for a new read, I suggest you check out Paul Offit's new book, You Bet Your Life. In it, Offit walks through a handful of medical innovations like heart transplants, radiology, and, yes, vaccines. It is extremely easy to read, contains super-interesting stories, and offers a no-nonsense conclusion.

Good investing,

Dan Ferris
Eagle Point, Oregon
February 25, 2022