Bitcoin Fever: What MicroStrategy’s Stock Rally Teaches Us About Market Efficiency

Cover Image Source: IntoTheBlock/Medium

Wednesday December 4th, 2:39 AM Greenwich Time. Bitcoin breaks for the first time in history the 100'000 USD mark. At the same time, MicroStrategy's shares are up over 500% since the beginning of the year. Where's the link?

Once a - though relevant - quite unexciting business intelligence firm, since its co-founder Michael Saylor took a heavy bet in 2020 exchanging $250 million worth of cash for Bitcoins, MicroStrategy has progressively shifted its business model towards some sort of a hybrid creature: half a crypto holding and half the software company it once was. And ever since the firm has linked its destiny to Bitcoin, it has started making headlines too, as its stock price has skyrocketed following the rallies of its crypto holdings.

Now, the stellar valuation of MicroStrategy has pretty nothing to do with what is still officially its main business model. Hence, some have argued that MicroStrategy's case challenges the idea of market efficiency.

But what does it mean, and why is it important?

WHAT IS THE EFFICIENT MARKET HYPOTHESIS?

To better understand the implications for investors like me and you, let's revise shortly what the efficient market hypothesis, a cornerstone theory in Finance, is about.

The concept of efficient markets was first introduced by the economist Eugene Fama in 1965, to represent the idea that stock prices reflect all available information. This basically means that it's impossible to "beat the market" (earn consistently higher returns than the market without taking on additional risk), because the future movements of the prices are unpredictable (they follow a "random walk").

Why? Think of it this way: if everyone knows the same facts about a company and uses them to make rational decisions, no single investor has an edge. Today, nobody knows "something more" that can help them predict which stocks will yield the highest returns tomorrow.

To spice things up, the theory comes in three different flavors:

• Weak Form: Prices reflect all historical price data.
• Semi-Strong Form: Prices reflect all publicly available information.
• Strong Form: prices reflect all information, both public and private.

If the Weak Form was true, analysing price charts to find patterns that help predict future fluctuations (the so-called "technical analysis") would be a waste of time. If the past information is already fully incorporated in the prices, technical traders have no advantage against the market, right?

If we were to believe in the Semi-Strong efficiency also fundamental analysis, which tries to spot undervalued or overvalued stocks analysing published financial information, would be worthless. That is because all of that financial information (which is public) would already be reflected in the current prices.

Between 2023 and 2024 passive funds have overtaken active funds in total assets under management.

Source: Morningstar, "The Recovery in U.S. Fund Flows Was Weak in 2023", accessed December 6, 2024.

Available at: https://www.morningstar.com/funds/recovery-us-fund-flows-was-weak-2023

The main practical implication of the Efficient Markets Hypothesis is that active investing (trying to pick mispriced stocks or be ahead of market movements) does not yield a higher risk-adjusted return than the market. Generally speaking, investors should rather go for passive investing, meaning they should invest in the market as a whole (which they can do through instruments like ETFs that replicate market indexes).

But does this theory hold true in the real world?

ARE MARKETS ALWAYS EFFICIENT?

It's been decades since Fama first put forward his hypothesis, but the debate around it has never been settled. Here is an overview of the main arguments in favor and against it.

Empirical evidence supporting EMH

Many empirical studies have been conducted to find evidence of market efficiency, and their findings seem to align with it:

1. Stock Prices seem to follow a Random Walk. The first study of this kind was conducted by Fama himself, and it has been followed by a prolific literature. Most of the empirical research seems to provide evidence supporting the Weak Form of market efficiency, demonstrating that prices are indeed unpredictable.
2. Earnings Incorporation. Some studies found that quarterly earnings announcements are incorporated into prices in a matter of minutes, which is consistent with the Semi-Strong form of efficiency.
3. Active Funds Underperformance. Numerous papers have found that most actively managed funds fail to provide consistently higher returns than the market (especially after adjusting for the additional risk and deducting the costs). This proves that "beating the market" through active strategies is challenging.

Criticism to the Theory

Critics of the EMH, on the other hand, point to some inconsistencies that are hard to reconcile with the hypothesis:

1. Anomalies. A large literature has developed around strategies that on average provide better returns than the market. Examples include value investing, famous thanks to its champion Warren Buffet, and price momentum, the tendency of stocks that outperformed over the last six months to keep doing so, and vice versa.
2. Challenging the rationality assumption. The theory is built around the assumption that investors are rational agents, but this view has been increasingly challenged by the development of behavioural finance, which argues that investors, as all humans, are subject to irrational behaviours and "cognitive biases".
3. Market Bubbles. A stock is "fairly valued" when its price correctly reflects its "fundamentals" (discounted future cash flows). While some random fluctuations do not undermine EMH assumptions, there is evidence of episodes - commonly called "bubbles" - when prices appear to be significantly overvalued compared to any rational expectation on the future cash flows, for a prolonged time.

The Dot-Com Bubble of the early 2000s is an example of "irrational exuberance" on the NASDAQ.

Source: StockstoTrade, "Dot-Com Bubble Chart", accessed December 6, 2024.

Available at: https://stockstotrade.com/dot-com-bubble-chart/

Critics of the EMH argue that external and irrational factors play a role in determining prices. The term "sentiment" was introduced to indicate that sometimes stock rallies are only driven by a sudden spread of hype in the market, which has not much to do with changes in the fundamentals.

CHALLENGING EFFICIENCY: A CASE STUDY

We started this post with the story of MicroStrategy, and now it's time to come back to it. Following its incredible rally on the market, many started to wonder: is MicroStrategy a bubble?

Most observers would give you a positive answer. As a pure business intelligence company, Saylor's firm is extremely overvalued. The company's revenues from its analytics software have been stable for years, its profitability is relatively low, and nothing seems to justify its monster multiples five times (or more) above those of the industry.

But financials of course don't tell the full picture, and some have correctly argued that its share prices are not based on the valuation of its core business, but rather on its crypto holdings. However, even considering MicroStrategy from a Bitcoin-ETF viewpoint, is it fairly valued?

The current market cap of the company is around 2.5 times the value of its bitcoin assets. MicroStrategy stocks act as a multiplier of BTC market movements: while the crypto has gained 117% since January 1st at the time of this writing, MSTR shares are up over 500%.

This is not necessarily a sign of irrational valuation: a huge chunk of its Bitcoin purchases was financed through convertible bonds and other debt issuances. When we use debt to buy assets, we take advantage of something called leverage: if prices go up, we gain even more because we're earning not just on our own money, but also on the money of the lenders. Of course price drops hit harder too, because on top of the losses we need to repay debt. This can help explain why MSTR shares amplify BTC price swings. The company has now a very high risk-reward profile, resembling a (dangerous) leveraged bet on Bitcoin's price.

Other reasons could be delays in the approval of Bitcoin ETFs by the SEC, and regulation constraints that come with directly investing in the crypto. The ease of accessing the publicly traded shares of MicroStrategy has likely pushed investors willing to gain exposure to BTC to pile up on the company's equity.

MicroStrategy's normalized returns amplify Bitcoin's due to the high degreee of leverage.

CoinDesk, "MSTR vs. BTC", accessed December 6, 2024.

Available at: https://www.coindesk.com/opinion/2024/12/04/mstr-vs-btc

Have you noticed? The more we try to assess MicroStrategy's fair value, the more it seems an impossible challenge. But why is that?

The key to understand why it is not possible to find a fair value for MicroStrategy is that it's impossible to find a fair value for its Bitcoin holdings. What are the "fundamentals" of the crypto asset?  Most of its original use has been lost: there are plenty of newer and more efficient blockchain-based tokens; part of the original privacy guarantee has been lost to the tracking of transactions by crypto exchanges; and it has lost most of its use as a medium of exchange, consolidating into few wallets as a speculative store of value. Today, Bitcoin prices seem to be purely determined by psychological factors like availability of capital and positive sentiment (the "hype" of the markets). There's no objective metric to determine its intrinsic value.

MODERN CHALLENGES FOR MARKETS EFFICIENCY

This case study exemplifies how today the efficient markets hypothesis faces several new challenges, including the following:

• Market volatility has increased over the last few years, as the pandemic and geopolitical tensions have driven uncertainty and fear into our economic environment. Think of uncertainty as the evil brother of risk: you can't model it or price it. Sudden and excessive price movements are more common when markets are characterized by uncertainty.
• Sentiment-driven price fluctuatons are increasingly difficult to ignore or explain with a framework of rational expectations. Often, tweets from influential figures and reddit speculation drive huge price movements without any changes in the fundamentals of the assets.
• New asset classes like cryptos are hard to reconcile with traditional valuations, and elude traditional market dynamics.

It looks like markets have become somehow "less efficient" over the last years, as even some of Fama's loyalists admit, like his former student, now hedge fund manager, Clifford Asness. After all, Fama himself has recently been quoted saying that the efficient market hypothesis is just "a model" and "it’s got to be wrong to some extent".

But what can investors learn from this?

LESSONS LEARNED FOR INVESTORS

Let's start with saying that this does not mean that beating the markets has magically become easier. In the hypothesis that financial markets are increasingly subject to uncertainty and irrationality, this also means that volatility swings can be deadly for everybody.

Markets, anyway, don't seem to be too scared by the perspective. 2024 has been a record-breaking year for many indexes, and the riskier and more volatile the underlying assets, the better.

So, what are the key takeaways?

First of all, diversification is still the best way to avoid unpleasant surprises. Mixing exposure to the stock market with less volatile, counter-cyclical assets might be a good idea. Second, be aware of your biases when you choose what to invest in. Before going into FOMO, ask yourself: why am I making this investment? Am I actually buying something for its underlying value, or is it just a wild gamble?

If you can answer this question honestly and sleep well regardless, then go for it!