Is GameStop the Missing “Event”? - Weekly Blog # 666

 

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?

1. 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.
2. Payments to individuals during the current pandemic where in many cases saved and not immediately spent.
3. 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.
4. 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. 
5. 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?

1. 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.
2. 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. 
3. 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.

1. Create a schedule to recognize all loses serially between now and June 30. Thus, create a capital gains shelter for sales of winning positions.
2. Examine winning holdings that need a current bull market to reach the investors’ price objective.  Sell at least half.
3. Sell at least half of all positions in stocks where current management’s decisions seem inappropriate.
4. Build an opportunity reserve for two new purchases.
5. Increase exposure to stocks that trade beyond your home market.
6. Expect surprises and usually invest against the first identified decision.
7. 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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To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2020

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.

Searching for Bottom, Understanding, and Select Futures - Weekly Blog # 620

Mike Lipper’s Monday Morning Musings

Searching for Bottom, Understanding, and Select Futures

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

“The Bottom”
Even before the end of hostilities, survivors begin to determine how bad is bad when someone is attacked. Is this the bottom? For those in and around the stock market there is lots of history to provide clues. At 9:26 AM on the 13th, Larry Goldstein, a very successful micro-cap fund manager and a junior analyst in the same shop with me years ago, wrote the following:

The factors that make a bottom in the US stock market include a combination of climatic selling with an intraday reversal, combined with a breakthrough announcement on testing and treatment for the Coronavirus...This will turn, it always does.

On Monday he was generally right. There was a sizable price gap opening in the DJIA compared to the previous day’s close. The low for the day (21,159 vs 21,200 Thursday close). The close on Friday, which may be close enough to fill the gap, was 9% higher than Thursday’s close.

A Largely Predictable US Stock Market Fall
What was not predictable is the size of the decline in one month’s time. A student of history could have predicted two out of the three causes for the decline. I know of no way to predict the rapid spread of Covid-19, although it’s clearly possible that some in the medical sphere had knowledge of Chinese conditions. The rapid spread of the Coronavirus was a convenient time for Russia to attempt to grab a much larger share of the oil market from US shale frackers and “swing” producer, Saudi Arabia. A student of 19th century world trade history would not have been surprised.

In the 19th century a great German military strategist proclaimed that war was just another way to execute national policy. In the 21st century one could easily substitute trade wars for military wars. Some may even suggest that Germany provided the muscle for WWI due to that country’s late economic development. Germany needed more global markets but found themselves blocked by the trading strengths of the US, Great Britain and others. One could also point to the Japanese attempt to build a “Co-Prosperity Sphere” as being a contributor to the Pearl Harbor attack.

In the current era, China’s contribution of at least one quarter of the growth in world trade was dramatically changing. Under their command economy they needed to create both employment and a rising standard of living. They were evolving from being an export driven economy to having greater reliance on internal market development. Thus, the growth rate of their exports declined, so too would the rate of import growth. The trade issues with the US added to these contractions, Europe lost some exports to China and they received lower price imports diverted from the US.

Europe’s general economy had slowed and in some cases was approaching stall speed, while Russia and Saudi Arabia attempted to catch up with the more developed world through massive capital projects. Both are critically dependent on oil exports to generate the capital needed to hold off the global drive of popularism. Thus, the Russian move to capture greater market share makes sense, it came with much lower prices, contrary to the Saudi’s own needs.

Remember, most large expansions by industry and government are debt financed. The equity market is often slower to react to economic trends than the fixed income market. That is exactly why the following quote from BlackRock’s CIO of Global Fixed Income was so unnerving.

“If you don’t know where the safest asset in the world is, it becomes impossible to figure out (where) everything else is.” 

This uncertainty for the week ended Wednesday led to net redemptions in corporate investment grade bond funds of $7.3 Billion and $5.1 Billion from high yield bond funds. (More on the threat of the bond bomb later.)

Going Forward
The odds are favorite that we have seen the bottom of the major US stock market indices for some time. (I am guessing there is a 60%-75% chance that this is a correct assumption.) I assume any top or bottom will be tested before investors accept a major turn in the cycle. The test can be above or below the bottom, but it will have less sustained force behind it. I have reasonable confidence in the turnaround as a result of measuring the price differences of our closely followed roster of financial services stocks, between Wednesday and Friday closing prices were within 0.3% of being equal.

The reliance on reported earnings per share is a worry for equities. It is a much-manipulated figure due to changes in accounting standards, federal/state tax rates and rules, plus buy backs. Utilizing I/B/E/S data from REFINITIV, analysts estimated that fourth quarter reported S&P 500 earnings would be +10.2%, but net income only +8.2%. That spread widened from 2% in their first quarter 2020 estimate to 2.4 % (+14.3% earnings and +11.9% net income). Since mid-February, or even earlier, no one is holding to 2020 earnings estimates.

The reason for showing the spread is that analyst and perhaps corporate management believe others will accept the reported per share numbers. I always look at any equity in terms of what a knowledgeable person in that or an affiliated business would pay for the entire company. I believe most acquirers would start with net income in building their price bid, or 20% lower before adding premiums and discounts. Thus, many stocks were priced too high, historically they normally are priced at a discount to what an occasional acquirer would pay.

The problem of valuing fixed income paper is more fundamental. There is far too much reliance on debt in our society. Starting with most governments running a deficit, businesses issuing debt to meet current needs, and individuals use debt through credit cards and other devices to cover living needs.

Too many in the population are not using debt to leverage their equity in the purchase of investment producing assets. Those that properly use debt, their underlying equity assures the lender is not taking the first or possibly the largest long-term risk. These days, most debt issues are largely for refinancing existing debts, not increasing earnings generation. (Most of the time, long-term gold owners use their gold positions to hedge against the valuation of other assets. However, after an extended price rise, such as now, they use some of their gold to meet current cash needs or payoff their debt.)

Opportunities 
In many respects we have involuntarily entered a new era. Because Coronavirus it is now critically important that most families be connected electronically. Instead of traditional European style food shopping where one goes to the food market daily, we will attempt to regularly store essential food needs for two weeks or more. We may change our entertainment mix so that more is delivered electronically and less in theaters and stadiums. Universities and other schools may have to learn how to educate differently, rather than putting on classes and giving exams on paper. Perhaps we will need to reconfigure the structure and size of campuses and student housing.

To me, as both an analyst and entrepreneur, I believe we have this year a unique opportunity to build soundly without paying too much attention to the impact on the record. We have involuntarily entered a “gap year” and the track handicapper can throw out one or more races as long as the horse, jockey and trainer are building skills.

As an investor and portfolio manager for others, I am going to be searching for what will be different after these crises are over. Covid-19 and similar problems will be addressed with increasing success throughout the year. Near-term energy prices will settle as market forces find equilibrium points. The “debt bomb” will take much longer, perhaps a generation of both write offs and long-lasting penalties.


Discussion for the week: I am happy to chat with subscribers and explore the opportunities they did not see as we finished 2019.         



Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2020/03/searching-for-bottom-and-plan-weekly.html

https://mikelipper.blogspot.com/2020/03/should-changes-in-markets-change-your.html

https://mikelipper.blogspot.com/2020/02/hate-doesnt-work-for-investors-weekly.html



Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.