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...

How To Bake A Bubble

Bubbles are not random, chance events. They do not materialize out of thin air anymore than pizza bakes itself.  Bubbles are created to convince the gullible masses to suspend their disbelief, to participate and part with their money.to buy assets created, or previously accumulated, by the manipulators. As such,  they are a form of fraudulent wealth transfer from the many to the few. 

It takes just two ingredients to “bake” a bubble.

1. Lots of liquidity i.e. a pile of cash / easy, cheap credit. That’s mostly provided by the otherwise innocent monetary authorities, but not exclusively.
2. A "story" which captures the public’s  imagination and transforms cautious, rational individuals into a stampeding herd, a “crowd”. 

Are we in a bubble? Lets look at today’s ingredients:

1. Money has rained down from the “helicopter”. Governments have distributed trillions, borrowed  from their central banks. As of last week, the additional money created during 2020 by the Fed and ECB amounted to a combined $6.33 trillion, ballooning the banks' balance sheets by an unprecedented 66% (Chart 1).  And it's virtually "free", since interest rates are zero, or negative.
   

 

 Chart 1

 2.  Today’s main “story” is firmly connected to (1) above: The Fed and ECB will keep pumping money to support the economy and markets, no matter what. Obviously, it is circuitous logic at its very best: markets can’t go down because there is a lot of money, and there is a lot of money because markets can’t (are not permitted) go down.  

Ok, we have the ingredients and we have the oven (markets/social media).  So, who’s the pizza man? Who is responsible for the manipulation, the pumping up?  The short answer is... there are many.

 In the Credit Bubble of 2006-07 there were those who bought CMO and CDO squared and cubed by the billions, and then there were those who bought CDS on those self same bonds. Very frequently, and certainly not coincidentally, the most laudatory bond sellers/financial engineers were also the buyers of the underlying CDS. Meaning, they knew they were selling junk.

So, in today’s environment it is best to ask the Roman jurist’s question: cui bono, who profits - who really profits - from the insane goings on? The answer is pretty obvious, once you know where to look...

Innovation And Bubbles

 I just came across a very interesting scholarly paper from the Yale International Center For Finance. It examines London's infamous 1720 South Seas Bubble, which saw share prices in shipping, trading, insurance and finance companies rise as much as 800% in a matter of weeks, only to collapse within days. Chart 1 below is from the above mentioned paper.

Chart 1

At the very top, the public's gullibility and folly had reached such heights that money was raised, and I quote, “For an undertaking of great advantage, but nobody to know what it is”. This quote may, in fact, be apocryphal, but it accurately reflects what was going on in that crazy time.

Yet, as you may read in the Yale paper, there was a “story” to the South Seas speculative frenzy, an otherwise rational driving force of innovation, new horizons and prospects for highly profitable trading ventures.  Innovation was then - and still is - a major factor in initially capturing the interest of informed investors.  What happens next, however, is crucial: if this interest expands to involve traders, speculators and the wider public, it can become a frenzy resulting in a bubble.

Chart 2, also from the paper, shows the massive overvaluation of  shares in “innovation”  New World companies vs. more traditional Old Economy ones.

Chart 2

Investing in innovation is, by definition, more novel and intellectually challenging than the established “old economy”.  It is best understood, at a rational, scientific level, by “intelligent” investors who can evaluate the business dispassionately.  However.... scientists are rarely, if ever, conversant with the  “animal spirits” part of markets and can very easily get blindsided by them. Case in point, the genius Sir Isaac Newton speculated and was bankrupted by the South Seas bubble.

Sir Isaac Newton, South Seas Bubble Victim

Innovation, in the form of a “story” which captures the public’s imagination, has been present at every bubble and subsequent crash: the Panic of 1901 (railroads), the Crash of 1929 (radio, aviation), the crash of 1987 (LBOs, junk bonds), the dotcom collapse in 2000, the crash of 2008 (subprime lending, credit derivatives, financial engineering).

Are we in for a repeat today?  You be the judge: Chart 3 is a comparison in share price performance between "innovative" Tesla and "old economy" Toyota Motor, the world's largest automotive manufacturer.  In just 12 months, Tesla soared 900% versus Toyota's 0%.  Tesla now has a market cap of $752 billion and Toyota $195 billion. Annual revenues: $32 billion and $280 billion, respectively.

 Chart 3

Now, I'm not even remotely suggesting anything other than using those two companies as examples - and nothing else.  As always, please don't take this as advice, prediction - or even suggestion - for the individual companies and their stocks.  

If you want investment advice here are my two cents' worth: please consult a professional, NOT chatrooms, social media, influencers and the like. Or blogs.

The Devil Is In The Details, GameStop Edition

 The GameStop short squeeze (pump and dump, bull raid, call it whatever) is headline news so...

1. When such arcane stories become headlines in the popular press, beware. It means the bubble is very popular and overinflated (aka who’s left to buy?).
2. Such operations may seem novel, given the Internet and social media angles, but they are as old as the hills, including the “social media” angle. During the late 19th and early 20th century bull raids were routinely and intentionally leaked in newspapers and tip sheets in order to capture the greedy small fry speculators and thus complete the “pump and dump” cycle. Read all about it (and lots more) in Reminiscences Of A Stock Operator, originally published in 1925.
3. When stocks become so wildly volatile within such a short time (Chart 1) brokers and clearing companies (essentially DTCC) have to protect themselves against the very real and highly increased  probability of “fails”, ie failure of a customer to pay for his purchase or to deliver the stock on settlement date T+5) (he has 5 business days from trade date). It’s not rare for a retail customer to renege if he has bought a stock at, say, $400 and two hours later it’s at $150 or vice versa, to deliver the stock. So, clearers will ask for additional intraday collateral from brokers who will then have to come up with the money immediately. This, in turn, means the broker will have to either (a) ask their individual customers for immediate cash (ain’t gonna happen, ever) or, (b) tap into their own cash and/or bank credit lines. In the case of the recent nonsense, we’re talking tens of billions, not chump change.
4. Following along, will banks be happy to lend this extra margin money to the brokers? Trust me, they will not - the risk is just way too big that the money will evaporate into thin air. They may do it once to maintain their customer relationship (the broker), but they will do it under duress and only if provided with separate, high quality collateral.  And if it happens again, all bets are off: the margin “window” will close firmly shut, or the cost will be so high that it will be ruinous to borrow. This is exactly what happened in October 1929, by the way.
5. Next step is to raise cash by selling out the customers’ stocks, which pushes down prices further, creating more margin calls, etc. Rinse, repeat.
6. Customers accounts go into deep, unsecured debits which they cannot possibly or desire to meet, which means the brokers themselves are on the hook, and so they fail too.
7. Dominos start crashing fast.  If one or two banks were stupid enough to keep lending margin money, they, too, will get swept into the hole. They will sell collateral to protect their margin loans... further dominos fall.
8. The Fed will certainly step in to protect the banks by opening up the repo window wide, but that doesn’t mean the money will trickle down to the brokers. Quite the opposite, in fact: the banks will hoard whatever liquidity they get and will only lend against Treasury (or equivalent) collateral.
9. We’ve seen it all before, and it always ends up the same way. Crash. 
10. There’s nothing new under the sun.
11. Addendum: the dominos are falling, huge margin requirements result in trade restrictions.

Chart 1

Is The US Headed For A Debt Trap?

A debt trap is a situation where a country’s excessive debt load creates a vicious economic cycle of very low or negative credit expansion, high real interest rates and very weak growth or prolonged recession.  The cycle feeds upon itself, becoming self-perpetuating until something radical happens to break it (eg bankruptcy).

We have seen a recent full-cycle example in Greece, bankruptcy included. Italy is a mess and France is not  very far behind.  If it wasn’t for the ECBs massive QE operations the very existence of the euro would be in serious question. Another example is Japan, which went through 30 years of economic stagnation after its debt/bank/real estate/stock market  bubble burst in 1989. Iceland, Ireland, Portugal, Spain and Cyprus also come to mind.

Still, none of the above were/are issuers of the world’s reserve currency, therefore the negative impact on the global economy was/is manageable, if not downright negligible (certainly so in the case of Greece).

However, as US debt soars to unprecedented highs we now need to seriously consider the possibility that America could fall into a debt trap. The probability (P)  of it happening may be relatively small right now (although higher than ever), but the negative consequences (C) of such a development are enormous.  

So, we really need to pay attention to the equation:  R = P x C 

 where R is the consequences-weighted risk of a US debt trap.

 It’s a bit like the risk inherent in huge earthquakes - they don’t happen too often, but when they do they are truly catastrophic; so, it is prudent to take necessary measures well in advance. 

Let’s examine the US debt situation.

First up, the annual cost of debt service (interest alone) on all US government public debt as a percentage of GDP has increased substantially from 1.25% in 2015 to 1.75% in 2019 (Chart 1). During 2020, sharply lower interest rates were offset by higher debt and lower GDP numbers, so the debt service  jumped further to around 2.50% of GDP, the highest since 1998.  Note, however, that interest rates were much higher back then; for example, 6 month Tbills were around 4.50%.

Chart 1

Chart 2 shows the interest expense of the US government as a percentage of GDP (Y axis) for various average interest rates (X axis).  It assumes $30 trillion in debt and GDP of $21.5 trillion

Chart 2

What is more interesting, however, is interest expense as a percentage of total government revenue. Assuming the same revenue as in pre-COVID 2019 ($3.5 trillion), we get Chart 3.

Chart 3

Currently, even with near zero interest rates for Tbills, the US has to pay around 15% of its total revenue in annual interest.  Since the government is running a deficit, this expense is not actually “paid” - it’s just added to the debt load in the form of issuing more bills and bonds.

It is quite obvious that even a small increase in interest rates back to more “normal” levels, will rapidly escalate the annual debt service cost and create a dreaded vicious cycle leading to unthinkable insolvency - if revenues don’t increase, that is.

Therefore, it is clear that the US government needs to raise revenues significantly and must do so immediately.  Fortunately, corporate and wealthy individual income tax rates are near all time lows and could be raised significantly.  Other taxes should also provide additional revenue: increased capital gains and wealth taxes can be instituted with immediate effect, particularly with financial assets now at record high level.  The wealth gap is so wide now (see previous posts) that targeted tax increases will be very popular with the vast majority of tax payers (for once, “sock the rich” will not be just political hot air - it will also raise substantial revenue).

Back to the R formula: the probability P of a US debt trap is rising fast, as can be seen from Charts 1-3 and the consequences C are pretty easy to imagine (very large).  Therefore, risk R is also growing fast and must be reduced immediately. 

 Raise taxes, period.

Very Sudden Debt

There was never a time when the title Sudden Debt was more apt than right now. Federal debt has exploded to 130% of GDP (Fig. 1) , and when Mr. Biden’s new $2 trillion program is added it will jump to 140%.  Such a debt burden may be acceptable for countries like Italy and Greece, or even Japan, but certainly not for the country claiming to be the Leader Of The Free World and issuer of the global reserve currency.

Figure 1

Talking heads are trying to underplay the (sudden) debt, claiming that what really matters is the annual cost of debt service, currently manageable because of near zero interest rates.  Indeed, the average interest rate on all government debt is now 1.7%, down from 2.4% last year (Figure 2).

However, notice that this happened almost entirely because short term (up to 12 months) T-Bill rates have come down to near zero (red arrow above).  Outstanding marketable US debt is, in fact, very short term with its average maturity now down to 62 months or perhaps even less (Fig. 3).

Figure 3 

That’s because T-Bills and Notes up to 2 years make up $16 trillion of the total $28 trillion debt. Another $6.5 trillion are special issue bonds held by the Social Security trust fund. They are, indeed, very special issues: they pay interest at the average of all Treasurys with maturities over 4 years, but they are redeemable at any time at face value. So, in fact, their maturity is zero (Fig. 4).

Figure 4 

Doing just a bit of math we see that the real average maturity of the entire US debt is around 48 months as of 12/31/20. In other words, it’s very short term and thus very susceptible to refinancing risk. In 2019 the government’s interest expense was ca. 1.8% of GDP or 15% of all government revenue. As things stand today these figures are likely significantly higher and slated to rise even further due to Mr. Biden’s  additional $2 trillion debt package.

The Treasury is not financing all this additional debt by selling bonds (well, bills mostly) in the open market, of course.  They are purchased (or repoed) almost entirely by the Fed which thus prints 100% deficit money to be dumped by the proverbial helicopter onto the US public.  The Fed’s balance sheet has ballooned from $4 trillion to $7.5 trillion in less than one year and will go to nearly $10 trillion soon, when Mr. Biden’s $2 trillion are added (Fig. 5).

In case you are wondering, that’s the country’s central bank holding debt equal to almost 50% of GDP.  Is it sound banking to lend so much to ONE borrower?  Obviously, the Fed’s supposed independence has now gone completely out the window. 

Which further begs the question: if the Fed is lender of last resort, savior of the financial system when it crashes... who will save the Fed? 

Figure 5 

Make no mistake: this has never, ever happened in the US before, not even during WWII which was financed with war loans, bonds and stamps sold to the public.

Bottom line: if the US economy does not come roaring back within just a few months, all of this huge deficit spending will raise serious questions about the country’s ability to continue meeting its debt obligations in an orderly fashion.  The dollar will weaken, interest rates will go up and the vicious cycle very familiar to over-indebted countries shall take hold in the US.   End of Empire.

Unthinkable? I think not.

It's A Volat(oil) World - Tail Events

I touched on tail events on the previous post and how they can precipitate entirely unforeseen consequences.  Let’s look at this in more detail.

First, a recent example.

Last April WTI crude oil front month futures traded at an unprecedented -$35 per barrel, ie. sellers had to pay buyers (Fig. 1).  The  sudden collapse in demand due to COVID lockdowns created a physical oil glut which filled all available storage tanks at the authorized delivery locations. No one wanted to take delivery of oil, at any price, simply because there was nowhere to store it.  

No one ever imagined negative oil prices, but they happened and  that’s the very definition of a “black swan” or, in more mathematical terms, a “tail” event (ie at the tail end of a probability curve).

Figure 1

Switch to today. As financial markets soar to ever higher highs they predict an ever rosier future for the US economy, and the risk/reward balance overextends heavily towards risk (Figure 2).  It is therefore more probable that a “normal” negative event will produce a proportionately bigger drop than otherwise, something like a reversal to mean, while a totally unexpected “tail” event may have entirely unexpected consequences, something analogous to negative oil prices.

Figure 2

Let’s let our imagination run wild..

What’s the most unthinkable scenario for stocks if a true tail event happens?  Well, I can’t see how negative stock prices could occur, but... how about zero?  Or thereabouts? What if no one wanted to part with cash all of a sudden, no matter how attractive the offered price?  What if margin money disappeared, or became so expensive as to be practically unavailable? 

What if some or many CFD counterparties could not honor their contractual commitments and failed, creating a domino effect? CFDs work on razor thin margins and the brokers as a matter of standard routine immediately close out losing client positions once the margin money put up as collateral evaporates.

Imagine a day that opens with a gap down of 10%, creating a tsunami of automatic closing out sell orders which avalanche through the system. Will “real money” institutional investors step in? No way, they’re not stupid to catch a falling knife and, anyhow, they already know this is a bubble. Margin calls to cover the excess losses will be automatically executed since these days trading accounts are linked to speculators’ bank or credit card accounts. Remember, with margins as low as 2%, a 10% move generates losses 50 times greater, ie 500%. If XYZ stock is down $10 the loss on the account will be $500.

What could lenders do? Well, exactly what they did in October 1929: quickly shut down the margin lending window, creating even more selling pressure to raise needed liquidity. Even if most brokers run a square book, even a few counter-party failures will quickly spread and force everyone to hoard cash. Ergo, no buyers at any (reasonable) price.

But that’s what the Fed is there for, right? Lender of last resort and all that jazz? Ok, but lender to who? Joe Bloe plunger from London? Or Stavro Bloefeld credit manager of the AlphaBet CFD platform in Cyprus? Oh, maybe their prime brokers will act as intermediaries? Yeah, right, like they won’t  remember what happened to Lehman and many more back in 2007-08.  Remember, it was not the Fed who saved the likes of AIG, Citi, Merrill, et al.  It was the Treasury Secretary who blackmailed financial industry leaders into saving their failing brethren by threatening a complete government takeover.  (Paulson could do it because he was the ex CEO of Goldman and knew exactly how to do it, he was one of them and could stare them down.  You think Janet Yellen could do it? Not in your, or her, dreams.)

From my own experience I tell you that when panic rages it’s every man for himself. You sell first and ask questions later. I was there in October 1987 when credit managers were going around from desk to desk screaming at brokers “your customer has 30 minutes to bring in a check/wire or I’m selling him out”.  With e-banking, today that 30 minute window is now more likely 30 seconds. And 1987 may be considered a hiccup today, but it was a bigger single day drop than even Black Monday in 1929.

Index tracker funds are very likely another potential accelerator, particularly “short” ones that promise 2 and 3X performance.  I won’t go into detail, but you can see how they would be forced to sell into a down market.

Now, compound all of the above with algo and flash trading which make up as much as 80% of daily volume, creating a false sense of market depth and breadth. Such systems have “circuit breakers” which will shut them down immediately.  This leaves only “real money” traditional investors, people exactly like Buffett, Munger, Dalit, Grantham, et al.  Most all of them are already on record saying we are in a bubble, so they won’t buy until the blood flows...

In summary: this is a very thin and very narrow market masquerading as a real, structural bull market. It is highly susceptible to some kind of black swan event which will produce very, very high volatility.

What could that tail event be? I have no idea.  By its very definition, a black swan is an unknown-unknown.  But we know they exist, even though the market is behaving as if they don’t...

ETFs CFDs Bucket Shops and 1929

The worldwide number of Exchange Traded Funds (ETFs) has soared 20-fold since 2003 and their assets in the US alone has increased even more by 30 times to $4.4 trillion.  Keep in mind that these are 2019 numbers, so they are certainly higher today.

Take a guess what was the most popular retail product for “investors” in the years leading up to the Great Crash of 1929? Yessiree Bob, exchange traded funds - they called them Trusts back then.  And guess what?, just like today they made speculating on margin even more leveraged than regulations allowed. Trusts leveraged their portfolios and then the buyer could again margin the Trust shares on his own account.  So, with margin set at 50% (2x leverage) the investor could ramp his leverage up to 4x  (Some erroneously believe that margin requirements were as low as 10%  and that’s what accelerated the crash, but that’s not so. Margin for stocks was at 50% back then, just as it is now).

Now we have 2X and 3X S&P 500 or NASDAQ 100 index tracker ETFs that go up (and of course down)  double and triple as much as the underlying index. Put that baby on 50% margin and... guess what? Your effective leverage is 6X. If you’re not worried about what that means in a sudden market break...you should be. I mean... seriously, we’re talking trillions of dollars here and those products are 100% retail.

Next subject is Contracts For Difference (CFDs).  You (but not if you’re in the US) can go into your favorite electronic trading platform and buy a CFD on just about any stock or index They are NOT stocks themselves, they are agreements between you and the broker that they will credit/debit your account with the difference between the stock prices shown on the regular exchange at the time of sale and purchase, respectively.  I say it again, you are not investing, you are merely punting on a move, up or down. And again, guess what? Because CFDs are not securities they are not bound by margin regulations and, in fact, are typically margined as low as 2%, ie you leverage 50 times. Yes, fifty.

Ever heard of bucket shops? That’s exactly what they did back in the 1920s. Only thing is, they posed as legitimate stockbrokers because such CFDs were illegal and they often got raided by the police.  But today... OMG they’re legit!! Outside the US, anyway. 

So, dear reader, and particularly if you are an old reader, we’re back to the lunatic alphabet soup era. Back in 2007-08 it was subprimes, bonds, tranches and credit derivatives ABS, CMO, CDS, CDO, etc etc. Today, it’s stocks, funds, ETFs, CFDs and huge leverage.

There’s nothing new under the Sun.  Loonie valuations for “new technologies”(it was radio in the 1920s), lots and lots of small speculators, easy money, high leverage - it all looks awfully similar to 1929. Oh, and just like in 1929 there’s an unshakable, almost religious belief that the market can’t go down because...of a “permanent high plateau” in the economy (1929) or that the Fed will keep pumping liquidity and support markets,  no matter what (today). Remember the 2006-07 meme? Mortgages just don’t default, not above a very small percentage? Right-o and away we go... 

Scared yet?  I think we should all be... because a black swan, aka tail event can - and always does - appear out of nowhere. More on that tomorrow... 

Smoke And Mirrors, Literally

 RLX Technologies, a Chinese vaping company just did an IPO to raise $1.4 billion. That’s a lot of money for smoke, but that’s not all: it listed on the NYSE and on the first day of trading its shares jumped 133% from $12 to $28 giving RLX a market cap of $44 billion.  That’s 1,900 times annual earnings... for smoke...to be clear: that’s one thousand nine hundred times. Oh, and a mere 97 times revenue.

Does every man, woman and child on Earth vape?? I guess they must!!

You know, Tulipmania was sane by this measure...