"Give me control of a nation's money and I care not who makes it's laws"
- Mayer Amschel Bauer Rothschild
“Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true”
“It is impossible for a man to learn what he thinks he already knows”
“Facts do not cease to exist because they are ignored.”
- Aldous Huxley
“An era can be said to end when its basic illusions are exhausted.”
- Arthur Miller
A. Ride or Die Markets aka Reflexivity
Last week turned out to be perhaps one of the biggest pivot points in how the financial markets are seen to operate.
We can step back and see the two huge changes that have slowly been in place over the last six months and have now crystallised (h/t Three Body Capital, who I’ve paraphrased below):
1. Narrative Driven Markets: GameStop might be an extreme example, egged on by the great personalities and none other than the masters of social media spin himself: Chamath and an increasingly confident Reddit community.
There are flows in the market that are involuntary and driven by factors unrelated to fundamentals, and the deviations from fundamentals can be so huge and so violent that the very viability of investment managers as they used to be is at risk.
Today market structure with a convincing narrative is as important as earnings and cashflows in determining price action.
The only time fundamentals matter is when other investors think that fundamentals matter and for the moment that is not the case.
The market is made up of its participants and the more influence the new-age investor has in this access-enabled world, the more old-school investors need to think out of the box.
Just because this new style of investing is different does not mean it is wrong.
Markets constantly evolve and there are some smart minds out there that do not belong to the establishment and look at the world through different eyes.
2. Tails are wagging the dog: This dog (the market) is being wagged not just by the tail of passive investing; it is also being wagged by its other tail of derivative hedging – with both tails substantially bigger than the dog itself.
The hedging of options flow in the market is big business, but just like passive instruments, hedging trades placed by options dealers are involuntary.
The meteoric growth in options volume (largely long) from retail investors is leading to dealer hedging behaviour that exaggerates moves in the underlying: if the market is moving up, hedging activity makes it move up more; if the market is moving down, hedging activity makes it move down more.
The key message here is that markets are not the way they used to be, and we need to construct investment cases based on more than just plain old school fundamentals.
Having identified these two new forces: Narratives and Derivatives, we can look at the GameStop and Wall Street Bets saga through the lens of massive reflexivity loops.
Reflexivity is an important idea to keep in mind because it will likely drive the market in both directions in 2021 and beyond.
For those who want to skip the essay, the theory of reflexivity states that a feedback loop exists in which investors' perceptions affect economic fundamentals, which in turn changes investor perception.
Notice the circularity.
Simply, rising asset prices can positively impact economic fundamentals and falling asset prices can negatively impact economic fundamentals.
In the short squeezes over the last two weeks, we saw three reflexive loops:
1. When you have a heavily shorted stock like GameStop, a lot of people have borrowed and then sold the stock, and are hoping the stock price will go down (so they can re-buy the stock at a lower price, close their short, and make a profit). A heavily shorted stock, has a lot of committed future buyers. “Squeezing” a heavily shorted stock is when you buy up all the float and push the stock price higher, pushing the shorts to close their positions at unattractive prices, which then drives the stock even higher still.
2. The second reflexive loop is what the Redditors have learned how to do with short-dated call options. If you purchase a call option on a stock like GameStop, whoever sold you the option can hedge their contract by buying GameStop shares. In normal market conditions, this is a perfectly plain-vanilla hedged transaction. But the Redditors learned that under certain conditions, you can weaponize this relationship. By buying super short-dated out-of-the-money call options, you can force a reaction, which is the offsetting buying of a lot of shares; for a short period of time. If the price of those shares then moves materially, (moving the options closer to in-the-money) they’ll have to buy even more to maintain their hedge.
3. The third reflexive loop, and really the most important one, is that the Redditors don’t have to do it alone. They only need to initiate the mayhem. If Wallstreetbets is able to initiate moves in a certain company’s stock price, there are all kinds of other buyers and funds who are gonna see an opportunity. You might see hedge funds pile into both sides of this trade, cause why not; you can’t really know how this positive feedback bubble will resolve.
By the way for those who missed it, this was the original Reddit post discussing the GME trade four months ago.
Where does that leave me in the near term?
This picture by the great Bobby Vedral (who writes the amazing Macro Eagle), says it all.
We might be following the 2009 / 2010 recovery analogue. The last two weeks saw violent price action leading to de-grossing and de-risking at least in the hedge fund community, and there are far too many investors on the look out for a market bubble for there to be a market bubble.
Consensus is never usually right.
Credit to the team at Three Body Capital who’s writing contributed a lot to this essay.
B. White Working Class
Many of us are lucky to live in a world where class doesn’t exist. But for the majority of the developed world it is very real.
Over 70 million people voted for Donald Trump. In fact, he received the 2nd highest votes in US history. I am still trying to understand this phenomenon and Prof. Joan Williams book was helpful (recommended by Joe Biden, NY Review of Books and the FT).
The book took me on a journey from the America of the 70’s and 80’s to the America of today. In those days, the highest grossing movies were: 9 to 5, Rocky, Working Girl and the biggest songs were Springsteen’s Born in the USA.
We had an idealised portrayal of the noble blue-collar workers.
But slowly, America stopped trying to understand and connect with the working class and instead began to portray them in a more unflattering light. Think Homer Simpson, Al Bundy (Married…With Children), or Archie Bunker (All in the Family).
The book doesn’t try to explain why the shift occurred, but instead focuses on the bottom line: during an era when wealthy white Americans have learned to sympathetically imagine the lives of the poor, people of color, and LGBTQ people, the white working class has been insulted or ignored during precisely the period when their economic fortunes tanked.
In an era when the economic fortunes of the white working class plummeted, elites wrote off their anger as racism, sexism, nativism.
The book has a simple message: when you leave two-thirds of Americans without college degrees out of your vision of the good life, they notice. And when elites commit to equality for many different groups but arrogantly dismiss “the dark rigidity of fundamentalist rural America” this is a recipe for extreme alienation among working-class whites.
The book then asks a number of questions per chapter and answers them, including:
Why Does the Working Class Resent the Poor?
Why Does the Working Class Resent Professionals but Admire the Rich?
Why Doesn’t the Working Class Just Move to Where the Jobs Are?
Why Doesn’t the Working Class Get with It and Go to College?
Is the Working Class Just Racist?
Is the Working Class Just Sexist?
Don’t They Understand That Manufacturing Jobs Aren’t Coming Back?
Can Liberals Embrace White Working Class without Abandoning Important Values and Allies?
Why Are Democrats Worse at Connecting with the White Working Class Than Republicans?
Here’s a great TED video she did on why we won’t fix American politics until we talk about class.
C. A Few Things Worth Checking Out:
1. Ray Dalio (of Bridgewater) shared his detailed analysis on Bitcoin.
2. Chamath was on Invest Like the Best discussing The Major Problems Facing The World.
3. Great article on Jeff Bezos by Ben Thompson of Stratechery.
4. There were two types of people in the 90’s in NY, those that watched Seinfeld or those that watched Friends. I was a Seinfeld guy. Jerry Seinfeld was on the Tim Ferriss show sharing his systems, routines and methods for success.
5. Live your life like it’s always Day 1.