14 Dec, 2020

The wisdom of crowds: how stock markets picked the pharma winners from the vaccine contenders

When the race to develop the coronavirus vaccine became public news, stocks of pharma and biotech companies were on fire. These were the companies that would save the world and mankind.

While there were many contenders, only a few were going to make the vaccines. With the market pricing in all the information, the stocks of these companies started to move up faster than the rest of the market.

Pfizer and Moderna saw their share prices jump in October 2020, almost a month before they announced around 95% effectiveness of their vaccines. The markets had estimated the vaccines will bring in around USD10 billion each for these companies by the end of 2021. There was no way anybody could have known their test results.

From November 6, since the Pfizer test results were announced, the stock is up by 18%, highest among all large pharma stocks, while Moderna, a biotech company, moved up 97%. But why did the Moderna scrip ace out Pfizer?

According to a fool.com report, Moderna said there were 30 severe cases of Covid19 observed in its clinical trial, but all those participants had received placebos and none in the group received actual vaccine (indicating 100% protection).

Pfizer announced that 10 severe cases of Covid-19 were observed in its study. Nine of those occurred in the placebo group with one in the group getting actual vaccine.

The stock market had discounted this information before it became public.

Closer home, Glenmark Pharma announced it would begin a clinical trial in India to test a combination of two anti-viral drugs for Covid-19 on May 26. The stock did not immediately react to the news but moved 17% in the next one month. On June 20 (Saturday), the company announced it was coming out with a drug called Fabiflu to treat mild-to-moderate symptoms of Covid-19. On Monday (June 22), the stock saw a single-day jump of 40%.

Thereafter, more information followed, and calculations were done to see if the stock-price increase was justified. In the next three days, the stock fell 20%. This immediate pricing of stocks is always instantaneous.

The market, it seems has always been able to price stocks much before the actual information or reasons are made official. This is not insider trading but something totally opposite — the wisdom of crowds. It seems the crowd is way smarter at pricing stocks as compared to individuals. Stocks, in general gyrate between the wisdom and madness of crowds but in most cases, they are factoring all the little pieces of information which try to give a real price at any particular point in time.

The Challenger explosion: a look-back

Consider this. At 11:39am on Tuesday, January 28, 1986, the space shuttle Challenger took off from the Kennedy Space Center at Cape Canaveral. Seventythree seconds into its flight, the Challenger exploded.

At first, no one knew what had happened. At the press conference, the National Aeronautics and Space Administration (Nasa) said it would refuse to speculate on the causes of the disaster until a full investigation was done. “It will take all the data, careful review of that data, before we can draw any conclusions on this national tragedy,” a Nasa official said.

Ronald Reagan, the then US president, signed an executive order and appointed the Roger’s Commission, a 14-member panel of experts that included Neil Armstrong, Nobel Prize-winning physicist Richard Feynman; Sally Ride, the first American woman in space; and legendary test pilot Chuck Yeager (who recently passed away at the age of 92). They gave their report in around five months and found that O-rings, a small but important product made by one out of the four contractors, at fault for the explosion.

This was in 1986 the pre-Internet and social-media era. While this was a widely televised event, not many knew what and how it had happened. In the light of this, how long did the stock market take to price in this event?

In 2003, Michael T. Maloney and J. Harold Mulherin, wrote a paper, which showed a shocking outcome: the stock market punished one company — Morton Thiokol — not on the day of the report, nor after Feynman’s demonstration of the defective O-rings, but on January 28, 1986, itself.

By 11:52 am, 13 thirteen minutes after the Challenger explosion, NYSE halted trading in Morton Thiokol because volumes spiked more than what the system could manage. By the time Morton Thiokol circuits were lifted that afternoon, it had dropped 6%, and by end of the day it was down around 12%.

On January 28, 1986, Morton Thiokol shares traded at 17x of their three-month average. Rockwell, Lockheed, and Martin Marietta also took a hit, but volumes were lower and so were the end-of-the-day losses.

“If you’re cynical about the ways of the stock market, you might suspect the worst: People in the know at Morton Thiokol or Nasa realised what had happened and began dumping their stocks immediately after the accident. But Maloney and Mulherin were unable to find any evidence for insider trading on January 28, 1986. Even more startling was the fact that the lasting decline in the market capitalisation of Morton Thiokol on that day — about USD200 million — was almost exactly equal to the damages, settlements, and lost future cash flows that Morton Thiokol incurred,” notes Andrew Lo in his book Adaptive Markets.

Five months later, on June 6, the Rogers Commission concluded that the explosion was caused by the failure of the shuttle’s O-rings on the right solid fuel booster rocket. The release of the Rogers Commission report was bad news for one of those companies, Morton Thiokol, the contractor that built and operated the booster rockets.

What took the Rogers Commission, with some of the finest minds on the planet, five months to establish, the stock market or the “wisdom of crowds” was able to do within a few hours.

Vaccines: first out ofthe Gates

In February 2020, as Covid-19 started spreading in China, Bill Gates and senior members of the Bill & Melinda Gates Foundation, fearing a global threat, gathered to take stock and plan their response. On March 13, two days after the WHO declared a global pandemic, Gates conferred online with top pharmaceutical companies on their leading vaccine candidates. As of April 9, there were 115 Covid19 vaccine candidates in the pipeline. Gates opined that eight to 10 of those looked particularly promising. In April, Gates also said that “at most” two of the seven potential vaccines would be chosen for mass production. While Gates had potentially bet on seven candidates, the stock market seems to have sniffed out early on the two, out of the seven, to which Gates was referring.

Incidentally, in April, he also wrote on his blog Gates Notes that probably there could be a vaccine in nine months, and it could be RNA-based. This also seems to be what the market was backing.

We look at the stocks in two buckets:

Biotech companies, which are much more volatile and riskier because they are dependent on early-stage candidates and smaller than large pharma companies and have a higher mortality rate. The four biotech companies (one was listed in mid-August) that Gates had been backing are also the ones on which the stock market was bullish. Two of those four have been outperforming other biotech stocks and the markets since February 2020.

Big Pharma: The largest vaccine manufacturers among Big Pharma are Pfizer, GSK, Novartis, Merck, AstraZeneca, and Sanofi. The market has been backing Pfizer, AstraZeneca, and Sanofi.

We also looked at the biggest beneficiaries since November 9, when the market also reacted strongly by punishing work-from-home stocks and rewarding those that would benefit from the opening up of the economy. There hasn’t been such a strong response in the past when Gilead and other companies announced their vaccines or treatments.

The wisdom of crowds

Human beings are not perfect decision makers by themselves. They have limits to their capability of making rational judgments. But astonishingly, when these imperfect judgements are aggregated, the errors cancel each other out and the crowds come up with a judgement, which usually turns out to be the wisest. This intelligence is what author James Surowiecki calls “the wisdom of crowds”.

This presents itself in many ways. In democracies to elect a leader; on the Internet it is used by Google in their page-rank algorithm to give the most relevant results to a search; or in the stock market where it makes it tough for most investors to beat the wisdom of crowds, which is reflected in market averages. Most so-called experts perform even worse, but then who is keeping track of their predictions?

John Maynard Keynes in The General Theory of Employment, Interest and Money (1936), likens the stock market to a common newspaper game “in which the competitors have to pick out the six prettiest faces from 100 photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole, so that each competitor has to pick not those faces that he himself finds prettiest, but those that he thinks Returns: Big Pharma and biotech Source: Refinitiv 20 10 0 -10 -20 Pfizer Merck GSK AstraZeneca Novartis Sanofi Big Pharma Figures in percent 600 400 200 0 Moderna BioNTech Vir Biotech CureVac Feb 1, 2020 Sept9, 2020 Biotech likeliest to catch the fancy of other competitors, all of whom are looking at the problem from the same point of view”. He is in effect referring to the “wisdom of crowds”.

The marketis a complex adaptive system

Markets take the stairs on the way up and the elevator on the way down. Most downtrends are sudden and volatile, whereas uptrends are slower and less volatile. This is very much like human behaviour. Because of the activation of the fight-or- flight survival mechanism, people react fast to danger, whereas it takes time to build confidence. It takes one incident to damage reputation that may have been painstakingly built over the years.

What was the mechanism which enabled this outcome?

Stock markets are a complex adaptive system — a network of many individual agents acting in parallel and interacting with one another. The critical variable that makes a system both complex and adaptive is the idea that agents in the system accumulate experience by interacting with other agents and then change themselves to adapt to a changing environment. It is more Darwinian evolution and less Newtonian physics. We know how the stock market works in practice, but we just do not know how it works in theory.

So, what is the purpose of all this in an investing sense? Isn’t this just a hindsight analysis? Not really.

Prices viewed over a medium to longerterm factorin the wisdom (of crowds) and their view on the future prospects of a company before they become evident and known to the public atlarge. An investor who wants to use this wisdom, can do so by implementing a rules-based, momentum-based investing system. For long-only investors, buying winner stocks and discarding losers (stocks) over a medium time frame like the previous six to 12 months is shown to work well in academics as well in practice.Itfollows David Ricardo’s age-old advice: “Cut short yourlosses, let your winners run on.”

We will discuss how to build this strategy in a later article.

Richard Dennis, who was profiled in Jack Schwager’s Market Wizards, said that earlier he thought price was appearance and intelligence was reality. But actually, it was the other way around. Prices, if understood and used correctly, are nothing but the wisdom of crowds. Price momentum is an often misunderstood and misused style of investing and confused with punting or chasing price. If understood and used correctly, “wisdom of crowds” is a winning strategy across stock markets and economic cycles.

It all comes down to beauty and singing contests that happen on prime-time television. During the first rounds, the wisdom of crowds is used to remove the chaff from the grain. This works at many levels. But later, experts are called in to evaluate the first among equals.

The Bill & Melinda Gates Foundation or for that matter, the expert committee of the Challenger, are trying to figure out solutions to a complex situation. The markets, on the other hand, had already given the results. The market did punish Morton Thiokol in 13 minutes and rewarded Moderna almost immediately, where the experts were also part of a complex adaptive system. It can price almost anything as long as there are enough buyers and sellers to create a market.

(The author is managing partner at QED Capital, a quantitative investment management firm. He can be reached here.)

(Graphics by Sadhana Saxena)