Stock prices and valuations are driven by storytelling. Yes, this would be contrary to what all the finance textbooks will teach you. And if one were to be very, very good at telling stories, one could spin enough hype, convince market investors and keep valuations far higher and far longer than underlying earnings could rationalise or justify. And there has been no bigger story than Nvidia over the past two years, fuelled by the excitement surrounding generative artificial intelligence since the public launch of ChatGPT at end-November 2022.
Nvidia’s share price has soared manifold since then, from around US$15 at the beginning of 2023 to as high as US$140 in June 2024, before paring gains to around US$100 currently (at the time of writing). The stock is currently trading at significantly higher-than-market average valuations — price-to-sales of almost 28 times and price-to-earnings (PER) of more than 50 times — predicated on the belief that demand for AI technologies, hence demand for its chips, will continue to grow at a sustained breakneck pace. Indeed, current valuations also suggest that the company can maintain its near-monopolistic position as well as huge margins for its GPUs (graphics processing units). That is the power of good storytelling!
All the excitement and hype has generated massive investor interest in the company, not only in its shares but even more so in its derivatives. The volatility in Nvidia shares relative to the broader market (the beta) has spiked sharply higher. The stock now has the highest beta among the Magnificent Seven, the leaders in the US equity market rally, at 1.74. This high price volatility encourages speculative trading. So much so that we think Nvidia has become a “gambling” stock.
Of course, all forms of investing involve an element of risk — because we cannot know the future for certain. We can only assign probabilities to each possible outcome, at best. But the amount of risks traders are taking on Nvidia is abnormal. For starters, the traded volume of options on the stock far exceeds that of its underlying shares (see Chart 1).
Options give one the right (but not the obligation) to buy/sell the underlying shares at a specific price (called the strike price) by a predetermined maturity date. They are useful tools in various trading strategies, including for hedging purposes. Because of their leverage factor, however, most options are, in fact, bought and sold by traders mostly for speculative purposes. For the same amount of money, one could buy significantly more options on the stock than the underlying shares itself. Thus, every 1% gain on the stock price will translate into manifold percentage gains on the options.
See also: Education lies in the heart of our nation’s problems and the pathway to our solution
We did some very simplistic maths to demonstrate how gains — and losses — can be magnified though the use of options (see Table). In this simulation, a US$10 price swing translates into an 8% gain or loss if you had bought the underlying shares. Buying the options can, however, either give a huge 67% gain or totally wipe you out (100% loss)! This simulation assumes the options are held to maturity. Options can also be bought/sold at any point in time prior to maturity — the price determined by its implied volatility, exercise price and time remaining to maturity. The leverage factor still applies, whether you trade the options or hold them to maturity. Chart 2 shows the calculated change in the option price versus change in price of the underlying Nvidia shares using the parameters of an actual option contract. (There are many different option contracts in the market, each with different parameters and, therefore, different leverage.)
See also: The pendulum swings right: A pushback against liberal, progressive, interventionist economics
Clearly, options are very high risk/high returns propositions. Notably, the volume of options traded tends to spike sharply around the time the company announces its results, when price swings are greater than other days of the year. This indicates that investors are betting on the expected share price volatility post-results — that the price will either surge on a huge beat or tank if the results disappoint. Studies have shown that traders unwittingly lose money by bidding up the option prices higher than they should be based on the amount of realised volatility (which often subsides quickly after the announcements). The options market is a market for options, where prices are determined by demand and supply. In short, you either get a huge pay-off or you lose big or, worse, everything. That, for us, is the definition of gambling.
The bigger the story, the higher the valuations
Another stock whose price and valuations are driven by storytelling is Tesla. Aside from being an outstanding entrepreneur with the ability to turn bold ideas into disruptive and successful businesses, Elon Musk is also excellent at creating stories. It is the main reason that Tesla has been able to sustain huge premium valuations compared with other global automakers that have significantly higher sales volume and profits than it does. What’s more, Musk has managed to create new stories (new S-curves/ engines of growth) and convince the markets each time the previous ones falter, when the reality of sales and profits fails to meet lofty promises. Now, this is a great talent! According to a not-so-credible publication, Informa Connect Academy, Musk could be the world’s first trillionaire … from storytelling.
Like Nvidia, Tesla stock has also seen a huge surge in options trading volume, well in excess of the volume traded on its shares. Tesla has a beta of 1.56, the second-highest price volatility among the Magnificent Seven stocks, after Nvidia (see Chart 3).
Perhaps the huge speculative activity in Nvidia and Tesla is a more extreme example, but there is no question that options trading in the US is becoming increasingly popular, especially since the Covid-19 pandemic. This is evident in the broader market, the Standard & Poor’s 500 stocks, and even in more “boring” stocks such as Berkshire Hathaway (see Chart 4). At the time, many who were unable to bet on sporting events during the lockdown turned to the stock market for their gambling fix. The gamification of the stock market — trading apps with game-like features, viral memes on social media and community-driven strategies that seek to turn investing into fun and challenges — has further encouraged risk-taking behaviour among traders, particularly the younger generation.
For more stories about where money flows, click here for Capital Section
This growth in the options market, we believe, has helped attract even more investors and funds into the US equity market. A vibrant equity market needs all types of investors, including speculators (not market manipulators, mind you, for which there must be regulatory safeguards against, to ensure a fair trading environment). We should not fear price volatility. Liquidity will boost relative valuations. Momentum, fuelled by storytelling, fear and greed, is what really drives markets.
As much as we are fundamentally driven analysts, we must acknowledge that markets need good stories to thrive. There must be a compelling story to attract investors, which generates trading liquidity and momentum. Liquidity matters because the equity market is a market for stocks — prices and valuations are driven by demand and supply. Markets with higher liquidity tend to trade at higher relative valuations. High-quality companies — with the best stories and growth prospects — can and will choose to list in the market that gives them the highest valuations. This is a fact. And it perpetuates a virtuous cycle — good stories attract investors and improve liquidity, generate momentum and raise valuations that in turn attract more companies with good stories.
What is clear is that efficient and superior stock markets need higher relative valuations — not just to attract the best companies but also to grow the ecosystem of investments, jobs and economic growth. It is why the US equity market is the envy of the world. And why other stock markets, from Japan and South Korea to the European Union, are undertaking reforms to boost valuations. We will elaborate on this next week.
The Malaysian Portfolio gained 2.7% for the week ended Sept 17, outperforming the benchmark FBM KLCI, which gained 1.5%. All the stocks in our portfolio finished higher, save for United Plantations (-0.8%), while the share price of Kim Loong Resources was unchanged from the previous week. The biggest gainers were Insas Bhd – Warrants C (16.2%), IOI Properties Group (11.6%) and Gamuda (4.9%). Last week’s gains boosted total portfolio returns to 196.4% since inception. This portfolio is outperforming the FBM KLCI, which is down 9% over the same period, by a long, long way.
The Absolute Returns Portfolio also performed well, up 2.6% last week, on the back of strong recovery in the US market. The Standard & Poor’s 500 index touched a new all-time record high on Sept 17. Total portfolio returns now stand at 10.1%, marking the first time we made a double-digit gain in less than six months since inception. The top gainers were Crowdstrike (+6%), DR Horton (+5.5%) and CRH (+4.7%). The only loser last week was Itochu (-1.5%) — the stock is up 18.7% from our initial investment cost. We made no transaction for either the Malaysian Portfolio or Total Absolute Returns Portfolio.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
