the bare bones

GME is a mall-based videogame retailer. Its business has been badly hurt both by the movement of gaming online and the pandemic. This has made the company’s stock a favorite target of professional short-sellers.

In the simplest terms, these are stock market players who borrow shares of a company’s stock and sell it, hoping to make a profit by buying it back at a lower price. There are other players who also short stocks. A traditional hedge fund would have a number of short bets but would also invest the proceeds in “long” positions, stocks it thinks would go up. It makes money on the spread between the performance of its longs and its shorts. In the GME saga, though, the big forces putting downside pressure on the stock appear to be exclusively or predominantly short players.

In fact, the short GME trade has been so popular that at the end of last year many more shares of GME had been borrowed and sold short than there are available for trade (current “short interest” figures are publicly disclosed a couple of times a week). That’s because some shares have been borrowed and sold more than once.

This is an inherently unstable situation. The short-selling pros appear to have been betting that GME’s future is so bleak, and that it is therefore is so uninteresting as an investment, that there was zero chance the stock could begin to rise. They had to know that if they were wrong, someone could set off a gigantic “short squeeze.” a mad scramble to unwind the massive short positions that shortsellers had built.

Enter Reddit. It promoted, very successfully, the idea that lots of small investors buying GME at the same time, either the stock itself or call options, would have enough heft behind them to set the short squeeze in motion.

yesterday

Yesterday a number of brokers–Merrill, TD Ameritrade, Interactive Brokers and Robinhood are the ones I’m aware of–announced they would not take buy orders for GME and similar stocks, although they would take sells. Some basically said they would no longer recognize GME et. al. as collateral for margin borrowings, potentially forcing account holders to put more assets into their accounts to keep them above water.

The results were what you would have expected–panic selling and a collapse in the GME stock price.

my take

–I think the crowdsourcing of investment ideas, long or short, through Reddit or other forums is going to be a big deal and eventually a serious threat to the research departments of establishment brokers. There may be questions about whether in this instance the Reddit movement has 100% complied with securities laws (the SEC is now investigating). But I think this is something that can be easily fixed.

–I was shocked by yesterday’s brokerage house bans on purchases of Reddit stocks. I can’t remember anything like this happening before in any world stock market during my working career. My hunch is that this, too, will be investigated by the SEC.

My Wall Street experience is that firms rarely, if ever, do stuff like this for the greater good. My cynical guess is that the brokers who placed the bans will turn out to have proprietary trading desks that had very heavily shorted GME and similar stocks and were losing their shirts. It could also be that their stock lending operations (whose job is to put stock lenders and borrowers together) were unable for some reason to unwind the deals they’d put in place.

This is my highly simplified account–although as an active investor in Japan for much of the 1980s I did live through this one in a way most American investors didn’t.

The point of what follows, which I’m not sure I’ve made clear, is that what popped this bubble, which is the closest I’ve experience to what’s going on in the US today, was seeing interest rates begin to rise.

general background

Japan decided to rebuild itself after being devastated in WWII by concentrating on export-oriented manufacturing. The US was the only developed country whose industrial base remained standing after the war, so it was the target destination for Japan’s exports. To make sure Tokyo’s plans weren’t upended by unfavorable currency movements, it tied the yen to the dollar. (The most important firms in this rebuild were the industrial conglomerates founded by nineteenth-century samurai stationed in Tokyo and with too much time on their hands. These zaibatsu were the driving force behind Japan’s twentieth-century militarism. They were outlawed by US occupying forces but basically just renamed themselves keiretsu and carried on. As I see it, even today they remain the dominant political force in Japan.)

Japan was so successful it became the model for other developing countries. It was so successful, in fact, that in the 1970s the US forced Japan to reset the peg from 360 yen = 1 dollar to 308. In the Plaza Accord of 1985, the US forced a second revaluation of the yen from 250 yen = 1 dollar to 160.

the 1985 endaka (“high yen”)

After the Plaza Accord, all at once every Toyota, Nissan or Honda exported to the US became 50+% more expensive. It didn’t help matters, either, that the yen strengthened further to 120 yen = 1 dollar in short order, mostly because of trade and government spending problems in the US that hurt the value of the greenback.

Tokyo’s response to the doubling in dollar value of its currency was to lower short-term interest rates from 5% to 2.5% in several steps. This was both to stop the yen from strengthening further and to help the keiretsu to finance automating their manufacturing operations.

the Tokyo stock market

Given that much food and fuel in Japan is imported, suddenly Japanese consumers had a lot more discretionary income. And interest rates were cut in half. So there was an explosion in the stock market. More than that, interest shifted away from export-oriented names to domestic demand beneficiaries, from retail to utilities to property developers. By 1989, things had gotten pretty wacky (see my posts on tobashi, for example). Real estate speculation was rampant. Trading on margin was through the roof.

popping the bubble

Then Yasushi Mieno became the head of the Bank of Japan in mid-1989. To end the market craziness he began to raise rates late that year, boosting them to 6% over the following eight months.

The Topix index was cut in half.

Mieno announced his plans in advance but the index didn’t peak until he actually began.

why I think this is important

Late 1980s Japan is the closest period I can think of to what is happening in the US today. I don’t think speculation here is anywhere near as intense as it was in Japan back then. But then–as now, I think–many market participants, even professionals, don’t seem to grasp the essential relationship between stocks and interest rates, in two respects:

–one reason, maybe the reason, stock prices are so high is that interest rates are so low; and

–as/when the world begins to recover from the pandemic, interest rates will begin to rise. That will compress PE multiples.

To my mind, the scariest thing about the comparison is not irate Japanese brokerage customers disemboweling their brokers with samurai swords. It’s the thirty years of economic stagnation that followed the bubble bursting, due to a set of preserve-the-keiretsu-status-quo economic policies that are essentially the Trump economic platform.

There’s a practical issue here that I don’t know the answer to. How quickly, if at all, can Biden undo the severe economic damage Trump has caused over the past four years? This has a bearing on how soon and how high interest rates will rise.

Boom and Bust: A Global History of Financial Bubbles is a recent book by two finance professors, William Quinn and John D. Turner, from Queens University in Belfast, published by Cambridge University Press. In it, the two give an interesting history of financial market bubbles over the past several centuries. For me, the most interesting part is the detail the book provides about bubble episodes from the 18th and 19th centuries, extracted from financial reporting in those times. Both seem to be observers of contemporary events rather than market participants, so their accounts of current-era bubbles doesn’t have the detail I might have wanted. That’s probably me being too picky, though, because this really is a useful book.

the bubble triangle

Quinn and Turner offer the idea of the bubble triangle as a framework for thinking about possible financial market bubbles. The three sides of the triangle are:

–marketability

–money/credit

–speculation.

the basic ideas

–bubbles occur during times of easy money,

–changes in marketability (the ease with which buying/selling can happen) can be like throwing gasoline on the fire, and

–the staple activity of the bubble is speculation, or transactions made not because of the intrinsic value of the trade, but with an eye to offloading at a profit to a “greater fool” in short order.

By far the most damaging financial bubbles are those in which the money/credit system become incapacitated, as in the 2007-09 financial crisis. My too-simple summary: back then, corrupt/incompetent bankers issued tons of mortgages to people who had no prayer of being able to repay and packaged them into toxic derivative instruments that they sold to one another. Ratings agencies rubber-stamped these deals–until one day the world woke up and realized that many of these institutions were likely bankrupt. International economic activity came to a dead stop, because no one trusted the banks to act as intermediaries any more. A scary mess.

today

marketability–several key developments that have increased marketability are: zero-commission trading, trading in fractional shares, app-based trading, and the emergence of Robinhood, which has gamified the stock market and made options trading exceptionally easy

money/credit–the deep economic and public health failings of the Trump administration have blown out the money supply and pushed interest rates in the US to effectively zero. Yes, the banks are solvent, but credit is exceptionally plentiful

speculation–look at Gamestop.

Looks like a bubble to me.

More tomorrow.

Historically, stock market returns around the world have averaged something like inflation + 6 percentage points annually. Bond markets, typically less risky, have returned inflation + 3 percentage points. Stocks tend to be much more of a roller-coaster ride than bonds, though, mostly because they’re driven much more strongly by the ups and downs of the business cycle than fixed income.

Given this role of thumb, the US equity returns over the past 12 months have been startlingly good:

ARK Genomics ETF +228%

ARK Innovation ETF +177%

NASDAQ +48%

Russell 2000 +30%

S&P 500 +17%

Dow Jones Industrials +7%.

(To underline the obvious: the Dow is loaded up with very mature companies and is not really relevant; the R2000, made up of US economy-linked, mid-cap stocks, has made all its gains–and then some–since Trump’s election defeat.)

The returns since 1/1/19 have been just as eye-popping:

ARKG +338%

ARKK +280%

NASDAQ +110%

R2000 +57%

S&P 500 +52%

DJI +32%.

As I see it, the two broad story lines behind this strong preference for secular growth names have been:

–the economic incompetence of the Trump administration, and

–Trump’s position that the pandemic is a hoax, and his resulting demonizing of any effort to halt its spread.

Trump is now out of office, his attempt at violent overthrow of the election results having failed. Biden has been inaugurated. So the clock is ticking down on these two drivers.

Perhaps just as important, the gigantic spread between winners and losers in the raw numbers themselves argues that a rotation away from today’s leaders must be on the way. And, of course, there are both institutional (e.g., SPACs) and individual (Robinhood) signs of speculative froth that typically signal a market top.

I’ve been taking the strength of the R2000 since the election as an important sign that this rotation is finally underway. Since January 6th, however, the R2000 has lost relative steam to NASDAQ. The main reason, I think, is that the market is learning that the pandemic is worse than feared and that Washington has done far less than advertised to combat it–both implying that interest rates will stay lower for longer. Republican politicians are also currently mulling over whether they’re in the party of Trump/Putin or of Lincoln–early signs seem to indicate they prefer the former. If so, this would likely mean no resumption of foreign direct investment here and a continuation of the slow repositioning of multinationals away from here, despite the large domestic market and the availability of skilled workers at reasonable cost.

As a citizen I find it frightening that the Senate may choose to let the Capitol coup attempt go unpunished. The US starts to look like fallen angels Boeing or Intel writ large. As an investor concerned with short-term market rotation, however, I think interest rates are much more important.

Tomorrow, a look at 1989 Japan (the closest analog I see to the US today) and 2000 US.

Good news and bad.

On the bad side, it seems like the Trump administration vaccination plan was more press announcements and less acquiring actual vaccine doses than expected. So vaccinating the population will take longer than we’d thought a week ago. Evidence is also coming to light that Trump’s efforts to illegally remain in office, first by falsifying the election results and then by attacking Congress, were much more extensive and carefully planned than I’d realized. He was abetted by Republican congresspeople and apparently supported financially by foreign governments. Around the world, it was very disturbing to see Republican legislators continue to press baseless claims of election fraud even after the assault on the Capitol. It’s hard to argue that Senators Cruz (Princeton/Harvard Law) and Hawley (Stanford/Yale Law), for example, don’t have the cognitive resources to understand the harm they were doing in pursuit of personal gain.

On the good side, the coup attempt failed, mostly, as I see it, due to the heroism of state-level Republican election officials who refused to yield to presidential cajoling/threats. From a purely investment point of view, the mess Trump left behind is bigger and uglier than the market had thought even a week ago. So ultra-low interest rates aren’t going away any time soon.

Random data points: about a quarter of the national work force has already stopped working at home and has returned to offices; vehicle traffic over the bridges and tunnels into New York City is back to 90% of its pre-pandemic level. Public transport within the city, however, hasn’t recovered much so far at all.

There’s been a lot of discussion recently about the possible relationship between the strength of penny stocks and the falloff in sports betting. I think there’s something to this, but I don’t know how much. At the same time, the failure of the money management establishment to even keep pace with the S&P 500 at a time when amateurs are raking in money calls into question whether the services of “old men in bow ties” is worth the 1% -3% of assets (or more) they charge. I have no idea how this all plays out, other than that we probably don’t go fully back to the status quo ante.