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Meme Stocks and Market Structure

Unless your investment horizon is measured in milliseconds, it’s usually best to ignore what everyone else is doing. But, occasionally, the market throws up something so peculiar that you have no choice but to sit up and pay attention.

The GameStop debacle, and the meme stock phenomenon more broadly, certainly fit that category. The story bears all the hallmarks of a Hollywood script: how a ragtag group of mostly retail investors, armed with commission-free trading apps and loosely coordinated across online message boards, executed a colossal short squeeze on the hedge funds betting against a down-at-its-heels brick-and-mortar video game retailer while inflicting bloody noses on some of Wall Street’s supposedly most-sophisticated operators. Predictably, several films are already in the works. But beyond the thrill of extravagant market pyrotechnics served up with a generous side of schadenfreude at seeing the odd master of the universe brought low by the great unwashed, why should we care?

Market manipulation is hardly new, and short sellers have always been a vulnerable target. The algebra of short selling, where the size of a losing position balloons ever higher as losses accumulate, is such that short sellers are forever in danger of being squeezed. Wait too long to cover or, worse yet, fail to rebalance at all, and you risk being wiped out. No surprise then that short selling for profit (as opposed to for hedging) is the province of dedicated specialists.

Despite their somewhat louche reputation, attested to by the prevalence of short-selling bans that reflexively blossom every time the market wilts, short sellers are nonetheless a key part of a healthy market ecosystem. A healthy market, one that allocates capital to its most productive use at the lowest possible cost, is predicated on many financial species with different time horizons, preferences, and liquidity needs co-existing in symbiosis. Despite what the textbooks might say, liquidity and price discovery are not created in a vacuum; they spring from the unceasing dance between three types of market inhabitants: long-term investors, arbitrageurs, and liquidity providers. Long-term investors attempt to steer capital towards its most productive use, arbitrageurs improve price discovery by correcting the occasional mis-pricings that emerge between assets with similar payoffs, and liquidity providers lubricate transactions, which helps to shrink transaction costs. If any one of these groups grows too dominant, the dance can quickly turn into a scrum.

It may be too early to add dedicated short selling to the long list of business models disrupted by the internet just yet, but it’s safe to assume that the shorts’ cost of capital has gone up.

Dedicated short sellers are a rare breed of arbitrageur whose relatively small number and modest asset base belie their importance. Much like value investors, whose tendency to buy when others are selling has a stabilizing effect on falling markets, short selling has a similar calming effect in the opposite direction. By leaning against unwarranted price increases, short sellers are a counterweight to market excess, one that makes for a more hospitable environment for beta grazers and alpha hunters alike. In helping to expose flimsy business models, ferret out accounting malfeasance, and unearth cases of outright fraud, short sellers are natural predators that benefit the market’s ecology. Enron, Lehman Brothers, Valeant, and, more recently, Wirecard and Luckin Coffee all owe their comeuppance in large part due to the sleuthing of dedicated short sellers.

Although short sellers are at the center of the GameStop saga, most of the ink spilled has focused on the more conspicuous elements of the story: the evident power of massed retail investors, their copious use of derivatives to magnify leverage, and the populist tendencies that seemingly motivated many of the squeeze’s participants. What has received less coverage is the potential impact of meme stock manias on market structure.

On the face of it, the debacle mirrors many previous episodes of market manipulation, no different, say, than the Hunt brothers ill-fated attempt to corner the silver market in 1980. But there is a crucial difference. A conspiracy to manipulate markets pre-supposes a central origin, a mastermind to hatch the plot before putting it into action. But on this occasion the conspiracy, such as it was, emerged spontaneously. It began with local, seemingly random interactions online that began to feed on themselves in an accelerating feedback loop.

There was no syndicate head, no directives whispered into disposable cell phones, no encrypted texts, none of the subterfuges typically associated with a conspiracy. Quite the contrary, discussions were held in the open, within freely accessible (albeit anonymous) web forums, where anyone was able to proffer their views about the fundamental value of the business, comment on the high short interest, or add an opinion about the implications of the tight float of underlying shares outstanding.

Decentralized and self-organizing short squeezes that materialize spontaneously represent a new type of concern for regulators because it’s unclear which rules, if any, are being violated. Moreover, it’s far from clear what mechanisms can be put in place to prevent it from happening again. But while this may be a headache for regulators, it represents an existential threat to short sellers. It may be too early to add dedicated short selling to the long list of business models disrupted by the internet just yet, but it’s safe to assume that the shorts’ cost of capital has gone up.

The impact of this new regimen on short sellers is impossible to gauge with any precision. They are a secretive bunch, after all. But we can guess at their travails by looking at the performance of the most shorted stocks as represented by the Citibank US Short Interest Equity Index. The index is akin to a long/short portfolio constructed according to the level of short activity for each stock in the Russell 3000, measured as the ratio of the amount of stock on loan relative to its overall trading volume. After ranking stocks according to this ratio and removing stocks with the most extreme metrics such as high borrow cost, the index simply shorts the 10 percent of stocks with the highest short ratio and goes long the 10 percent of stocks with the lowest short ratio. Historically, simulating short sellers in this way has been a profitable strategy: from its inception in June 2015 through the end of 2019 the index generated a cumulative return of 35%, with a highly respectable return to risk (Sharpe ratio) of close to one. At the onset of the pandemic in early 2020, which coincided with a jump in retail trading reminiscent of the tech bubble, the index collapsed. Over the following months it gave up almost its entire accumulated historical performance before reaching its nadir in January of this year, just as the GameStop episode reached its crescendo. Given the index’s long exposure to the least-shorted stocks, it likely understates the actual damage inflicted on many actual short sellers.

Source: Bloomberg

It’s a truism that no one enjoys losing money, ever. And if the performance of the index is indicative of the damage inflicted on short sellers, we can expect an imminent thinning of their ranks and with it a weakening of their stabilizing influence.

There is a small town in Thailand whose large population of macaque monkeys draws a steady stream of tourists. The locals sell bananas to the tourists who feed them to the monkeys. When the flow of tourists dried up during the pandemic, this balance was thrown into turmoil. Within weeks, the town was overrun by gangs of starving monkeys. Whole neighborhoods were declared no-go areas by authorities after videos of rampaging monkeys went viral.

It’s probably a stretch to claim that having fewer short sellers would have quite such a dramatic impact on market structure as the loss of tourists had on this Thai town, or that the monkeys are now calling the shots, but markets are notoriously susceptible to unforeseen events. A seemingly inconsequential disturbance in one area can ripple out, propagating and growing until it ultimately leads to systemwide effects. While our attention is often drawn to conspicuous price movements, it’s easy to overlook the veiled institutional or structural changes that sometimes precede and may even precipitate them. Bananas, anyone?

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Getting Real About Inflation … and Gold

As favorable vaccine news piles up, the winds of reflation are stirring. Early signs of an equity market style rotation in favor of cyclical value stocks, a weakening of the safe-haven US dollar, and a run-up in market-derived measures of inflation expectations all point to a resurgence of animal spirits despite a gloomy outlook for the economy. With our monetary maestros promising easy money into the distant future come what may, it is time to spare a thought for what the possible return of higher inflation might do to your portfolio. Inflation is viewed as the bane of fixed income investments, and rightfully so. But inflation can also wreak havoc on stocks. In theory, inflation should have no impact on equities provided companies are able to pass along higher input costs to their customers. In practice, equity valuations are highly sensitive to changes in the price level, tending to plummet when prices jump. No wonder investors are already casting about for inflation protection.

For a vociferous minority, the only bankable hedge for inflation is gold. For them, every spike in the gold price is reproof of government perfidy and foreshadows an inflationary surge. The evidence linking gold’s price and inflation, however, is curiously threadbare. If gold is an unreliable hedge against rising prices, what role, if any, should it play in a portfolio?

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Don’t Just Do Something—Stand There

Humans prefer to do something rather than nothing. We like office environments that are a “hive of activity” and commend “men of action.” When stuck in a traffic jam, we will take an alternate route just to keep moving, even if it prolongs the journey. We tend, though, to conflate activity with productivity, mistaking the people whom we see doing the most with those who are the most valuable.

We see this bias in many domains. Our political leaders tend to respond to a crisis with ill-considered policies that capture attention but often do little good and may even do harm. It would be unacceptable for them to stand by and simply do nothing. While serving as both vice chairman of Harding Loevner and as chairman of a professional soccer club that competes in the English Football League (EFL), I have been struck by the parallels between investing and sports when it comes to the biases that damage effective decision-making. Studies have looked at penalty kicks in soccer. When a penalty is awarded, the ball is placed 12 yards from the center of the goal and a kicker gets the opportunity to score with only the goalkeeper standing in the way. It turns out that because of the goalkeeper’s bias for action, the optimal place to kick the ball is directly at the center of the goal. A goalkeeper will almost always dive one way or another in anticipation. If he dives the wrong way, he’s forgiven as having simply guessed wrong, or as being sent the wrong way by the kicker’s supposed feint. If he dives the right way, he has a chance to stop the ball entering the goal. If he merely stands in the middle, however, he is the subject of much abuse for doing nothing.

Investors fall victim to similar pressures and impulses. The immediate costs of transacting are low, and the propensity to transact is high. The result is that investors transact too much, and their returns suffer. They tend to transact at the wrong time, buying after prices have risen, and selling after prices have fallen.

Underlying these behaviors is a general misunderstanding of the roles of luck and skill. In sports and in investing, short-term results are the outcome of a combination of the two. Yet, we tend both to attribute the outcome more to skill than to luck and to extrapolate a series of outcomes (good or bad) into the future. This tendency stems from our deep-seated need for explanation, and a need to feel we are in control even when we are not. This occurs particularly in those sports, like soccer, that are generally low-scoring affairs. Unlike in basketball, for example, where there will be more than a hundred points in a game, the average number of goals in a professional soccer game is roughly three. The result of a single game will largely be driven by luck—one bobble of the ball, the inches between hitting a goalpost and scoring, a poor refereeing decision. Yet the narrative in post-match interviews is seldom “we got lucky.” At least, it’s seldom the case that “we got lucky” when the interviewee’s team wins. When the team loses, the loss is the result of bad luck! How similar this is to investment narratives, where there seems to be only two kinds of investment managers: the talented, and the unlucky.

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Stock Portfolios, Football Teams, and the Stories We Tell Ourselves about Each

The world is complex and unpredictable, but humans prefer order, and cause and effect, so therefore tell stories that purport to explain what is simply random. Narratives pre-date writing. They help make events coherent and memorable, while arousing emotions in the listener. Behavioral biases, which all humans share, are in many cases essentially products of the stories we tell ourselves. The more detailed the story, the more entertaining it is and the more powerfully it can affect our emotions. We love stories. That can often be wonderful, but in decision making it can be dangerous.

In investing, there has been at least a little progress towards improving decision making by resisting the power of stories. Quantitative investors describe how they adhere to purely objective rules (rules and lines of code that, of course, they themselves have written) to govern their behavior and reduce bias. “Quantamentalists,” another breed of investor, allow some judgement to enter their decision making once they have established the framework. They do this in part in recognition that, as a rule, most humans don’t like rules. We suffer from what psychologists call “algorithm aversion,” i.e. preferring to go with our gut. That preference results from our need to remain in control, or at least to believe we are. Permitting human override of an algorithm may degrade the quality of its output, but in granting themselves the comfort of exercising some degree of control, decision makers likely improve their rate of adherence, for an overall improvement in outcomes. I fully expect self-driving cars to come with a steering wheel that will have no impact on direction of travel, but will allow the human passenger to feel more secure than if she were simply sitting back and giving herself over fully to the computer under the hood.

In his book The Success Equation, Michael Mauboussin writes extensively about the importance of a strong process and rules in activities where the immediate outcome is driven by luck and skill. He describes how it is possible to improve skill through what has become known as deliberate practice: repetitive, purposeful, and systematic repetition with immediate and specific feedback. Luck, however, can only be managed by having a strong process, with rules or standards constraining decision making and the urge to impute too much importance to our role in any one result. In activities such as investing or team sports—arenas where skill and luck both come into play—narrative is particularly seductive, making adherence to this recipe for success a constant battle.