The retreat of leveraged retail from Equity markets is leaving a lot of ‘concept stocks’ friendless, (no profit, no bid as Bob Marley almost said) but this looks to us more like 1987 than 2000, despite the noise and nonsense of SPACs etc. Unwinding of dealer side hedges risks outsized selling of rallies and undersized buying of dips, particularly in NASDAQ. Meanwhile, last week’s ‘no inflation’ view on the dollar has accordingly flipped into a ‘yes inflation’ view on equities and of course commodities, which is where the leveraged retail investor has seemingly gone. Interesting to note that lumber is up 500% over the year, more than bitcoin. Guess that’s what happens when you, quite literally, burn your stockpiles for energy because it’s apparently ‘good for the environment’.
The dream for a corporate financier looking to do a (highly lucrative) IPO is that the company qualifies for a benchmark index and thus large institutional investors are ‘forced buyers’ of the stock. No worries about its underlying profitability or the cash flows – or even increasingly the governance structure – just as long as it is in ‘the index’ then the passive funds will buy. That is the plan at least and the less liquid the stock, the more it squeezes up. Meanwhile, favoured hedge fund clients in the pre-IPO or early allocation stage get to book reassuringly high profits on day one, leaving the companies to their own devices. As we found out in 2000 after a similar burst of IPO enthusiasm, this often ended badly for anyone that stayed the course. Special Purpose Acquisition Companies (SPACs) were a way for companies to avoid paying the very high fees for listing (the SPAC investors pay the, still very high, fees instead) but they only really work if the company being acquired has those old fashioned notions like cash flow and profitability.
Into such an environment have come the Thematic funds, epitomised by our old friend Cathie Wood with her ARK active ETFs (and also, perhaps more importantly, the Japanese retail money ‘clones’ that follow the same strategy). To be clear, we are big fans of the concept of Active ETFs as the evolution of mutual funds, they are a great way for retail investors to get exposure to active equity investment rather than simply buying passive clones of indices which are structured by computers and are simply a narrow(er) investment universe. However the problem with these type of thematic funds, as we have previously discussed, is that, too often, they are over-invested in illiquid stocks, something that works very much in their favour when money is flooding in, but very much against them when it starts to reverse. Such funds are natural homes for the narrative rich but cash poor IPOs.
Chart 1 updates the rather torrid year to date performance of the Ark Innovation fund, which we regard as the poster child for this type of issue. It squeezed massively higher in 2020, dragging in huge inflows in its wake, only to reverse this year. Again, this is not to gloat, we love the idea of thematic investing even more than we like the concept of active ETFs, rather it is to highlight the very important issues of market mechanics that develop around these new phenomena.
Chart 1. Arrgh..k!
Technically, we see Arkk flipping from a series of higher highs and higher lows, to one of lower highs and lower lows and the fund looks to be in what technicians might refer to as a ‘distribution phase’. It is being sold on rallies and not bought on dips. Redemptions mean selling equally across the portfolio, which can be difficult given the underlying liquidity of some of the stocks, especially as many of them have been pushed hard, but now abandoned by leveraged retail investors.
Greek Alert
(Apologies, but it’s back to the greeks. You can skip this bit other than to know that the sell off in NASDAQ is most likely down to deleveraging positions by options dealers as retail sees its call options in no profit tech stocks evaporate. )
This is actually not that unusual, what is different is the scale and also the use of derivatives. Last summer we noted the squeeze higher in Tech stocks attributed to the Gamma squeeze deliberately put on by the ex derivative traders at SoftBank (see SoftBank. Again?) and there is no doubt that there was a similar level of options activity around the cash inflow effects of these booming thematic funds – especially, but not exclusively, ARKK. In the latest Monday Morning Musings we noted how the collapse in retail participation was leaving a number of no profit tech stocks essentially ‘no bid’, and this is causing some wider weakness in markets which is, we suspect, down to the gamma hedging factors, something we discussed a week or so ago in our May Market Thinking.
To recap briefly, most institutional investors use derivative markets as a way to hedge/enhance returns, while retail tends to use them to gain leverage. Thus an institutional investor will write covered calls (sell call options on stocks they own) or buy index put options to protect their downside. In the terminology they are short calls and long puts. Often they do one to finance the other. The dealers, or market makers, are on the other side of this trade and are thus ‘usually’ long calls and short puts and their actions to hedge this through their ‘delta one desks’ essentially involve buying dips and selling rallies in the underlying stocks, meaning they act to ‘stabilise’ market volatility.
Retail investors can mess this up however. When retail buys calls they are effectively joining the dealer on the other side of the institutional trade, but importantly, unlike the dealer they are not hedging. They are what is known as ‘naked long’. Perhaps more important, when retail buy options in smaller ‘growth’ stocks the dealers (who are now on the other side since it is rare that institutions would be the ones selling calls in this type of stock) tend to hedge via the bigger indices rather than the underlying stock. Thus if I, as a dealer, have sold you, as a retail investor, calls in small tech stock x, I try to hedge my position by buying the NASDAQ rather than the stock itself. This introduces the prospect of ‘basis risk’, ie me not being able to efficiently hedge the position, but also the prospect of exaggerated impact from deleveraging. As retail leaves the market and the price of the bubble stocks fall, so does the necessary long position for dealers in NASDAQ. If the price of a basket of bubble stocks drops 20 or 30% below the strike price on the options I have sold, then I need far less NASDAQ to hedge them. So I sell NASDAQ, not because I have a view on inflation or growth or any of the underlying stocks, but because I am deleveraging my book.
Finally, we can’t pass mentioning the guys at The Hut Group – now rebranded THG, presumably to sound more ‘tech’, but given the CEO’s penchant for posing moodily in leather jackets runs the risk of the same Red Glasses award as ‘A Burden‘. Evidently SoftBank (yes them, again) are buying into THG in order to spin off the tiny tech part of the online retailer into a seperate business with a valuation larger than the entire existing (already highly expensive) online retailer.
Chart 2. So far, a lot better for those ‘inside the Hut’
The placing at 596p will have come as something of relief to post IPO investors who have seen something close to an ARKK like performance this year. The original insiders will be less troubled, however, having already benefitted from a ‘waiver’ of a large part of their lockups that allowed them to get out in January at 760p. As will the brokers, who are relentlessly promoting the stock as the next Amazon (yes another one) and have just booked another big fee, The share price bubble post IPO had been enhanced by, you guessed it, inclusion in the Stoxx 600 in December, despite all the corporate governance issues that had kept it out of the FTSE. Still nevermind, the index trackers duly piled in as the insiders bailed out. Moreover, this, purely coincidentally you understand, helped keep the average share price above 670p for more than 15 consecutive days before Christmas and in doing so allowed CEO Matthew Moulding to participate in the absurdly generous bonus scheme he had written for himself for such a modest ‘target’. Around a billion pounds. The stock kept above the white line just long enough for the CEO (who also gifted himself the property portfolio on flotation) to get his bonus and then dropped like a stone until it was underwritten by the next buyer at the red line. Now with SoftTouch on board it looks like the insiders can all get out with even more.
