Reddit’s Rage: Is this really the way?
February 4, 2021
Is the recent speculative mania the beginning of the end of the bull market that began after 2008?
The latest market action is another reminder that investing is not the study of statistics and formulas but of investors near-infatuation with stories – and of their limitless imaginative capacity to fall for them.
Yet, we are not in a late stage bubble for risky assets generally.
Ironically, the recent instability of speculative targets will bolster confidence in more reasonably valued sectors and broader investment classes that have been underperforming for years.
For diehard fans of Disney’s The Mandalorian, misappropriating its mantra (“this is the way”) is a crime against the Star Wars franchise. Yet, a new wave of at-home traders have done exactly that. Their online forums, alongside boasts of moonshot profits and rallying calls to buy specific stocks, are littered with other creeds too (“flows before pros”) — all drenched in profanity and a laser-like criticism of the tyranny of Wall Street and other big money players.
Welcome to the spectacle of 2021, dear readers. For those that have been self-isolating on another planet, let us bring you up to speed on recent action. A shift in market tone has occurred in 2021: after years of indifference, individuals — working from home, idled by the pandemic and encouraged by the ease of new app-based trading platforms — are finding their way back into the stock market.
On the surface, this is neither good nor bad. There are simply more players in the market. Yet a dark theme has emerged. The perception among the community is that they can exploit weaknesses in a financial system that has left them behind in recent years, waging a kind of mercenary market warfare. Their alleged edge? The ability to coordinate on social media sites like Reddit to move prices where they want them.
In the short term, it would appear they have a point. In recent weeks, they have caused colossal losses for a few short-selling hedge funds and forced the online brokerage firm Robinhood to raise billions in additional capital (yes, we realize the rich irony in that name).
Much of the media has framed this as a David-versus-Goliath story. Admittedly, that has a certain appeal. Who doesn’t want to cheer on the underdog?
But let’s not pretend these traders are battling the Galactic Empire. This is not a good versus evil story, or another Occupy Wall Street movement. Markets are always full of several players, each with differing outlooks. For example, many hedge funds were also long Gamestop during its melt up. What’s more, the political fury and conspiracy theories that erupted after some brokerage firms halted the trading of certain positions reflects a staggering level of misunderstanding about how markets work.
But, yes, some elements are new here. Having the online scale to mobilize thousands of traders to influence a certain stock can indeed drive markets in the short term. And, sure they can inflict serious damage on short sellers. It’s called cornering the market and, 40 years ago, the Hunt brothers famously did it with silver (spoiler alert: it ended in tears). Yet, as everyone eventually learns, coordination, whether online or not, can be complex and can also be countered by other traders pursuing the opposite position.
The reality is we are not witnessing the discovery of some magic strategy for perpetually making money and sticking it to the suits. Instead, we are witnessing a moment that shares the same dynamics of other speculative episodes — performance chasing, copycat behavior and a rising belief that someone else will come along to buy a surging stock at an ever-higher price, with little regard for fundamental risk.
And don’t get us wrong. There are many reasons to be outraged with Wall Street. This is not one of them.
Coming Bubble or Bust?
Looking ahead, a blast of cold water to the face of this speculative phase is so plainly in the offing. History has not been kind to the hot hand. Alas, an entire new generation of investors will learn hard lessons (one industry colleague put it more succinctly: “they’re screwed”).
A far more interesting question, then, is whether a bust in these speculative stocks will be the catalyst for a larger bear market? Or, in other words, are we in the late stages of a financial bubble in risky assets generally?
To be sure, specific securities have seen extreme price movements and dangerous optimism is built into them. Some niche tech plays and covid-winners are clearly in unsustainable bubbles. Over 80% of recent IPOs have no earnings. SPACs are soaring. And the crypto craze has been re-ignited.
Yet many of these investment classes are hardly rooted in broader-based bubble mentality. In fact, many of the speculative surges are opportunistic reactions that arose from the crises of 2008 and the pandemic of 2020. We have called these “echo bubbles” as they successfully tapped into a post-crisis pessimism and general mistrust of policymakers.
What’s more, many of these investments have already experienced busts and yet inflicted only trivial collateral damage on the broader market. From early 2015 to late 2017, Bitcoin’s price rose roughly 125-fold, before collapsing by more than 80% in 2018. Unsurprisingly, as the ownership of Bitcoin is highly concentrated and held outside the balance sheets of systemically important financial institutions, the impact on broader risk assets was limited.
Even more important than the above market-related risks are that the conditions for a broad-based economic downturn are not yet present. Why? First, the credit growth and financial imbalances that have been hallmarks of bubbles are not evident today. Reforms since the 2008 global financial crisis have reduced leverage in key parts of the global financial system. For European and US banks, measures of leverage are much healthier than on the cusp of either the late 1990s technology crash or the 2008 crisis. The private sector deleveraging that needed to happen in the US and Eurozone after 2008 is largely complete (a reduction in consumer spending plus extraordinary income support has improved private sector balance sheets even further over the last year).
Additionally, the stage of the business cycle is far earlier than before previous crises. For example, in the late 1990s, the stock market bubble formed at the end of a business cycle expansion when earnings were on the precipice of a significant decline. Today, the business cycle only bottomed last year, and corporate profits are in a cyclical upswing. And, all of this with an ultra-stimulative policy backdrop. Previous crises were typically triggered by a policy tightening. Today, we have an environment of low interest rates with central banks willing to hoover up increasingly exotic assets on their balance sheets and, most importantly, aggressive fiscal activism. The era of deficit-phobia is over and global growth will be higher this decade than the last (see our latest Super Trend “You Say You Want A Fiscal Revolution” for more on this).
What makes markets move is a question to which this author has now devoted more than two decades of rumination. The latest action is another reminder that investing is not the study of statistics and formulas but of investors near-infatuation with stories — and of their limitless imaginative capacity to fall for them.
Looking ahead, the best hedge against a bust in some speculative investments is to build globally diversified strategies based on longer-term outlooks. Ironically, the instability of these niche assets will bolster confidence in more reasonably valued sectors and investment classes that have been underperforming for years. Cyclical sectors, such as industrials and financials are well positioned to benefit from an ongoing vaccine-charged economic recovery. Equities outside of the United States, with valuations in many cases that are not much higher than ten or even twenty years ago, have quietly started a period of outperformance (emerging market stocks are leading all major indices this year). These rotation themes have years to run.
But while the general bull market may not be over, volatility is set to rise in the period directly ahead. Among the elements that are part of the Mandalorian Way is to never take your helmet off. Serious investors are advised to do the same.