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PostShort Squeeze...or Perfect Storm? Price-Takers vs Price-Makers (A. J. Cave, USA, 02/11/21 3:23 am)
Since I am a member of subreddit's WallStreetBets (r/wallstreetbets) or WSB, along with close to 9 million others, who mostly joined after the game of GameStop started, I should unpack this right from the eye of the storm.
I have two reasons for this exercise: 1) This is just the beginning not the end; and 2) Because the "retail investors" like me, typically summarily dismissed as flies on the wall (street), have finally and fundamentally changed the nature of investing in the global financial markets.
This has been accelerated and amplified by the changing global demographics--more tech-savvy millennials than the mostly technophobic aging and dying baby-boomers--and more time to engage since the pandemic has restricted, redirected and rearranged the energy from almost all the socializing that used to be the norm.
There is also over $3 trillion in cash sitting on the sidelines waiting to be deployed.
In short, it's a perfect storm, not a short squeeze.
It's going to take a while for both professional and individual investors to wrap their heads around this.
WSB members are certainly not as polished as Bill Ackman of Pershing Square Capital, who made a cool $2.6 billion hedging against the pandemic market crash in the early days of economic shutdown. However, underestimating them and dismissing them as market manipulators misses the point.
Before unpacking WSB and GameStop, some housekeeping notes:
Disclaimer: I don't give financial advice or stock recommendations. Investors should do their own due diligence (called DD on WSB) when it comes to the stock market(s), and indeed anything to do with their assets.
Disclosure: I don't own any GameStop stocks [GME], but that doesn't mean that I won't invest in the company anytime from now to whenever.
Rules of engagement (or the low-hanging fruit): investing in financial markets is risky business. There are no guarantees. Investors try to de-risk their investments by any and all means possible. But risk and reward are inversely correlated--the higher the risk, bigger the reward, and vice versa. And using options reduces your risk to a fraction of your full exposure.
Tidbit: The average length of time a stock is "owned"--the span of time between the buy and sell--by the professionals is about 10 seconds.
So, in a nutshell, what happened is this:
The underlying framework and the force that can (and would be) fine-tuned and perfected and deployed again and no one thought even possible is an aggregation of "retail investors" for a common purpose. We call it a "de-fragmentation" of a fragmented market. The basic model has already been tested and proven with the likes of Uber and Lyft, and others like Doordash, and even Amazon's expanding fleet, using gig workers. The core concept is no different. WSB is sort of like a beehive. A single honey bee is both important and irrelevant, but a colony of them can and do produce honey.
Theoretically, if you can defragment a highly fragmented but lucrative market, in this case, the fragmented global retail investors, you are holding the biggest winning lotto ticket ever.
This defragmentation was thought not just difficult but impossible, because retail investors have different risk tolerance profiles and portfolios, and lack the tools that hedge funds (and institutional investors) use to hedge against market volatility.
Some have been calling WSB the "democratization" of the financial markets. But it's actually the weaponization of money and markets by a new aggregation of an old "class" of small investors who can move the markets in either direction. Money has always been a source of power. Now, it's the weapon of choice in hands of all, not just the top 1 or 10 percenters.
Here is the nitty-gritty (or you can just wait for the movie):
Reddit (written as reddit and pronounced as past tense "I read it") is another free social network, founded in the Silicon Valley 15 years ago or so, and now in the US's top 20 most-visited websites with over 50 million daily visitors (according to Alexa). It is privately owned. Advanced Publications is her biggest investor. Other investors are heavyweight VCs like the Sequoia Capital, Sam Altman, Marc Andreessen, Pete Thiel, and others, and as of 2019, the Chinese Tencent Group. The bigger "winner" of GameStop et al. brouhaha was reddit, who just raised another $250 million led by Vy Capital (founded by Alexander Tamas and funded out of Dubai), doubling its valuation to $6 billion.
Unlike other better known social networks, reddit is community-based (called subreddits), where members "assemble" around a common interest. Anyone can form a subreddit, and post and discuss whatever they want. subreddits have moderators who can delete and remove and censor, usually to the outrage of the members. WSB is first and foremost focused on aggressive options trading.
The movie rights to the "story" have been sold, so the full story of GameStop (and other heavily shorted stocks) for beginners has been removed. But, basically, it was not a "short squeeze" as lazy people who only read the blurbs and numbers pontificate, shudder, blast and distort.
Keith Gill, known as u/DeepFuckingValue on WSB and Roaring Kitty on Twitter and YouTube, did the initial analysis on the GameStop. He is a financial analyst and, in his view, (dating back to 2019), GameStop, the largest videogame retailer with thousands of shops in malls, each one doing about a million in sales, was undervalued. At the height of the first GameStop wave, his $53,000 investment in GME (bought when the stock was around $5) became a (almost) $50 million dollars fortune. Kudos!
GameStop had been increasingly losing money in the last decade as more and more videogames started to move online, and with the malls closing during the pandemic, short-sellers started to circle the GME wagons in a zero-sum funeral game.
What triggered the GME's massive rally was the events in January 2021 (among them, the continued political mess on the Capitol Hill) and the remembrance of (now forgotten) financial crash of 2008 when most of the WSB traders came of age and witnessed the devastation that Wall Street wreaked on their families and friends without any punishment. Wall Street was actually rewarded for ruining so many families by being bailed out by the Obama administration.
And let's not forget that about $2 trillion dirty dollars a year are laundered through five global banks: JPMorgan Chase, HSBC, Standard Charter Bank, Deutsche Bank and Bank of New York Mellon.
Short-sellers had shorted the GME stock over 130 to 150% of the actual stocks in circulation. That is on SEC to investigate. But the intention of the short-sellers was "nothing personal." They just wanted to make money by wiping the (stock market) floor with GameStop (a company with thousands of employees out of jobs). That's when WSB mobilized globally and members took a chance on "doing good" and "saving jobs" while making money by buying GME stocks. Basically, hundreds of thousands of small traders around the world risked their life savings to push back on Wall Street. Some sold when they realized massive gains and some held and are holding for the next wave.
At best, short-sellers provide a sanity check on stock analysts hyping their book holdings on big media (CNBC, etc.,). However, at worst, they could be very wrong and cause massive financial damage to good or great companies with faulty analysis. Tesla was among the most shorted stocks ever and every other day there was "news" on how Tesla stocks (TSLA) were worthless. Short-sellers lost billions when Tesla board finally brought in some adult supervision (Larry Ellison) to cool Elon Musk's jets.
GME wave couldn't have happened before the rise of frictionless trading in form of various popular apps like Robinhood. It was lapped up like free ice cream during the hot pandemic, and the initial $1,200 government checks seeded a new generation of small retail investors.
Unlike clunky apps from other trading firms, Robinhood is free and easy to use, especially when it comes to options trading. You link it to your bank account and you are off to the races.
Robinhood is now being sued for halting GME trading during peak volatility. They said they couldn't cover the minimum balance requirements. They got $1 billion dollar cash infusion overnight from private investors, and a total of $3.4 billion from Ribbit Capital, ICONIQ Capital, Andreessen Horowitz, Sequoia Capital, Index Ventures and New Enterprise Associates, raising the valuation of Robinhood to over $20 billion. That makes them the biggest "winner."
In reality, the massive buying of GME stocks and stock options, looked like a typical "short squeeze"--when short-sellers had to cover their shorts. But what actually happened was that after taking some losses during the initial shock, most of the short-sellers covered each other and tossed the stocks around without exiting their short positions to outlast the barbarians at the gates. Others who made massive money were the traditional trading houses like the Fidelity, and the like who took out options as the stock was on the rise.
Gains by WSB members pale compared to the gains by the people who really cleaned out--the same old private VC firms in the Valley, when both reddit and Robinhood added billions to their valuations.
The dip in the GME stock price (in the $50s now) is making it more attractive to those who missed the first round. WSB has grown from a 3+ million members couple of weeks ago to almost 9 million now and growing. They have added over 6 million members in less than a month. Probably some of them work for traditional financial firms.
Even though the VC firms have made the most money here, my bet is on the WSB citizens.
Because it is actually easy to create a social network site (front and backend) from scratch these days. What is hard is onboarding and growing the membership. With WSB track record notably with GameStop and other heavily shorted stocks, it would take no longer than a week to pack up and move to a brand-new network and let the network effect do the rest. Dido Robinhood.
Facebook and Twitter and TikTok and other social network users are "price-takers." They can scream bloody murder if they are pissed, but they have no influence over how those networks operate. WSB, on the other hand, is the very first online "colony" that is a "price-maker." They are not tied to the platform, but to themselves, and can leave reddit and Robinhood and set up shop somewhere else and take on Wall Street without missing a beat.
That's a major shift, with online power base moving from dominant platforms to pesky people.
JE comments: A. J., a parallel remark that might be relevant: last week for the first time in my decades of teaching, I heard three students talking stocks as they walked into my classroom. Most college kids have not been "stimulated" with the government checks, but they seem to possess investment capital from somewhere. Or maybe it's just the allure of trading with a game-like phone app.
I am fascinated by your price-taker/price-maker distinction. Until now, the "makers" were large and institutional. What we are seeing now is the democratization of market manipulation. I nonetheless wonder if Eipper's Rule of Market Information still applies: by the time you find out something that impacts the price of a stock, the price has already shifted accordingly. Is this a classic price-taker mentality?
Jump Market Risk
(Jordi Molins, -Spain
02/11/21 3:05 PM)
In relation to the recent discussion on GameStop, my conclusion is the market is pricing a serious amount of gap/jump risk.
The argument is as follows:
A clever and professionally accomplished friend described to me a financial strategy he is developing, as follows:
He has reached agreements with Hedge Funds he knows well. The Hedge Fund trades in his managed account (so no Madoff risks). Instead of paying the Hedge Fund the typical 20% of profits, he pays them 50%. In exchange, the Hedge Fund must agree to cover the first 10% of any losses arising from their strategy.
My friend has a good risk management system, and he is able to cut the positions of the Hedge Fund when the portfolio is down, say, 8%.
The portfolio never goes below -10%, so the investor never records a loss. Granted, the upside is quite limited, at 3% to 4% per year. But in Europe, many insurance companies may be highly interested in a product that yields in the low single digits, but with a high probability of no loss.
Apparently, this structuring "beats the market." However, and this is my main argument, we all know that by shifting risk one way or another, the market remains efficient. It is true that Jim Simons has been able to beat the market, but not by simply shifting risk.
A reasonable conclusion is that this strategy is able to "hide risk under the rug." And this hidden risk is gap/jump risk, since no risk management system can cut the positions in a portfolio if there is a sudden, unexpected move down in the markets.
My hunch is that the structuring of this strategy is telling us, in a convoluted way, that markets are already expecting some kind of gap/jump risks in the future.
JE comments: I'm learning a lot this week about investments. Do I understand correctly that jump risk is simply the risk of a stock going down massively and quickly? A vertiginous rise in a stock is never a problem, unless you've shorted it.
Jordi, do you believe this "first 10% of loss on us" strategy going to catch on? The downside is, you're giving up 30% of your profits. And the true pain is not in the first 10% of your loss, but in the next ten or twenty (or more) percent.
Ric Mauricio on Short Selling, Fiduciary Oath
(John Eipper, USA
02/23/21 3:23 AM)
Ric Mauricio writes:
I must admit, I have been trying to get my head around Jordi Molins' friend's Hedge Fund strategy. (See Jordi's post of February 11th.)
According to the strategy, if the hedge fund portfolio drops 10%, Jordi's friend is able to exit the portfolio with no loss. The hedge fund covers that loss. Considering that hedge fund portfolios are not insured against losses by any governmental entity, this puts the onus on the full faith and credit of the hedge fund itself. Since hedge funds cannot issue new currency, this faith is as ethereal as well, a belief in religions. But let's look at the positive side. Since the "upside is quite limited, at 3% to 4% per year," I am assuming that since the average hedge fund historic return is 7.3%, that this return of 3 to 4% is 50% of that historic return. OK, considering that the real global inflation rate historically has fluctuated between 3 to 4%, that gives us a return of possibly zero percent. And with the possibility of the hedge fund not being able to cover that 10% loss, I am thinking, "what's the point?" Kind of reminds me of Jesus' Parables of the Talents, where the third servant was so fearful that he just buries the bag of talents. By the way, talents were currencies of silver, but the word "talents" is apropos. There are those who do not fully utilize their "talents," no matter how great or small they are, because of fear.
Yes, I could see where insurance companies would be highly interested in a product that yields in the low single digits. What insurance companies do is sell these products to consumers, then turn around with the premium proceeds and invest in real estate (Buffett invested in companies or stocks) gaining a conservative 10 to 12% return. I'd love to earn 6 to 9% per annum on other people's money. What's the calculated return on utilizing other people's money to invest? Infinite?
I have only shorted one stock in my 50+ years of investing. Why? The risk/reward ratio is not good. For example, I shorted a stock that IPOd at 15, with the first trade at 26 (you should have seen how many rookie brokers placed market orders to buy at the IPO, only to get executed at 26; whoo, the market makers were giddy as they bagged an $11 profit per share at the outset on these foolish brokers/investors). I shorted the stock at 29. Here was the risk/reward scenario: I could bag a $29 profit per share if the stock went to zero or I could lose $100/$200 per share if it kept on climbing. But you see, before the company IPOd, I was at my local ToysRUs store. I noticed the company's Teddy Ruxpin end cap display. And I watched as kids stopped, pushed a button and watched the Teddy Ruxpin bear talk. Did they buy? No. Hmmm. Interesting. Then came Christmas time, and I noticed that a lady brought the Teddy Ruxpin bear back to the store because it didn't work. The ToysRUs staffer brought out new batteries. Didn't work. Brought out more Teddy Ruxpins. Didn't work. Finally, the 10th one worked. Oh boy, is that company in trouble. So thus my first and only short: Worlds of Wonder.
The hedge funds who shorted GameStop know the risks. Do I feel sorry for them? Not a bit. But those who bought to ramp up the price, well, to them it is gambling. It's an all-in bet, but without the skill of professional poker players who calculate the odds. Thus those amateurs late to the game lost big time as well. Hopefully, they'll learn. One person who will never learn, unfortunately, is the guy who killed himself. I think he read his account wrong. Sad.
Having been in the financial industry, I have a bone to pick. Fiduciary duty and its application. The brokerage industry continues to fight the application of this duty to its brokers and analysts. Why? Fiduciary duty is a legal obligation of the highest degree for one party to act in the best interest of another. The party charged with the obligation is the fiduciary, or one entrusted with the care of property or money. As a CFP (and now, retired, so CFP Emeritus), I was bound by the Fiduciary Oath. Before then, even as a stockbroker, I believed in practicing this duty. Even in other capacities, and as a person, I believe we should treat others with highest regard.
In accounting, we have the Sarbanes Oxley rules, which costs millions of dollars and thousands of pages to enforce. To me, that was the biggest waste of resources. Everything in the SOX rulebooks can be summarized in one sentence: Do the right thing. Unfortunately, the brokerage business relies on salespeople, humorously called Financial Advisors, to bring in the funds. Today, as Chief Investment Advisor for my Family Office, I have a fiduciary duty to my family, my kids, my grandkids and subsequent generations to do the right thing. But then, when my kids were growing up, wasn't I always trying to do the right thing for them? When I meet other people, do I not try to do the best for them? As a personal trainer, I subscribe to the medical Hippocratic Oath of doing no harm. And as Jesus taught, "Love your neighbors."
JE comments: Do the right thing. Add to this the Golden Rule, and you've created the perfect society. The rub we've observed over the last few millennia is in the implementation.
Ric, can you tell us more about the Fiduciary Oath? Is it literally something that Certified Financial Planners are "sworn in" with, like physicians with the Hippocratic version? Finance people (except you, of course) are famously cavalier with other people's money, but this impression may be inaccurate. What grade would you give the majority of CFPs?
Europeans are Happy with a 3 to 4% Return
(Jordi Molins, -Spain
02/23/21 1:29 PM)
Ric Mauricio (February 23rd) is right that Hedge Funds yield, on the long term, about 7.3%. Since the Hedge Fund manager of the strategy we have been discussing so far is able to get 50% of the (positive) returns, this means the investor in such a strategy gets about 3 to 4% per year.
The flipside is the Hedge Fund manager needs to post 10% of the assets he will manage as cash in an escrow account. The strategy will be able to draw from that escrow account, if there are losses. So, the 10% guarantee is real.
From conversations with Americans, I see a return of 3 to 4% per year is considered to be irrelevant. However, in Europe investors are desperate to get any guaranteed return (even 0%! cash yields -0.5% nowadays). An insurance company that is able to get, with a high probability, a 3 to 4% return (and with a low capital consumption in Solvency II, due to the 10% guarantee) will find this deal to be an exceptional one. The problem with this strategy, according to my friend, is that it looks "too good to be true."
As discussed, this strategy has its own merits. For sure, it is a better strategy than most. However, it reveals that the market is pricing a non-negligible amount of gap risk. I believe this is mostly unappreciated, so far.
Finally, there is a second unappreciated risk: if the gap risk materializes, the Hedge Funds that now are willing to risk 10% of cash to get the 50% upside could become reluctant to continue to do so. As a consequence, the strategy would cease to be practicable, and my friend should return capital to investors.
JE comments: Jordi, you mention Europe's negative .5% yield on cash. WAISer Bert Westbrook once tried to explain this phenomenon to me (while sitting on this very couch!), but I confess I still don't follow. What is the incentive to pay someone to hold your cash? US 10-year Treasuries yield 1.37%, and a coffee can in the back yard at least gives you a guaranteed zero.
- Certified Financial Planners and the Fiduciary Oath (from Ric Mauricio) (John Eipper, USA 02/27/21 7:16 AM)
Ric Mauricio writes:
To answer John E's question, yes, CFPs are "sworn in" to having a fiduciary duty to their clients. All of the CFPs within my sphere adhere to this, but since it is a small sample base, I cannot make a judgment whether other CFPs adhere to the Fiduciary Code.
However, my experience with stockbrokers is a much larger group. Out of 300 or so "non CFPs," I can state that I could only trust five of them. Let me share a story. One day I was in my cubicle with one of my clients when a broker came rushing over as he was on a cold call. He said he knows why stock mutual funds go up and down, but asked why would bond mutual funds fluctuate? My client asked if he could answer. He explained why. As the broker walked away, he said to me, "I'm sure glad you're my broker." But this wasn't as bad as another broker told a prospective client that a bond mutual fund couldn't go below $15. Another broker and I asked her how she could say this. Her response was that it IPOd at $15 so it couldn't go below that. Ouch!
As a consultant to the many high tech, biotech and VC firms here in Silicon Valley, I have encountered many managers who have no idea how to manage people. They just pretend that they know what they're doing. They cover up their insufficiencies and insecurities by bullying their employees. Known as the "Fixer," I am often brought in to fix the problems.
One of my team members asked why I don't scream at her and make her feel small when she makes a mistake. I told her it's because I'm perfect and I never make mistakes.
Let's change subjects for a moment. A question for Jordi Molins: if the hedge fund drops 20% (eg. a company that recently purchased bitcoin dropped 50% in a few days), then the client loses 10%. Still seems to be a lopsided risk vs. reward deal. I think that most insurance contracts pay that 3 to 4%, with no risk to interest or principal.
JE comments: Ric the Fixer! This sounds ominous, but WAISers know what a sweetie you are. The impression I've always had of traditional brokers is that they have their own interests in mind, not yours. This is probably an oversimplification, but it's also the basis for the Charles Schwab model of the 1970s, which has been imitated everywhere: the best manager of your money is...you.
- Certified Financial Planners and the Fiduciary Oath (from Ric Mauricio) (John Eipper, USA 02/27/21 7:16 AM)
- Europeans are Happy with a 3 to 4% Return (Jordi Molins, -Spain 02/23/21 1:29 PM)
- Ric Mauricio on Short Selling, Fiduciary Oath (John Eipper, USA 02/23/21 3:23 AM)