February 24, 2021
As discussed, the sell off in Bond Markets is also clearing out the trading funds and day traders’ stocks, as they all cut leverage. The short term traders may yet be buyers-on -dips, but we suspect that they have packed their tents and moved off to the Commodity Markets, where Oil and Copper continue to roar. Meanwhile, Bond markets themselves are now looking very much more like sellers-on-rallies; the regime change we talked about on Monday.
US long Bonds are now down 10% year to date and 16% from their peak last March. This is far worse than the general Global Benchmark for Bond funds (the Barclays Global Aggregate Bond Index), which is actually up 1.62% over the same period and down 1.96% year to date. Bond managers are facing their worst start to the year for at least 5 years.
Far more pressing for their clients, the pension funds and insurance companies, is that, as the biggest buyers of bonds, their Precautionary Principle approach to owning bonds versus ‘risky’ equities is becoming more and more expensive. Since the March bond peak, when almost all agreed that Bonds were the only answer, Global Equities have outperformed Global Bonds by almost 40% and, as Chart 1 shows, the long term performance now looks to have broken out. With Commodities now also booming, what will they say now at their quarterly review?
Chart 1: Global Equities now breaking away from Global Bonds
As noted on Monday, when Bond Markets have a tantrum, they tend to spoil the party for everyone as they deleverage, and the most vulnerable stocks tend to be the ones that are also bought on leverage, usually by day traders. Here, probably the most obvious is Tesla. As chart 2 shows, the short squeeze rally that lifted GameStop also took Tesla up 25% during the People’s Revolution /Peasants’ Revolt in January, but has now completely unwound (GameStop is down 86% from the brief peak). The question now is where is the support? Long term price support for the technicians is some 40% lower down. Notice that back in March last year Tesla was sat on that support line.
Chart 2. Tesla has lost all its 2021 performance. Will it lose its 2020 performance too?
This is not to predict a 40% fall from here (although that is entirely possible), but rather to think on what, if any, of what we call market mechanics might have been responsible for the dramatic run up over the last 12 months and whether they will cause it to rally or to sell-off from here. Certainly a short sellers’ squeeze helped and there were also some (not many) fundamental supports. The last 40% run, from mid December to the mid January peak, however, looks to have occurred around the time that Tesla was admitted to the S&P when all the index funds were supposed to be forced to own it. Thus looking at it, none of these looks particularly likely to come back as support. However, there is also likely another important piece of market mechanics at play here; fund concentration, which may not only no longer be helping, but indeed could be acting to accelerate the decline.
When a fund backs a single stock heavily (and successfully) the stock itself can exhibit very strong momentum, since for every $ that flows into the fund a certain, high, percentage of it will automatically flow into that stock, creating something akin to a forced buyer. The index trackers would only have been ‘forced’ to put 1.7% into Tesla, but the concentrated funds would be forced to match their (often heavily) overweight positions as they saw inflows. Fund mangers rarely complain when it is inflows driving a price higher of course but pretty soon all the brokers and traders are watching the flows into the funds in question and trying to front run the main stocks. This creates a buy-on-the-dips market; every weakness is seen as a buying opportunity.
Virtuous circles can become vicious
Of course, when the music stops, redemptions become a major driver of stocks and the unwind can be just as rapid – albeit more painful. It flips to sell-the rallies. The forced buyer becomes something of a distressed seller and the market moves first to get ahead of that and then to try and exploit it. The prime example of this type of fund concentration was the Janus 20 fund back in the dot com era, but the most obvious place to look at the moment has to be the (recent) headline grabbing ARKK Innovation ETF, which had only $3.5bn in Assets Under Management back in March last year alongside a large overweight position in Tesla. By the end of January this year however, the position in Tesla was still there, but AUM had hit $25bn ($45bn for the range, most of which were also heavily in these areas) meaning that to maintain the near 10% weight in Tesla the fund manger had to essentially invest almost as much in that single stock as they previously had in their entire fund.
Prices are set at the margin and thus as Tesla stock falls, so the ARKK ETF underperforms, which means it sees redemptions. It then has to sell Tesla to raise liquidity, which puts pressure on the stock, which leads to more under-performance. And so on. Something similar also appears to be happening with Roku and Square, the second and third largest holdings and also many other holdings in the fund are similarly off 10-15%. And thus the virtuous circle becomes vicious.
Interesting that ARK as a business has very much grown on the back of theme investing that looks more like meme investing which is very prone to this concentration effect as discussed last week. Indeed, one of its funds – the 3D printing fund has a large exposure to DDD, the stock we mentioned in the previous piece on memes. DDD is the second largest holding in the fund, the largest is EXone, a small cap company where Ark owns 12%. However, if we look at the other holders there are a lot of Japanese Banks, many of whom have funds under advisory to Ark. Together they add up to around 50% of the shareholders.
Chart 3: Is 3D Printing out with the ARK?
If we look at the chart of the two largest holdings of the 3D Printing ETF it certainly looks like a liquidity squeeze. The sell off may be associated with the recent announcement of ‘certain internal control deficiencies’ at DDD, or it could be the sharks circling a concentration risk. Either way, the managers at ARK may be feeling some sympathy with the long bond guys at the moment.