Breaking Down the ‘Big Market Delusion’ in EV Stocks

By John Banks

Wild and weird developments continue to unfold in the electric vehicle (EV) space.

For instance, Elon Musk gave himself a new official title this week: “Technoking of Tesla.” Zach Kirkhorn, the Chief Financial Officer of Tesla, was also given a new title: “Master of Coin.”

It sounds like a joke, but it isn’t. Or rather, Musk’s actions might be a joke — played on his own shareholders — but the titles were actually filed with the Securities and Exchange Commission (SEC).

Lenient Tesla shareholders might say: “Oh, that’s just Elon being Elon.”

And yet, surely, some shareholders will be feeling less lenient with Tesla shares down 26% from the January peak (as of the March 18 close). With another bad day or two, all of the gains from S&P 500 inclusion could be wiped out; if TSLA continues to decline, the antics will become less and less funny.

And here is where things get strange: While Tesla’s shares are cratering in full-on bear-market mode, the shares of old-school automaker Volkswagen rocketed higher this week, in part thanks to new optimism surrounding Volkswagen’s plans to challenge Tesla.

In fact, the Volkswagen AG share price (VWAGY on the pink sheets) moved so far, so fast this week, the Volkswagen chart looks like an echo of the GameStop short squeeze — or perhaps the original Volkswagen short squeeze of 2008.

Nor is it just Volkswagen feeling the love. The share prices of Ford and General Motors have roared higher in recent days, seemingly on optimism regarding their ambitious EV plans.

It is hard to make sense of this.

  • At first, Tesla was supposed to be the dominant EV juggernaut whose technology, and profit margins, would dominate all other players.
  • Then room was made at the top for dozens of EV-related companies, on the assumption that not just Tesla, but multiple new players — like NIO, Xpeng, Nikola, and so on — would own tomorrow’s EV market and crush the old guard.
  • And now, with Tesla and the other EV upstarts tumbling, bets have shifted back to the old guard, who will supposedly — we’re not sure what, exactly — conquer new heights of profit with their EV efforts somehow.

It doesn’t make sense because it was never supposed to make sense.

The original inflating of the EV bubble was not based on some rational accounting of the EV market as a competitive space — it was just a wall of money rushing in for a payday. With the original EV thesis fraying at the edges, that money is now rushing hither and yon; the only thing to make sense of is a tendency for manic behavior.

In many ways, the efficient market hypothesis (EMH) is pure nonsense, in the sense that EMH assumes an overlay of rationality that never existed.

In trying to rationally justify a price level, Wall Street analysts often do the same thing. They will start with, say, the empirical observation that Tesla has a $609 billion market cap, and then try to reverse engineer a rational, forward-outlook-based case for why that market cap exists.

Sometimes there really is a rational case; but at other times it is just the wall of money, or, in Wall Street parlance, “flows.” Flows don’t have to be rational; flows are just flows.

This is why investors can appear to embrace wild contradictions, like, say, giving Tesla a valuation that implies it will crush the old-school automakers — and then ramping the valuations of the old-school automakers simultaneously, on the theory they will be serious EV contenders.

Quant-based money manager Rob Arnott, along with Lillian Wu and Bradford Cornell, released an intriguing research paper this month that explains how the thinking process works. It is titled “Big Market Delusion: Electric Vehicles,” and you can read it here. Here are the key points:

  • The “big market delusion” is when all firms in an evolving industry rise together, although as competitors, ultimately some will win and some will lose.
  • The electric vehicle industry, with its astronomical growth in market cap over the 12 months ending Jan. 31, 2021, is a prime example of a big market delusion.
  • In the highly competitive and capital-intensive auto industry, the January 2021 valuations of electric vehicle manufacturers are simply not sustainable over the long term.

The paper goes on to underscore that “the hallmark of a big market delusion is when all the firms in an evolving industry rise together even though they are often direct competitors.”

It seems the opposite of rational, and the opposite of efficient, to bet that a whole crop of entrants can win a zero-sum game. In sports-betting terms, it would be like pricing every football team as a lock to win the Super Bowl. That isn’t how competition works; it doesn’t compute.

And yet, in theory, there is a justification for the “everyone’s a winner” approach. We can call it the venture capital model.

When a venture capital firm makes 10 investments, the expectation is that most of those investments will fail or otherwise lose money, but the gains from one or two out of 10 will cover all the losses.

The venture capital game is about spreading one’s bets across a new technology space, on the theory that you can’t be sure who will become the dominant player. So you make multiple wagers, and expect to lose on most of them, and then hope to turn a profit, on balance, through the outlier winners that rise above the fray.

In their zeal for defending the efficient market hypothesis, some economists have latched on to the venture capital model — or some version of it — to argue that markets are still efficient even in the presence of big market delusions.

If you bought all the EV names as an equal-weighted basket, this argument goes, and then made money on balance 10 years later from the one or two winners, that is enough to argue for market efficiency.

And yet, when venture capitalists do their thing, an important part of the methodology is awareness that 90% of the investment portfolio (if not 95%) could wind up as a tax write-off.

The venture capitalist who spreads their bets is not only cognizant of the need for a huge win to justify the strategy, but knows that most of the investments will fall somewhere between unprofitable and a complete loss.

Do investors in the EV space have that willingness to accept, in advance, the likelihood that 90% or more of the space could be wiped out? We doubt it.

In a funny way, the whole EV journey makes perfect sense to us — and doesn’t seem strange or puzzling — because it is just human behavior writ large. Trying to understand the rationality of market pricing is just the wrong lens, because sometimes there isn’t any; it is more about understanding the hardwired irrational tendencies of human behavior, which in many respects are predictable and timeless.