Novum Alpha - Weekend Edition 30-31 January 2021 (15-Minute Read)
Wishing you a wonderful weekend and a brief respite from the manic markets that have been their most volatile in months.
In brief (TL:DR)
In today's issue...
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Markets saw their worst week since last October as much like the attack on the U.S. Capitol building, retail investors stormed the stock exchange and made their presence felt, leading to huge volatility swings and institutional investors pulling out for fear of market carnage.
It's not that the economic situation has changed significantly since last week, rather it's more a case of fear and uncertainty by the institutional class of investors that retail investors have the capability to exact vengeance in unforeseen and unforeseeable ways.
That uncertainty has seen a large pullout of funds to wait till the dust settles.
Much like the purge, roving bands of retail investors are now stalking the markets to hunt for their next prey.
Over in Asia, investors took their cue from Wall Street and headed for the exits with Tokyo's Nikkei 225 (-1.89%), Hong Kong's Hang Seng Index (-0.94%), Seoul’s KOSPI (-3.03%) and Sydney’s ASX 200 (-0.64%) all sharply down.
1. Is the era of short selling over?
Much ado has been made about how the so-called “smart money” on Wall Street has been taken to task by a bunch (6 million and counting) of “degenerates” using the Reddit forum r/wallstreetbets to co-ordinate attacks on short positions.
Corralling the power of the masses, legions of retail investors pumped the shares of GameStop (+67.87%) and forced short sellers to lose an estimated US$6 billion, with even the mightiest hedge funds now nursing double-digit losses.
And while short sellers have long been viewed with derision, they’re also a necessary evil and do serve a contrarian function, especially in a market that has repeatedly demonstrated the dangers of irrational exuberance.
Dabbling in the dark art of selling borrowed stocks to buy them back at lower prices, some see short sellers as a critical market participant to sniff out fraudulent companies, dodgy accounting practices and questionable business models, or simply just to keep valuations in check.
Short sellers have exposed countless fraudulent companies, including Enron and Valeant Pharmaceuticals.
But the business model of short sellers is anathema to markets in general and investors in particular, who typically only want to hear goods news and see stocks go up.
Even before the most recent attack on short seller by retail investors, short selling was already a declining business, thanks in large part to the popularity of index funds and the longest bull market in history.
And that’s not necessarily a good thing.
Short sellers can serve as a check on market excess, and their decline suggests that markets are approaching dangerously inflated levels.
Given that retail investors have now seen the power they have, they’re unlikely to give it up anytime soon.
Devoting countless hours to forensic financial work, short sellers have what Nassim Nicholas Taleb calls “skin in the game” – exposing themselves to potentially unlimited losses and putting their money where their research is, which helps make their findings credible.
Contrast that to index investing and the traditional stock research industry, where the opaque fees collected by analysts, often comes from the very firms that they’re making recommendations on.
But short sellers aren’t saints either.
In the aftermath of the 2008 financial crisis, short sellers wielded their tremendous clout to punish companies that were viable, but short on liquidity, and the insolvencies they effected, were preventable.
Real people lost real jobs during that period and short sellers developed a nasty reputation.
For now, short sellers are on the defensive and those that put on leveraged bets are likely to dial back risk to survive.
These short sellers are also likely to be more selective and private when placing their shorts, careful to avoid drawing unnecessary attention to themselves, for fear of raising the ire of retail investors.
Short sellers may also use opaque over-the-counter put options (an option to sell at a specific price) since those don’t need to go into regulatory filings.
In the long run, ethical short selling is likely to survive.
And the lack of clear public targets for retail investors means that the grassroots-led movements like r/wallstreetbets may eventually peter out, as short-selling hedge funds adapt to go under cover.
But that also increases risks for normal market participants, as it suggests that the stock market bubble may be closer to bursting than imagined.
Markets typically crash when the last bear becomes a bull, and for that reason, short sellers shouldn’t be confined to the wilderness altogether.
2. The Dangers in Investing in Low Interest Rates
Investing has taken on a interesting flavor of late.
Whether it’s trawling Reddit forums to get a sense of where retail investors are rallying to next, or betting on unprofitable companies, generous fiscal policy and heady stock valuations all have a common cause – near-zero interest rates.
The rally in everything from big tech to Bitcoin are all manifestations of the so-called “TINA” trade – There Is No Alternative.
With bank deposits paying out next to nothing, gambling on any asset doesn’t seem like such a gamble anymore.
Whilst this investment philosophy is not wrong fundamentally – after all the present value of an asset is its future income, discounted to the present using interest rates, plus a risk premium – the extra return expected over owning something safer like a government bond – when taken to its logical extreme, can lead to some surprising outcomes.
Near-zero interest rates, with the benchmark 10-year U.S. Treasury yield falling from around 1.9% before the pandemic, to hover around 1% at present, have helped to explain the outperformance of big growth companies like Apple (-3.74%) and Amazon (-0.94%), for whom the bulk of profits lie in the far future.
To justify Apple’s current valuation, an investor doesn’t just have to have a lot of confidence about how the next few years will turn out, they have to be cocksure that things will play out as they perceive.
And for companies like GameStop, expectations are in the realm of fantasy.
Worryingly, that same low interest rate-logic is trickling into the fiscal debate on Capitol Hill.
Congress has borrowed around US$3.4 trillion so far to combat the pandemic and its economic fallout, but the Biden administration proposes to increase that by more than half, taking out another US$1.9 trillion loan – representing the largest burst of national borrowing since the Second World War.
To justify those borrowings, President Biden and his Treasury Secretary Janet Yellen note that interest rates are historically low and even if the U.S. were to add on to this debt, interest expenses won’t be much higher as a share of GDP than it was a few years ago.
And with the Fed pledging to keep rates near zero up till 2023, that argument is seductive in its simplicity.
But really, more government debt based on low interest rates means that it’ll be someone else’s problems down the line.
And in the meantime, investors holding assets such as real estate, stocks and commodities will prosper, while fixed income investors such as bondholders will suffer, yet ultimately, it’ll be taxpayers who foot the bill.
In Washington, there’s a growing number of politicians who believe that there is no limit to how much the U.S. can borrow because it can always repay that debt simply by printing more dollars and that more debt won’t necessarily lead to higher rates, noting that rates have fallen despite debts having risen in the last decade.
That “money for nothing” argument is alarming.
Because it ultimately assumes that interest rates are somehow independent of the level of debt – they are not.
At some stage the level of borrowing will eventually push up inflation and interest rates, except that nobody knows what that level is.
If the U.S. proceeds as if no limit exists to its borrowing, it will find that it will hit it sooner rather than later, and the economic fallout will be nothing short of nuclear.
3. How Risky is Bitcoin to a Portfolio?
If investors learned anything from the markets last week, it’s that it’s hard to call an investment risky anymore.
No number of charts could have rescued GameStop’s business model and under normal market conditions, its share price would be a reflection of its prospects – poor at best.
Yet somehow, the past 14 months has seen the stocks of companies that should technically be worthless, soar to dizzying heights, from Kodak (-2.84%) and Hertz (+7.36%), to GameStop and AMC Entertainment (+53.65%), investors are having to redefine what value even means and how that translates to a stock’s price.
Which is why whether you believe Bitcoin is inherently worthless or could eventually be priced at US$1 million, there is less argument over its emergence as an asset class worthy of note to investors.
And if Bitcoin really has gone mainstream, should even the most risk averse investors consider a portion for their portfolios?
Unlike stocks, which at the very minimum provide investors with a partial ownership of a business, Bitcoin is neither intrinsically valuable, nor a reliable store of wealth, and it certainly doesn’t produce an income.
But Bitcoin does however possess two unique characteristics that could make it a good fit even for the most actuarially-sensitive investor.
The first is of course Bitcoin’s much-maligned volatility.
Volatility in and of itself isn’t bad because the greater an investment’s volatility, the larger the potential loss, but also the potential gain – it cuts both ways.
If an investor had invested just 1% of their portfolio in the S&P 500 over a year ago, that investment, even though it returned a decent 16%, would have hardly moved the needle in terms of their overall portfolio.
But Bitcoin’s volatility means that if an investor had just allocated 1% of their portfolio towards Bitcoin during the same time frame, they would have seen a 300% return – a far more meaningful gain, despite only committing a small, manageable sum.
In other words, so long as you’re not all-in on Bitcoin, there is still the possibility of making a real gain without too much loss, regardless of Bitcoin’s current price.
And unlike other more risky investments like forex or options, an allocation in Bitcoin is unleveraged and limited to the initial stake.
With leveraged investments, the initial stake evaporates almost the instant that the underlying asset falls in value – leverage works both ways, and much more quickly.
Unleveraged investments afford investors the ability to live to fight another day, even after the most severe losses.
Investors often forget that during the dotcom bubble, Amazon’s shares were over US$113 and crashed to as low as US$5 before they reached the US$3,300 they trade for today.
Had investors panicked and dumped their Amazon stock, they would never have experienced the 2,740% upside – something that would have been impossible if investors had leveraged their investments.
Which is why trying to figure out if Bitcoin is a risky investment or not is the wrong question – it’s a question of asset allocation.
And even the most risk averse investor could do a lot worse than a 1% allocation into Bitcoin.
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Jan 31, 2021
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