GameStop - Look At The Forest, Not The Tree

The biggest, most dangerous mistake government regulators, Fed officials and market representatives can make right now is to write off the GameStop/Reddit/RobinHood "revolt" as a one-off event involving a "loonie" fringe, perhaps some criminal pump-and-dump operators, plus a limited number of the public who were after a quick buck. They should not merely welcome the rapid crash in prices, and sigh in relief as the "unwashed" hoi polloi get their just deserts (Chart 1).

The extreme volatility of those few stocks, or even silver, is not a transient, black swan phenomenon.  It is not a lone, unhealthy tree crashing down in an otherwise healthy forest.  Instead, it's the forest that is in deep trouble, and the sudden extreme volatility is a warning symptom.

 

 Chart 1

To begin with, the market has grown enormously in size in relation to the economy (Chart 2) - one could say it has become the economy itself, or at least an all-encompassing false proxy for its health.  Donald Trump constantly pointed to the stockmarket's rise as proof positive of his success in governing, though nothing was further from the truth.

 

 Chart 2

The current "meme" is that the market cannot possibly be wrong since it is an efficient discounting mechanism where millions of individuals come together to shape an infallible consensus. That could possibly be true, but only if the market was truly efficient, i.e. broad, deep, independent and stable.

1. How "broad" is the market? Right now, just one entity - Citadel - executes 22% of all US equity volume and 39% of all listed retail volume. It may be very well capitalized and savvy, but its commanding place at the very heart of the market makes it, by definition, too big to fail. A handful of other players complete the picture of a narrow market.
   
2. How "deep" is the market? Nasdaq estimates that 50% of all volume is driven by high frequency, algorithmic machine trading, also known as "flash" trading. Volume may have soared in recent years, but that doesn't mean there are more independent, real money investors out there, ready and willing to commit additional capital when prices correct.  Flash trades depend on microsecond executions to capture minuscule price variations in millions of orders, and it wouldn't matter if the exchange traded socks instead of stocks - it’s all about trade flow. The market is as thin as a microsecond is long.
   
3. How "independent" is the market?  That's best answered by another question: how dependent is the market right now on the oceans of liquidity provided by the Treasury and Fed, on its corporate bond purchases and zero interest rates?  What would happen if those actions were reduced, never mind stopped or - gasp - reversed?  The market is entirely dependent on the government and the Fed.
4.  How "stable" is the market? Flipping the question around, how "volatile" is it?  Looking at a 20 year chart of VIX (CBOE Volatility Index), we see that its 3 month moving average has crossed over its 12 month moving average 11 times in the last 10 years (black arrows).  In the 10 years before that, it had crossed only 5 times (blue arrows) - (Chart 3).  More troubling, the market is even more volatile in the last 5-6 years - the market is increasingly unstable.
   

 

 Chart 3

In sum, the market is narrow, thin, hooked on the government's "free" credit and increasingly volatile. 

This is not your daddy's stockmarket.  It is not Warren Buffet's and Charlie Munger's market of solid, fundamental value or growth investing.  Instead, it's a Brave New World of microsecond scalping, ruled by machines running algorithms, where physical proximity to the NYSE execution servers is much more important than proximity to the company's management.   

As the GameStop snafu has so clearly proved, today’s market is capable of wreaking havoc;  it is a menace to itself and, very unfortunately, possibly the entire economy.  It presents a clear and present danger, one that must be understood and dealt with in systemic terms, not in an ad hoc piecemeal fashion.

More tomorrow...