Making Sense of Nonsense

Robert Swift, Delft Partners

February 2021

If something is too hard or whacky then there is a tendency to ignore it and hope it goes away. The recent bizarre price moves in GameStop and AMC and other 'marginally solvent' companies is just such a case in point. However, 'hope' is not a strategy and it can pay to rummage in the information cellar where you might find something useful / or learn a lesson? So we'll have a stab at making sense of what looks like nonsense. We might come to a useful conclusion?

Briefly what has happened is that certain financially and strategically challenged companies have seen their share prices rise suddenly and dramatically to levels way beyond rational. (Isn't the whole market irrationally priced? Ed.) This has caused large losses by funds which had short positions in these companies.

It is not unusual for short positions to go wrong. We have run hedge funds and can testify that while we were careful to hedge our shorts with longs as best we could using risk models and a great deal of pragmatism and modesty, we still occasionally got 'whacked' by a short going against us with a wild and what seemed like unexplainable lurch upwards.   

Three aspects strike us as being noteworthy here in this recent spate of irrationality.

1. Short positions are potentially unlimited in their loss making. Consequently short positions should be hedged by long positions in risk equivalent factors, and constantly trimmed or fed. As we observe them, in many 'hedge' funds, there is no hedge; nor is position sizing as a % of client capital prudent.

For what it's worth we had more but smaller positions on the short side because they tended to be more volatile and more correlated. Additionally we shied away from remaining short a very small market capitalisation because bankruptcy meant that we couldn't buy back our short position since trading tended to get suspended, and that at that point the specialists in business reconstruction got involved and would know more than we did. Remember that at one point GameStop was trading at about $3 and as such had a market capitalisation of about $200m. What was the point of being short that if the market cap was shouting 'imminent bankruptcy'?

We don't know enough about the hedge funds that got whacked but guess that a loss of that magnitude meant a pretty large $ position as a % of client capital and trying to pick up pennies in front of the steam roller- when suddenly the steam roller sped up.

This stuff is so self-evident we will write no more on this.

MUCH more interesting is the fact that:

2. The short positions were very heavily advertised &
3. The buyers were also working to advertise their actions to the market

So we think the broader issue here is 'market manipulation' - on both sides of the ledger. It has been represented as "nasty evil hedge funds" aka the establishment vs brave individuals working together to earn a crust. Yet aren't both sides aiming to profit as 'consenting adults' with loud voices in a liquid market which has been increasingly heavily regulated and supervised?

Has the pursuit of profit entailed market manipulation (which is illegal) and if so, how is this alleged manipulation by the buyers of GameStop so different from what routinely happens?

Movies have been made - Boiler Room's pump & dump, Wolf of Wall Street, for example - about market manipulation and fraud. Research companies routinely make pronouncements about how company X is using fraudulent accounting and that they expect bankruptcy - all the while with a short position or being paid for their research by funds with a short position.

If investors work the other side 'in concert' to drive up a company's share price in the knowledge that short covering will kick in, is this not the same?

So which bit if either, is illegal? Which bit is just "business"?

Additionally one may argue that if I'm the CEO and I make some comments in an analyst call, abiding by Reg FD, I can move the stock. If I benefit from that too obviously, I go to jail. But if I buy back the company's stock it has the same effect. That's not illegal. Although I still benefit.

There are however rules on buy backs but not on short selling research, nor on trading to squeeze the shorts. The difference here then perhaps is that it is NOT the company which is disseminating the news but market participants trading against each other. So we have to ask whether this is to be discouraged by more regulation on the basis that it is damaging to the economy or dangerous for individuals who need to be prevented from self-harm.

We hope not. We are (naïvely?) convinced that stock market prices contain information; when 1 stock goes up, we think that is because fundamentals have improved, or the company's outlook has or something macro has changed that affects the company. Aside from GameStop, we've seen Softbank allegedly deliberately manipulate the market very recently. If you believe fundamentals will reassert themselves then you use this irrationality as part of your process. Run-ups in stocks trigger momentum models which should be part of any risk model menu. Serial correlation leads to understatement of volatility and portfolio managers assuming too much risk complacently. So portfolio managers should incorporate the risks in price momentum and serial correlation in their portfolio construction.

For the retail crowd, this just calls into question the wisdom of following ponderings spilled daily by people like Jim Cramer about XYZ stock being up 20% or biggest gains/losses of the day. If there's no information content/price discovery in the stock market and price moves can be ruinous, that should force us all back to fundamentals, which then becomes an opportunity to talk about how out of date our accounting statements are versus modern business and the difficulty of pricing intangibles. We recall in the mad Asian frenzy of the early 1990's how stock splits would cause a frenzied buying on the KL exchange by retail investors because "you got more shares for your Ringgit" as was explained to us. We also saw this behaviour in China almost two decades ago when the market was dominated by retail traders chasing news. To the best of our knowledge the Chinese did not change much at all but let losses fall where they did. The US should be capable of letting this outcome befall all investors - retail and professional.

Funnily enough we professionals DO already live with and utilise a lot of irrationality such as the January effect, price momentum as a strategy, and the so called Santa Claus effect. We actually rely on it since our investing strategies incorporate other people's irrationality! So simply put we should seek more news flow since news flow reduces information hoarding.  

Our conclusion in this specific US example is this. If you can't bear losses, don't play - either as a retail investor or as a professional. Retail may be sneered at as 'stupid' (unorthodox) but they too have a right to play?

It's more worrying to us that this strange turn of events is symptomatic of a broader malaise? This behaviour is symptomatic of a late stage capital markets circus with a belief in perpetually free money and a free get out of jail/trouble card always at hand. There's plenty of froth around, as evidenced by the listing of over 272 SPAC (Special Purpose Acquisition Companies) which have raised US$88 billion since August 2018... of which 193 with $63 billion are still searching for a target... and with 219 raising US$73 billion in 2020 alone. 1929 anyone?

Fake news and 'crowd think' isn't confined to "Freddy Starr ate my Hamster" nor that "Elvis Presley is living on the moon" but now permeates the stock market too and continually fed by poor monetary policy.

It is absolutely crucial that we prevent moral hazard permeating more deeply into the financial system. It's not more regulation we need here, it's "more consequences" and an acceptance that there should be no free put option.

We'll finish with a quotation from JM Keynes writing in the 1930's after the crash. It's not Reddit nor GameStop nor AMC we should be blaming, but what has led us to this systemic speculation?

"Speculators may do no harm as bubbles on a steady stream of enterprise," he wrote. "But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."

If you want more thoughtful pieces on the rigged casino that has been created by years of policy ineptitude, then we can happily supply you with William White's latest thoughts.