I can probably write five or more posts on last week’s market activity, but I’m going to try to consolidate it into one long post (about twice a normal effort) without it becoming a novel and do short(ish) comments on a long list of topics. Some of these topics I may come back to later and write more on separately.

Maybe the best way to start is to lay out the major topic areas below as a table of contents? These are what I consider the major issues coming out of last week’s market activity:

  1. Did Reddit users act legally? Was this a pump & dump?
  2. Should social media and investing mix?
  3. Should novice investors be allowed to trade options?
  4. Should there be limits on short selling and what is its future?
  5. Should there be limits on trading by social media platforms?
  6. How will the hedge fund business model change?
  7. Why did brokerages need to restrict trading? Will Robinhood survive?
  8. What is the near term risk of a systemic market failure?
  9. What role did cheap leverage play in events?
  10. Did the Fed create the conditions for speculative trading?
  11. Are we in a bubble?
  12. The plumber is asking me what stocks to buy. What should I tell him?

Was this a Pump & Dump?

A: Conceptually yes, but legally it will be hard to prove.

This is one of those that could be a post of its own. If I called all my friends and said “let’s buy a bunch of stock in a crowded short, then tell everyone we know what we’re doing, get some media attention to bring dumb money along, and not bother to file with the SEC about our co-ordinated holdings”, I would be in jail right now!

While the WallStreetBets (WSB) crowd claim they didn’t act in concert, there was enough awareness about the resemblance to a pump & dump scheme that moderators would warn people not to use those terms.

Unfortunately, the SEC doesn’t work like Harry Potter where not saying “V****mort” out loud let’s you insinuate it. If there is concrete evidence in the archives of people colluding, they will be charged.

Now they may not find that, at least in a conclusive way. However, that doesn’t mean this wasn’t a pump & dump operation. The sneaky thing about organizing through a large platform like WSB is there isn’t one ringleader organizing the scheme.

Rather, it acts through peer pressure and creates a swarm like intelligence. If enough worker bees shout “never sell” and “to the moon” and decry evil hedge fund managers, then the rest of the hive will read the room and realize that, to gain acceptance, they have to adopt the norms of the hive.

Thus, nobody has to tell the “noobs” how the pump works. They will intuitively figure it out and go along or, if that fails, be shouted into submission. It’s a little bit like the Mafia boss who never tells his underlings who he wants whacked, but they all can figure it out so his hands are clean.

Should social media be used for investing?

A: No, because social media adds no value to the world.

I could do another whole post on how social media has caused the polarization in society, but that’s not germane to today’s topic. Sticking to the topic at hand, why do we want to turn investing into a forum of who shouts the loudest or spreads the most mistruths?

Do we really want investing conspiracy theories or people only to be able to see investment ideas from people they already agree with?

The combination of anonymity, polarization, and most extreme view wins leads to things like valuing a dying company at $25B. That is not a good allocation of capital.

It leads to death threats against “enemies” like Andrew Left of Citron or Stevie Cohen at Point 72. It leads to celebrating the demise of successful investment firms like Melvin.

(Note: there is nothing wrong with a hedge fund failing for making bad investment decisions. There is something wrong with trying to intentionally put someone out of business for sport.)

The events of this last week are the equivalent of financial terrorism. It is the same psychology that led people to convince themselves they should attack the Capitol or others to go on boards where they egg people on to mass shootings and try to “score” the most kills.

It is a lot better to lose money than life, so I’m not equivocating the two, but it is the same emotional and psychological response driving the misguided thrill seeking behavior.

I’m certainly not saying everyone on WSB is unhinged, but some of them are and the group needs to take responsibility for their collective actions in the same way trading firms need to prevent rogue traders.

Should novices trade options?

A: No, of course not. Should I be administering covid vaccines? Should you be piloting an airplane?

There’s this idea that “democratizing” investing is good. Is it? Most of us have seen the studies of how retails buys the top and sells the bottom. Why do we want to encourage more of this?

And that’s typically with mutual funds! If buying a mutual fund is playing solitaire, then buying options is $1000 a hand poker.

The math behind option pricing is extremely complex. Most finance professionals don’t understand it. I have a math degree, an MBA, and took some PhD level finance classes, yet I rarely traded options. Why?

Because if you don’t know who the sucker is at the table, then it’s probably you. I realized as an individual, even though I understood the math, I didn’t have the resources to compete with large trading desks who had infinitely more resources to price that option correctly.

The idea that my kid should be trading far out of the money calls for fun is ridiculous. It is stealing money from the gullible. Just because it works once in awhile, doesn’t mean that it is NPV positive. Don’t confuse outcome with process!

Should we limit short selling?

A: No, because it will backfire, but don’t worry it will decline on its own.

Let’s do a thought experiment. Assume we effectively ban naked short selling, so only 99% of a stock can be shorted. Wait, you want to go further and say only 50% can be shorted? Fine, it doesn’t change the lesson.

What will happen when 40% of the stock is short? Others will see that, recognize there is only 10% capacity left, and rush in to grab it while they can. This increased demand will drive up the cost of borrowing which, oh by the way, happens to be one of the catalysts for a short squeeze.

But guess what else happens? If I see a squeeze start, will I cover like normal? Hmm, maybe not! Why? Because someone else will step in to replace me and I’ll never get my short position back because it’s at the 50%.

So now you are forcing shorts to really be stubborn and fight for dear life which will make squeezes that much more painful and further destabilize the system.

I’m not saying shorting more than 100% of the outstanding is a good idea. However, “banning” it creates its own problems and we should consider those before doing something shortsighted.

As to why I don’t think it will be a problem in the future? More on this below, but hedge funds will be more cognizant of this risk and will be more gun shy.

Should WSB trading be regulated?

A: Yes, they should have to follow the same regulations as other investors.

So what’s the difference between a hedge fund and WSB? Hedge funds have rules they have to follow about insider trading, co-ordination, holdings disclosures, etc.

None of these apply to the swarm at WSB! They are essentially acting as their own hedge fund. Therefore, they should be regulated as such.

No more hiding behind user names. When you sign up for WSB, you should have to provide your real name and investment holdings to some sort of clearinghouse where they can be monitored.

This would mean if WSB owns >5% of GameStop, it needs to file with the SEC. It also would help expose if any of the promoters are actually professional investors trying to manipulate their own positions anonymously.

How will hedge funds change?

A: Materially and many will likely decide to close the doors.

This is another one that may be a full post down the road, but one of the secrets to most successful hedge funds is that their return comes primarily from leverage. They take say a 3% gross return and leverage it to 15%. Thus, 80% of the return is leverage.

This depends on the benevolence of prime brokers (more on them below) allowing them to borrow at favorable terms. If prime brokers decide that the tail risk in the business is greater, they will not offer as much capacity to hedge funds.

If they even cut back from 5X to 4X, that’s 20% of the fund’s return and the asset class becomes less appealing to investors.

But that’s not all. Hedge funds once again learned their risk models don’t account well for tail events (because they model off of recent history, not all possible outcomes).

If the risk from short squeezes has been amplified, then individual managers will have to run smaller portfolios or own less volatile stocks (with less squeeze risk, but also lower return potential). They also will have a harder time finding shorts to fund their longs.

This means that 3% unlevered returned might shrink to 2%. This combined with the reduced leverage shrinks expected returns to single digits.

Why did brokerages really restrict trading?

A: They were worried about going bankrupt.

No, it’s not some evil effort by investment banks to screw over WSB. See, when you allow people to trade on margin, that requires capital. If you allow too many people to do it at the same time (or if market volatility explodes), you don’t have enough capital and you have to close the doors.

That’s what Robinhood was facing. That’s why they raised $1B overnight and drew down their credit lines. They had a near death experience…and they’re not necessarily out of the woods yet.

Think of them like an MGA that ignored underwriting standards because they assumed their reinsurers would always be there for them. Basically, their own customers pushed them to the edge of the cliff by taking advantage of the features Robinhood stupidly provided them.

Don’t let naive investors buy way out of the money calls they can’t fund and you won’t have to worry about how to clear the trades later. Their clients want everything for free with no consequences…unlimited trading capacity with no risk of a capital call.

That’s not possible. For them to now be mad that Robinhood took some of it away shows how uninformed they are. To be clear, that’s Robinhood’s fault, not the customer’s. The whole gamification and seduce people with pretty colors while hiding all the warning signs off stage is what led to this.

So Robinhood deserves for its customers to be mad at them, but not for the reasons they think.

Should I be worried about systemic risk?

A: Yes, most definitely.

Robinhood almost caused a market failure. Truth be told, they are so lucky they didn’t get their IPO done already. If this thing were public, the stock would be down 80% and nobody would have provided the rescue funding.

Think about that. Nobody is discussing it, but if Robinhood were already public, they’d likely be dying and the market would be praying someone would come along and bail them out.

Where else? Let’s go back to hedge funds. What prevents an LTCM event? Nothing. Melvin almost had a mini one, but there are plenty of others who might need rescue. If this goes on long enough, it may be the big guys in trouble.

The WSB crowd might think they’d like to see a big hedge fund fail, but they have no idea what they’re rooting for and what it would mean for them.

Who else could cause a panic? How about our usual suspect, the investment banks? Remember above about how they provide the leverage to the hedge funds? Yeah, that means every failing hedge fund leaves an investment bank with brokerage losses.

What else can get the banks? Umm, who do you think owns all the GME shares now? Let’s walk through this. I buy GME $1000 calls. What happens next?

The bank selling me that derivative has to buy GME common as a hedge. The further out of the money they buy, the more common I need. With all the crazy option activity last week, that means the big bank’s derivative desks are sitting on large positions in GME, AMC, etc.

When they do eventually crash, you know who takes the losses? Yup, the big banks. So they get hit with big derivative losses and big hedge fund brokerage losses. Are those enough to put a bank in a tight capital position? Probably not, but I wouldn’t dismiss it.

How did leverage lead to speculation?

A: Leverage always leads to speculation.

What caused the financial crisis? Cheap money to borrow homes. What let hedge funds short 100% of a stock? Cheap leverage. What let Robinhood customers take such big positions? Buying derivatives (aka leverage on stocks).

Leverage always leads to speculation and cheap leverage always leads to excess. Time without end. Nothing about this is surprising.

Every generation has to learn this lesson. The only real surprise to me is these same day traders who were scarred by their parents losing their house in the mortgage bubble think that – wait for it – “this time is different”.

Is the Fed (and Treasury) responsible for the speculation?

A: Do birds fly? Is the sky blue? Of course they are!

After all, who created this leverage? Who created the conditions for the internet bubble with easy money? Who let the mortgage bubble keep inflating rather than step in?

There has been a conscious policy to trade economic downturns for asset bubbles…even though the pricking of the asset bubbles cause more recessions than letting the business cycle play out!

And don’t forget the Treasury! Is it really coincidence GME finally took off right after the stimulus checks arrived?

Are we in a bubble?

A: Yeah, I think we can finally call it that.

OK, how do I not turn this into 2000 words? Deep breath, ok, let’s give it a shot.

So, first, every bubble is called way too early by the “smart” people. And they are genuinely smart. They just have no sense of market timing. Thus, I am very hesitant to call a bubble before its time.

Usually, you need to wait for something so blatantly stupid to say “ok, now we can act on this”. When the cab drivers were asking for stock tips in 2000, that was the sign the end was nigh.

When my parents started asking about flipping houses, I knew it was the end of the housing bubble.

Now, we have every twenty something in my extended family calling for stock tips. I think that’s a pretty good sign we are in the 9th inning.

Note, the 9th inning doesn’t mean it’s over. It means that it’s late in the game. Could it be another six months? Even another year? Sure, absolutely, but the easy money phase is over.

The people coming in now are like the people buying a home in mid 2008 (wait, didn’t I do that? Well, yeah, but I did it eyes wide open not looking to make money). If you want to be worried about somebody, worry about them.

The one brief editorial I’ll permit myself is we shouldn’t feel bad for the hedge funds (but we shouldn’t be dancing on their grave either), we shouldn’t feel bad for the guy who bought GME at $50 and might give back his gains.

We should feel bad for the person buying GME now at $300 thinking it’s “free money” going to $500 or $1000. Cause that person could easily lose 90% because they get stuck with the dump part of the pump and dump.

Yet I don’t hear any politician looking out for them or urging them to be careful. They’re all too busy celebrating how “the little guy stuck it to the man”.

My (friend/neighbor/cousin) wants to buy stonks. What do I say?

A: Tell them you won’t take them seriously until they start talking like an adult.

Next, read above and tell them they’ve probably missed the fun and wait for the eventual selloff. If they won’t accept that answer, ask them how much they want to invest and then tell them start with 10% of that and do 10% more each month. That hopefully keeps them out of too much trouble.

Final Thoughts

I should probably end by saying I don’t think this WSB aspect of investing is going away. Not even after the bubble eventually pops.

People tends to make the mistake of thinking these phenomenon are fads but a lot of them stick around (remember the initial dismissals of Trump or Bernie).

Their influence may change, but the idea that individuals will look to act in unison and challenge institutional investors probably has legs and probably needs to be regulated.

In all likelihood, it will add volatility to markets for a number of reasons (another future post). Just as it it accentuating the upside now, it will accentuate the downside later.

It is a new risk factor and one savvy investors need to consider when thinking about potential outcomes for a new position.

2 thoughts on “Making Sense of Reddit, GameStop, Robinhood, and Bubbles”

  1. Appreciate the analysis. Just a comment on the comparison of WSB to hedge funds. WSB are not an entity in any legal sense. The individuals using the platform should indeed be subject to regulation, but there is no means by which the site can be regulated – it is not engaged in market activity and has no assets. Further, hedge funds adhere to very few rules to begin with. Only those that flagrantly and systematically violate insider trading and disclosure rules run any risk of investigation, let alone charges.

    1. Thanks Mark for sharing your thoughts. I am not a securities lawyer, but I have spoken to enough of them in my life. I believe any group that co-ordinates their actions has to disclose that to the SEC, at least once they pass a certain position size. It doesn’t matter if you are an investment firm or an individual.
      As for hedge funds, they come in all flavors, but I can tell you that the ones I worked at were incredibly stringent with compliance to the point where it arguably was excessive and you felt disadvantaged vs. the rest of the market. Reputable hedge funds know they are one allegation away from losing all their investors whether that allegation is true or false. A hedge fund founder would rather accept lower returns than risk losing the firm to a greedy employee’s actions. I know that doesn’t fit the popular narrative, but I can only tell you what I experienced. Not saying there have never been bad actors, but there are a lot fewer than pre financial crisis. There are plenty of structural problems with the HF business model, but I don’t believe there is a market conduct issue.

Comments are closed.