Mike Lipper’s Monday Morning Musings
Is GameStop the Missing “Event”?
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
In the “Bubble”, Seeing the Trees and Not the Forrest
In recent blogs, I examined evidence of a stock market bubble about to burst. Is this week’s explosive coverage of the short squeeze battles of a handful of relatively small stocks, the classic unrelated event that leads to actions triggering the rapid deflation of general market prices? Could be, and it is worth thinking about.
Markets regularly fluctuate between high/low prices and valuations. Most of the time, they stay within an envelope around a loosely defined center. This is the type of period where stock and fund picking produces relative good and bad returns, getting the attention of both individual and institutional investors. The game dramatically changes at the two extremes. At both ends the driving force is the actual level of liquidity in the marketplace. The relatively few stocks that have high, two-way market volume get most of the action and attention. The others either don’t trade or have significant price gaps between trades. The deflation of a bubble is when prices rapidly collapse.
In the prelude before the bubble breaks, there are often signs of structural deterioration preceding some seemingly unrelated event, which spurs reactions. This can be the telltale sign of a bubble breaking. Two examples of these events come to mind. The assassination of the Austrian Archduke and the passage of the US Smoot-Hawley Tariff Act of 1930. In both cases, from a global standpoint, they were not earth-shattering events, but the reactions to them led to World War I and the global depression of the 1930s.
In both cases, various political leaders used the event as an excuse to make aggressive moves, resulting in tragedy. The murder of the Archduke and his wife became an excuse for aggressive, militant nationalism and an attempt to change the political structure in central and eastern Europe. It in turn eventually brought the US reluctantly into the war and was a contributing impetus to WWII.
The Smoot-Hawley Tariff was a political attempt to bail out the highly leveraged farm sector in the US. It raised import tariffs on agricultural and industrial products by 20% and was quickly followed by 20 other countries.
Possible Application to the GameStop Short Squeeze
Very little of the popular media coverage on the short squeeze of GameStop and a small number of other stocks starts with the recognition that short selling requires a margin (loan) account, funded by cash and/or securities. The buyer of the shorted shares looks to the selling broker, or in some cases a bank, to supply the shares. This requires the broker to borrow the shares from other shareholders or purchase them to make the delivery. If the broker borrows the shares, the firm must pay a rental fee or find another customer who owns the shares. To facilitate the trade, margin accounts permit the broker to loan out shares in margin accounts, using them as collateral to raise capital to support transactions.
The broker is often forced to buy shares in the market to make delivery in less liquid stocks. The mere fact of the broker buying pushes up the price, turning the broker into a short seller, having delivered the newly purchased shares. The broker must recapture the money it spends and occasionally if it borrows too much it may face forced liquidation of the firm. If this becomes the experience of many, there can be an effort to get the regulators to declare a “corner” in the stock, where they order the cancellation of all trades above a given past price. It thus wipes out some of the gains of the short sellers and reduces the losses of the brokers. (This has not happened in many years.)
How Did this Happen?
- In a period where there are large operating business losses, there is a political impulse to bail out the unfortunate to secure their future votes. To the extent the bailout is not quickly repaid with interest, it is in effect socialized, making the profitable portions of the economy pay the losses and any shortfall in repayments.
- Payments to individuals during the current pandemic where in many cases saved and not immediately spent.
- Many states have legalized both sports and casino gambling to tax it. This probably enlarged the gambling population and transferred public wealth to gambling interests.
- Currently, many are working from home (WFH) and sitting in front of their computers. Some have temporary cash to spend and in the absence of their normal sports betting vehicles they have developed trading relations with electronic brokers.
- Our educational process in schools and at home does not distinguish between gambling and investing. Furthermore, people and many politicians don’t differentiate between borrowing to meet current expenditures and capital invested in long-term assets. Long-term assets, like new plant or other capital expenditures, create new earning assets which in many cases become new collateral.
What May Happen?
- The popular media will likely produce numerous stories of individuals with losses. This will provide politicians with an excuse to produce more regulation, which will be expensive and send more investment overseas, and/or into non-public activities.
- The future “Debt Bomb” is now in the hands of the government, but with the shrinking share of the loan market at banks, credit conditions will loosen and the private sector debt burden will grow. Underlying every major collapse is the extension of too much credit and the resultant leverage.
- We live in a dynamic globe. Most financial systems are quite extended, with little room to handle medical, weather, technology, military, and political surprises.
What to Do?
For those portfolios structured to meet payment responsibilities over the next five years, this would be a good time to prune portfolios. The following actions may be appropriate.
- Create a schedule to recognize all loses serially between now and June 30. Thus, create a capital gains shelter for sales of winning positions.
- Examine winning holdings that need a current bull market to reach the investors’ price objective. Sell at least half.
- Sell at least half of all positions in stocks where current management’s decisions seem inappropriate.
- Build an opportunity reserve for two new purchases.
- Increase exposure to stocks that trade beyond your home market.
- Expect surprises and usually invest against the first identified decision.
- Read carefully what companies say. One Dow Jones Index company expects earnings in 2021 to equal those reported in 2019. Even if that happens, the company will not have produced sufficient earnings to cover the then expected growth rate for the two-year period, leaving their growth at least 10% behind the original plan. This should cause one to make some changes, either to the portfolio or to expectations.
Working Conclusion
Become more engaged and start managing your portfolio, holding a collection of investments that can both absorb some losses and find new opportunities.
What Do You Think?
Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2021/01/are-we-strolling-promenade-deck-of.html
https://mikelipper.blogspot.com/2021/01/contra-messages-weekly-blog-664.html
https://mikelipper.blogspot.com/2021/01/the-wisdom-of-3-wise-men-weekly-blog-663.html
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A. Michael Lipper, CFA
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