A Damning Motive

Malt Liquidity 89

Timing is Everything

A couple posts ago, we talked about insider trading — namely don’t do it — but also highlighted that

Proving causality of flows is notoriously hard and requires assumptions that defeat the purpose of ascribing a narrative — what is the proof that the stock moved due to X? It’s much easier to ascribe reasons to a trade. People buy a stock because they think it will go up. People sell stock for various reasons, including rebalancing, profit taking, and limiting exposure, but it still tells you something. People buy certain puts to hedge, etc. Most notably, insider trading convictions rely on the irregularity of the reason of the trade, not necessarily the outcome itself — it’s possible to lose money while insider trading! That being said, if someone’s buying a metric ton of short term OTM call options, they probably know something that other people don’t. Of course, the golden rule is don’t insider trade, but you’d think that when people do, they’d at least disguise their flow.

So when I read this article, I honestly felt a little bad:

An Idaho man who hacked the Motley Fool site and made millions of dollars trading on its stock recommendations before they were made public was sentenced to more than two years in prison…

Prosecutors said Stone used another person’s credentials to access Motley Fool’s internal systems in 2020, enabling him to see the popular personal finance site’s stock picks before they were released. Stone earned more than $4.8 million in profits trading on the information.

The government said he also tipped off another person who traded on the information and made more than $3 million in profits…

According to the SEC, the pair traded the stocks of dozens of companies recommended by the Motley Fool in 2020, including Amazon.com Inc., Coinbase Global Inc. and Peloton Interactive Inc.

First of all, COIN didn’t even go public until 2021. Second, AMZN and PTON were up 68% and 440%(!!) at their peaks in 2020 respectively.

It is overwhelmingly likely that precisely none of the stock movement of either of those tickers was due to Motley Fool recommendations across the year. As anyone who followed stocks that year knew, literally everything rocketed up after pandemic central bank stimulus. You quite literally could buy anything after March and make a boatload. But while the Elon trial had to show that the losses suffered were directly attributable to flows impacting the stock, to show insider trading, prosecutors need only show that the intention the trade was made with was illicit — in this case, trading off of nonpublic stock recommendations. It’s honestly sort of a tragedy in this scenario that the legal standard to show insider trading is trade causation rather than flow causation, which, as we highlighted before, is much easier:

The “manipulative and deceptive devices” prohibited by Section 10(b) of the Act (15 U.S.C. 78j) and §240.10b–5 thereunder include, among other things, the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information.

To be clear, I’m not advocating for trading on illegally acquired information asymmetry to be less prosecutable. But this case emphasizes why legal knowledge is useful for any practitioner — I’m positive that if I surveyed 100 institutional traders, every single one would answer that Elon’s “funding secured” tweet impacted the volume and the price of TSLA far more than a Motley Fool recommendation would to AMZN or PTON during the peak intraday trading volume environment. In all likelihood, Stone would have made a bag trading these stocks either way with or without knowledge of this recommendation. But what’s the more easily prosecutable conduct? It’s completely antithetical to the intuition. Man, this feels bad to read.

Stone had argued for leniency, claiming that a traumatic brain injury he suffered in a 2020 car accident led to “physical and behavioral changes that made him stressed about the family’s financial security and led him to act in ways he wouldn’t have before the accident.”

I’m no lawyer, but what I would have argued is that the information wasn’t “material” in any real way, perhaps by doing a more rigorous analysis of Motley Fool recommendations’ impact on next-day trading volumes (especially in 2020, when volume was being blasted everywhere) and their performance over time — while it’s hard to find any articles that aren’t blatant advertisements, this paper does seem to highlight that there is in fact historical out-performance of the market by some metrics, though it acknowledges that this could be due to outsized performance in certain buckets of years vs others (from a 2017 paper):

In general, I tend to think about analyst ratings as lagging indicators of sorts — the analysis that comes with the reports is kind of nice because it means I don’t have to dig through financials myself, but overwhelmingly “upgrades” and “downgrades” follow a stock running up or down or an earnings report. Some of this is obviously useful, but I think trend-following regimes tend to reflect much better on sell-side research than their recommendations as an actual portfolio strat. As David Einhorn famously said about sell-side analysts a while ago:

I think it’s prudent to be careful of any analyst that habitually purports to explain why a stock moved the way it did after the fact, and then adjusts their modeling to a stock price, rather than off snapshots of fiscal reality (I don’t do fundamental analysis myself, but Damodoran — linked prior — is always a great read.) Then again, we haven’t really been in a “fundamentally driven” environment in a while, but rather in various hybrid technical-macro-monetary policy regimes of various weighting. I’ll have more to say on this in the future.