January 31, 2021
I guess this comes from “Caddy Shack”, a movie I’ve of which (I’m ashamed to admit) I’ve seen only a part. I hope you don’t think worse of me for this omission.
Meantime, the entire world is a-buzz about the doings around GameStop (GME), and, though I must fight to be heard against the associated din, I feel no less duty-bound to weigh in on this topic.
Because it has significant implications from a risk management perspective.
Let’s start with the punchline – our title is aimed at you, my newly lauded army of micro investors. Though it brings me no joy to say so, I do indeed suspect that this fate may await you.
An unavoidable retelling of the narrative wants the following disclaimers. First, what has been reported may not match up with the facts, which I believe are deeply misrepresented – in the financial press, in the mainstream media, in the blogs and even in the latest edition of “Field and Stream” magazine.
I believe (but do not know for certain) that these sources have gotten it wrong, that this was anything but a redux of the biblical David/Goliath story – played out on the battlefields of electronic trading. Rather, I think it was a “Beyond Thunderdome”/Two Enter/One Leaves sequence -- involving behemoth, battle- hardened combatants, and rife with contours that have played out, in various iterations, since time immemorial (and certainly since before the bible was written down on stone or parchment).
Further, to the extent that we are able, we will refrain from naming names, because we’re too classy for that sh_t, right?
OK now, let’s begin.
At the epicenter of it all is a short squeeze in arguably overvalued, illiquid stocks -- most notably GME – a buggy whip vendor of electronic entertainment, the owner of retail stores in malls that no one ever visits, where it seeks to sell products that the world now purchases almost exclusively on-line. Other than providing a pre-pandemic meeting-place for hormonal teenager males (not exactly a high margin business -- even before covid), I’m not sure it has a raison d’etre of any kind.
So, the stock attracted short sellers like moths to a flame (or like me to you), and, as recently as a few weeks ago, they were comfortably poised to push the valuation of GME -- from its prevailing levels below $1B -- down to $0B. The shorts then began to concentrate, and the market saw an opportunity to do some squeezin’. Over the 2nd half of 2020, GME rose from ~4 to > 20, which, by my accounting, is a five bagger.
OK; fair enough. This sort of thing happens routinely in the short selling game, often-times with the short sellers emerging as winners. But then the squeeze itself started to take on an epic urgency, catapulting the stock, at one point on Friday, to a market capitalization of over $25B. To place this in context, a purveyor of obsolete Nintendo cartridges and Blue Ray copies of “Caddyshack” is at present worth more than companies such as State Street (world’s largest custodian) and Republic Banks, NASDAQ, Consolidated Edison and Tyson Foods (to name just a few).
Prominent short sellers were caught in the whirlwind, unable to buy back shares at any (fathomable) price and facing margin calls that they could not meet – issuing from the brokerage houses that had lent them the stock to sell. One fund in particular was thus forced to fold itself into the strong (but not always loving) arms of its competitors, with the only other likely alternative being ignominious bankruptcy.
All of the above caused perhaps the biggest market disruption since that bizarre-o day last spring when Crude Oil traded negative. It sparkplugged the Gallant 500’s worst week since October and spilled over into virtually every sector and asset class, as investors, quite sensibly, reduced risk across the board so as to find a quieter space to assess the sequence and its attendant consequences.
It was, if you’ll pardon me for so stating, the type of small black swan that was the theme of last week’s publication. So, maybe I was right when I suggested to y’all that black swans do matter?
But here’s the thing, my loves, I’m pretty convinced that the whole narrative about a bunch of Redditor day traders taking down the big, bad hedge fund dude(s) is not only wrong; it’s counterproductive.
To begin to understand this, we must revert to the truism first coined by Cicero, later purloined by Vladimir Lenin, and ultimately mis-quoted with great hilarity by Walter in “The Big Lebowski”.
Specifically, when trying to determine who was behind a certain sequence of events “Cui prodest \ cui bono ("To whose benefit?") is as good a place, as any, to start. To which I will add: Et dictum (Who was informed?”).
Well, the fund in question had institutional Prime Brokers that were watching its book tick off in real- time. Its order flow was mapped to big market making institutions, many of which are themselves large hedge funds. These mega-capitalized institutions, who, by the way, are at the top of my pantheon of effective risk managers, were in a position to observe the trajectory of impairment of the misanthropic fund at the center of this morality tale, and were thus able to purchase the shares at geometrically rising prices from this fallen, forlorn fellow, and, by doing so, benefit from his losses.
And maybe, just maybe, they were able to lay off most of these shares to the teeming millions of proles trading their PPE money, on the platform named after the famous, good-hearted thief of Sherwood Forest. Albeit on an uniformed basis, I envision remote agents of these big institutions using social media to feed the buying frenzy.
As matters now stand, yes, a Goliath has been cut down to size. Yes, a bunch of day traders have booked windfall profits, but any of them that didn’t sell out and lock in their gains should know this. They own shares in a zombie company that will certainly soon see its stock price come crashing down, and may end up, in short order, nothing but a memory of Gameboy console days gone by.
If so, oh my riders of the Hooded Orinth, it’s sad but true: you’ll get nothing and like it.
And who benefits? The big institutions, of course. Through it all, the rich grow richer. But that again is a story that repeats itself time and time again, since the unit of investment account was not currency, but rocks.
And though you need not join me in these conceits, one parallel that comes prominently to mind is the demise of MF Global. MF was a trading shop taken over and speedily run into the ground by former Wall Street Titan/New Jersey Senator/Governor Jon Corzine, who, when bounced from the rolls of government, decided to try to regain his glory in the realms of investment and finance.
His is the only name I will name.
Soon after his arrival at MF, he bet the farm, making concentrated speculations that the yields of government bonds in Southern European jurisdictions – then in the high single to low double-digit ranges -- would come careening down. His counterparties – some of whom who used to work for him -- accommodated him -- by taking the other side of these trades, noting all the while, that he had finite liquidity with which to sustain these positions.
So, they crushed him in the markets, traded in a way to keep these yields rising, issued endless margin calls which tapped out all of MF’s funding liquidity, until, ultimately, it was forced out of business.
But the colossal irony here is how right Corzine was about these original trades. Spanish and Portuguese bonds now yield not double digits, but rather fractions of 1%. Didn’t matter, though; Corzine failed the risk management test, the wages of which were the demise of the firm he’d just taken over, and all to the benefit of large institutions with deeper pockets and better risk management.
I could offer other examples but won’t. Instead, I’ll just state my belief that this whole GME saga is nothing but another scene from the same playbill.
What remains, for us, is to take inventory of current risk conditions, with an eye towards deriving what lessons we can from what has just transpired.
So, here’s what I got:
- The GME short squeeze arguably catalyzed, and is at minimum at the epicenter, of a visible risk reduction cycle/rise in risk premium.
- While I do not believe that it will lead to a widespread, longstanding market reset, the disruption by all means could continue for an extended period of days or weeks.
- The characteristics of the new pricing patterns are highly idiosyncratic, implying:
- They are not particularly visible in most factor models.
- Counter-intuitive pricing patterns are materializing in market segments bearing little or no relation to GME or other prominent names in the cycle.
- They are also evident across a broad range of sectors and asset classes.
- I believe that the cycle will run its course, and, for those who have prudently managed their risk, its conclusion will present an appealing opportunity for incremental risk taking.
- Patience and discipline are the keys here. No need to catch the precise turn.
- If I am correct about the opportunity that is forming, it will extend for a significant period once it begins.
- In the meantime, my specific risk advice is as follows:
- Shade towards the conservative in portfolio decision-making.
- If risk reduction is appropriate or necessary, cut down on exposures (i.e. gross down).
- In other words, as I am fond of stating, if you want to reduce risk, ‘tis better to remove items from your portfolio than it is to add to your holdings.
- In other other words, hedges are not likely to be effective mitigants here.
- Unless your investment hypotheses have changed, preserve core positions. This is a very bad time to liquidate well-vetted speculations that that have been indirectly, adversely and (in all likelihood) temporarily impacted by recent events.
- As we always try to relate, the short side is considerably riskier than the long side. Current events both reinforce this and offer a warning for portfolio construction on a permanent basis.
And finally, let’s say a prayer for those who got nothing and liked it, as well as for them for whom this fate looms large on the horizon. Know, though, for the latter group, there’s a way out.
It’s called prudent risk management, which is the key takeaway from this morality tale.
In the saga described above, those who embrace this holiness not only avoid our titular fate, but routinely find themselves the beneficiaries of the misfortunes of those who don’t.
I can’t emphasize this enough – particularly in these troubled times. Lord knows we’ve been whacked around a good bit lately, and the hits seem to still be coming. But you, and I, together, are too many for even these. Because we know these lessons when we encounter them and have the ability to emerge stronger from their rendering.
And, to the rest, I can only offer that time-honored blessing (which God conveyed upon Cain after casting him out from civilization) which has long served as the salutation for this publication: