Market Thinking

making sense of the narrative

Fomo plus Lol = OMG

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The second half of the year saw accumulated fragility within markets, as a Fear of Missing Out dragged in more retail investors and day traders, many of whom used Lots of Leverage via short dated options to exploit a Lack of Liquidity in mid cap meme stocks. This ‘upward crash’ effect has seemingly hit a wall and is now turning into something more akin to a conventional one. When the dust settles, the good companies will still be there, just rather cheaper.

The end of November marks the end of the year for many hedge Funds, who close their books in the run up to Thanksgiving and ‘The Holiday Season’. As such it also marks the start of the next investment year, which is why there is often a Santa Claus rally as money is put to work once again. Of course, it isn’t always a rally, sometimes it can start with, at the very least, some tax loss selling or indeed some attempts to generate some activity on the short side, the Grinch rather than Santa. This year is beginning to look like one of those.

As we ran into the Thanksgiving ‘year end’, we had already noted some curious activity in markets, especially beneath the surface. While the headline number on the S&P500 was relatively stable for example, the Morgan Stanley Index of the Most Crowded Trades had dropped 20% during the month of November alone and many of the more popular tech midcaps were down 50% or more. The US $ trade weighted index, having been range bound for over a year, suddenly broke up into a new range against everything but the Yuan – suggesting that this wasn’t about trade, but about financial flows – while Gold also appeared to finally break out only to collapse shortly afterwards. Meanwhile, Industrial metals, indeed, pretty much the whole commodity complex, found itself in steep backwardation, with spot trading higher than futures as the Economic Long Covid induced disruption to supply chains distorted markets. Energy prices were also high of course – not least Natural gas, but Oil as well, which was also in backwardation along with other commodities and an unwind of which may best explain why it too, appeared to sell off so heavily on the modest release of Strategic Petroleum Reserves.

Ostensibly, the latest market weakness is to do with another variant of Covid, but the set up over the summer months had been suggesting fragility, hinted at in the September selloff, only to apparently disappear in October. Fear of missing out, or FOMO, had dragged many retail investors into the ‘hot’ areas of tech, especially the ones with powerful narratives in FinTech or the Metaverse and many started using short dated options to enhance their returns. These day traders on Redditt or Wall Street Bets, with their RobinHood trading accounts were thus able to have a disproportionate impact on a number of mid cap ‘meme’ stocks. This had two components, the first was that in many mid cap stocks – and also some large stocks with limited free floats, most obviously Tesla – it was common for there to be ‘gamma squeezes’ as the market makers who wrote call options were forced by a spike in prices to buy increasing amounts of the underlying stock, forcing the prices yet higher, a liquidity effect. The second was that in addition to using short dated call options, many participants started also selling puts against their stock to buy the calls, effectively doubling their leverage, a leverage effect. Lack of Liquidity, or Lots of Leverage are both alternative derivations of LoL and when combined are the most common reasons for an ‘upward crash’ as well as a more conventional one. For a generation used to buying and selling on their mobile device, FOMO + LoL has ended up as OMG.

And then the Tide Went Out

You need an ARK when there is too much liquidity, not so helpful when it disappears

When we see large moves in certain areas of the market and what looks to be like distressed selling, we tend to look for what our good friends at Gavekal call a ‘whale’ – a large player floating to the surface, often mortally wounded by a strategy gone wrong. We aren’t alone of course, there is a whole cottage industry of traders looking for wounded funds to short their known book positions, including (whisper it who dares) the Prime Brokerage desks of the big investment banks. Unlike (some of) them, we are not in a position to know for certain and thus wait to see what, if anything surfaces, but if we were to speculate, then we would not be alone in wondering if the ARK has sprung a serious leak. Looking at the biggest holders of some of the mid caps hit hardest, the ARK funds do appear, but lower down than some of the others in the mid cap tech space, like T. Rowe Price and Tiger Global – who if they are not the distressed sellers must at the very least have had an absolutely shocking November. There is even a ‘short ARK innovation’ ETF available through Tuttle Capital that aims to achieve the inverse of the ARK innovation fund. Not surprisingly perhaps, it is currently trading at a high.

What also makes us focus on ARK however, is the sudden hit to BitCoin over the weekend, Kathy Wood of ARK is a big holder of Bitcoin through the GrayScale Bitcoin Investment Trust ETF, and if the redemptions are coming in thick and fast (rather than two by two) as we hear, then the need for daily liquidity means the same stocks are going to be switching from daily bid, to daily offer. In any event, the whale hunters are going to be pushing the stocks lower on the short side.

Another factor is likely to be the clone effect, both the official and the unofficial. Alongside the publicly quoted range of ETFs, ARK has a number of Japanese distributors with a form of ‘white label’ or clone fund. These can be meaningful in size and can contribute to the lack of liquidity in both directions – flattering when they are buying, insulting when they are selling. Equally, a large number of private accounts will have been tracking ARK’s stock picks, but often with a lot of leverage via options, helping make the trades not only crowded, but volatile.

As we noted recently, the discussions about shifting some of the financial Tech names, such as Mastercard, VISA and PayPal over to the Financials sector has appeared to lead to some forced selling of those stocks, leading us to consider more widely a new FinTech theme for inclusion in our Thematic baskets for 2022 once the dust has settled and the stocks have passed ‘from weak hands to strong ones’. Thus the recent unwind of the illiquidity driven extreme valuations in other purer fintech names, as well as those exposed to the other big theme for 2022, the Metaverse, offers the opportunity for longer-term investors to soon be able to take a ‘better value’ opportunity to acquire a thematic exposure to both of these areas.

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