Australian Financial Review
December 16, 2021
The following is a short article written for the Australian Financial Review summing up the current situation in markets.
Long-term investors need to look through short-term confusion
Mark TinkerDec 12, 2021 – 11.49amSaveShare
Long-term investors could be forgiven for wondering what on earth just happened in the last few weeks.
Sure, we got the predictable appearance of a new strain of COVID in time for Christmas and the equally predictable response from most governments and, if nothing else, markets have learned to react to the likely (and fairly predictable) negative economic effects of government policy rather than the still extremely uncertain, health effects of any new variant.
So, in market parlance, it was very much a ‘risk off’ move after Thanksgiving, as equities, oil and crypto sold off and bonds and the US dollar spiked, only for it all to switch around again a week later.
Anyone trying to rationalise the market moves in terms of economics or earnings fundamentals, let alone in the context of market concerns such as growth and inflation, was understandably left scratching their heads in confusion.
As ever, this is as much, if not more, about how people were positioned before Thanksgiving than it is about any change that occurred in fundamentals or indeed risk appetite with the announcement of omicron.
The second and third quarters of the year had been curious, in that not only did most markets outside of the US peak in early Q2, but since then, there has been something of ‘an upward crash’ in US mid-cap tech stocks, along with the exploding interest in crypto as short term, leveraged investors have become dominant in the former, while long-term investors are becoming increasingly involved in the latter.
As a result, both markets are starting to behave differently, and participants are having to adjust. The result has been a number of sharp spikes in volatility across markets as ‘things behave differently than usual’.
This arrival of new players, with new rules, is most obvious in the US mid-cap tech space, where a number of thematic, or meme, stocks have seen dramatic upward price movements in the last six months, many of over 100 per cent or more.
A large number of these stocks have been associated with IPOs where there is still only a modest available free float available and where a number of large thematic investors have been steady buyers in response to continued subscriptions into their underlying funds.
Steady inflows plus relatively low liquidity is a classic recipe for a squeeze, but if we then add in some leverage via the options markets, then things get even more frothy.
The leverage has largely come from retail investors. Back in January readers may recall that we discovered how the Reddit forums such as Wall Street Bets and associated twitter groups enabled a number of US day-traders with RobinHood accounts and access to option markets to act together to ‘take on’ the big Wall Street players in small stocks like Gamestop.
That process expanded over the following months to lead to a relatively large number of day traders using leverage via short dated options to enhance the returns on their underlying stock positions by squeezing the options market makers.
This happened across a large number of these mid cap tech stocks over the last nine months, but also, and especially, in the ultimate meme stock, Tesla.
“History tells us that markets are good at identifying long-term winning themes… but are often poor at pricing them.”
This, then, was the set-up as we went into early November, with the recognition that, for many absolute return funds, Thanksgiving is effectively ‘year-end’ and, as a result, trading books tend to be squared away running into the US ‘holiday season’.
Partly for this reason then, we found that even though the headline indices were steady, a sub-index of the ‘most crowded trades’, effectively most of those high performing mid cap tech stocks, hit considerable profit taking and started to sell off in early November, such that by the time we got to Thanksgiving the average was down 20 per cent in a few weeks, with many individual stocks down significantly more than that.
This was made worse by the fact that, following a weak September, a number of the big thematic funds saw a wave of redemptions, meaning that instead of subscriptions forcing prices of illiquid mid-cap favourites higher, redemptions forced them lower, compounding the effect; the virtuous circle turned vicious.
Thus when news of omicron hit the day after Thanksgiving, there was a rush to liquidity which added further pressure and the parts of the markets that had also sold puts to buy calls in mid cap tech suddenly found themselves as distressed sellers of the stocks they were hoping to squeeze higher.
An upward crash was followed by a downward crash. The fact that some of these theme funds owned bitcoin helped spread the selloff to Crypto as well. And yet a week later, it was all, apparently, gone.
To the extent that markets had identified a number of winners in the long-term themes of FinTech and internet 3.0 (sometimes known as the Metaverse) and overpaid for them as they became ‘crowded’, does not change the narrative simply because they have now, in many cases, become distressed sellers. It only changes the valuation. For the better.
Long term investors could do worse than take a second chance to look through the rubble and take the relatively quiet holiday period to do some homework on these upcoming themes.
Mark Tinker is CIO of Toscafund Hong Kong and the founder of Market Thinking. He blogs on behavioural finance and markets at Market-thinking.com.SaveShare