Luis Arenzana

Extraordinary Popular Delusions and the Madness of Crowds

«The problem with hubris is that it is a very bad source of advice, especially in the case of a money manager»

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Extraordinary Popular Delusions and the Madness of Crowds
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Luis Arenzana

Luis Arenzana

Llevo 31 años subido al andamio de la industria financiera, los últimos 25 gestionando patrimonios. He vivido en Nueva York y en Londres, donde he tenido la gran suerte de conocer y trabajar con algunos de los mejores inversores de nuestro tiempo. A ellos y a mis socios les estaré siempre agradecido por la formación que he recibido.

Most people may never have heard of GameStop until last week and yet the stock price of this waning video games store chain, which saw its halcyon days nearly a decade ago, has become the field for a Battle Royale between popular capitalism and the hedge fund elites. Only in America could a class struggle movement choose the stock market as the setting for its revolution.  Last week’s gyrations and forced deleveraging of several large hedge funds that were coming out of one of their best years ever, thanks in part to the money handed out by the government to their current foes, may mark the end of an eleven-year long bull market. The storming of popular hedge fund shorts organized by ringleaders in social media chatrooms has been very costly so far for the shorts but also costly to many of the latecomers on the long side that may have seen their margin accounts wiped out during any of the sharp intraday declines that GameStop and other targets have suffered.

To some observers, it is surprising that neither the SEC nor the FBI are investigating the participants in chatrooms such as Wallssreetbets for market manipulation. What these Daves are doing to decimate their Goliaths may be interesting to understand the profound wounds that rising inequality have opened in American society. Yet, above all, a “when someone artificially affects the supply or demand for a security by rigging quotes, prices, or trades to make it look like there is more or less demand for a security”, that person is committing a felony under 7 US Code Section 13 punishable by a fine up to $1,000,000 or 10 years imprisonment. On the contrary, when some of the online brokers sensibly restricted trading and increased margin requirements on some of these stocks, an irate crowd accused the brokers of trying to bail out the fat cats on Steamboat Road.

Only a few days ago, Ray Dalio, the founder of what many people consider to be the world’s largest hedge fund manager, reflected that the US is on the verge of a “terrible civil war”. Yet he remained constructive  at this “inflection point  between entering the type of hell of fighting or pulling back to work together for peace and prosperity that addresses the big wealth, values, and opportunity gaps we’re now seeing”. This is the kind of analysis that leaves us perplexed and that perhaps is the source of the current wave of anti-hedge fund sentiment. For how could you remain invested in US Treasurys yielding negative real rates or US stocks at current valuations, if you seriously believe that there is a non-zero probability of Civil War in the US?

It is also remarkable that organizations that manage billions, including some of your pension money, may have such weak risk management in place that they are nearly taken out of business because of a bunch of crowded shorts.  As we have often discussed with our own investors, the risk reward of short stock positions is terrible. So bad indeed that nobody in their right mind should ever do it in their personal account. Whereas a long position’s risk decreases when it moves against you, the opposite is true of a short position. With shorts, when you are wrong, you are really wrong.

In any case, for most managers equity shorts generally do not contribute much to their long-term performance and are a source of constant headaches.  Short equity positions increase a fund’s leverage in a manner that is hard to quantify as seen these last few days or 13 years ago in the case of the Volkswagen squeeze. In addition, the market for stock lending is opaque and relationship driven, not unlike the market for Initial Public Offerings (IPOs). The stock lending desk may pull the rug from under your feet when you least expect it.  Crowdedness risk is also a negative risk factor as has been demonstrated this past week. We have advocated for two decades that it is generally better to express a bearish stance on a terminal company by shorting their bonds when available, but surprisingly most investors in hedge funds are not comfortable when their managers choose a different claim on the same issuer to express a view.

At the end of the day, what this debacle shows is that huge performance years increase managers’ confidence beyond what may be reasonable.  As a result, leverage increases in the industry, and liquidity risk grows underappreciated by a community of investors who for months could do nothing wrong. People forget to their own peril, that margin officers determine the end of many investment careers. There have been many signs of market excess in the past few months from the number of IPOs, to the trading activity in call options, to the nosebleed valuations assigned to many companies that are yet to show a profit. Yet, we are told every day that there is no alternative to investing in stocks because of central banks exerting financial repression. As it may turn out, the end of this bull market may come from a self-inflicted wound coming from its largest beneficiaries.

Should some of the rumoured monthly drawdowns turn out to be true, there may be massive redemptions not just for those managers with large losses, but for all managers, as those who are doing fine will once again become ATMs because they will offer liquidity that others will deny their investors by setting up gates to stop the carnage. Should history repeat itself, this deleveraging could have far-reaching consequences especially if we were to suffer another external shock to market confidence. We may take some lessons from events that took place twenty years ago.

In 1999, the market was on fire, not unlike today. A pandemic of fear of missing out on the Internet v. 1.0 revolution spread across boardrooms and executive suites culminating with the AOL-Time Warner merger; as it expanded rapidly it infected many investment portfolios as well. There were several factors inflating that bubble. Perhaps none more important than a low real Fed Funds rate so late in the cycle resulting from a myriad small and large crises, both foreign and domestic, that sprung up seemingly randomly since Alan Greenspan delivered his “Irrational Exuberance” speech on December 5, 1996.

The Fed left rates lower for longer than would have been prudent in hindsight, because of a number of successive shocks starting with the Asian Financial Crisis of 1997, which was precipitated by a combination of the deflation caused by excess capacity in China, too much leverage, and fixed exchange rate policies. The state of emergency continued in 1998. The winding down of Salomon Brothers Arbitrage books by new management augmented the impact of several unusually large market moves starting with a multiple standard deviation reading of US mortgage pre-payments in February that sent the Interest Only strip (IOs) of Mortgage Backed Securities reeling into oblivion decimating several Mortgage Backed Securities hedge funds.

In the fall, panic and mayhem reached a climax with Russia’s devaluation and default on its domestic currency debt (but surprisingly not on its foreign currency debt) which sent all Emerging Markets financial assets into a downward spiral. This was the backdrop for the demise of Long Term Capital Management and Bankers Trust, two highly levered market participants. While the former was unwound; the latter was acquired by Deutsche Bank, in what became the beginning of a long decline for that lender. A plunge in market liquidity that took no prisoners was a common characteristic of many losses in those turbulent markets. Arbitrageurs did not have enough capital left to profit from price discrepancies.

A terribly complicated 1998 was followed by the introduction of the Euro and the Brazilian Real devaluation in 1999; and finally this turbulent period culminated with some misplaced fears on both the glitches around the introduction of the euro and the devastating consequences of a software problem known as Y2K, a prime example of how our civilization conducts long term planning. By the time the Fed started hiking in the spring of 2000, few companies, and many fewer investors were well positioned.  The NASDAQ which could do no wrong for years took an 80% plunge before it found a bottom.

There is a lot less leverage today but there is also a lot less liquidity because financial intermediaries stopped providing liquidity with the financial crisis.  There is no danger of a rate hike today, there is even talk that should the yield curve steepen the Fed will come out to the rescue.  Many people believe that were asset prices to decline, the authorities will intervene forcefully.  As one of my business partners puts it: for this market, good news is good news and bad news is good news as well. As we have seen this week it does not take a bear market to create many problems. Actually, this time around the opposite of a bear market has allegedly inflicted considerable damage to some legendary investors. The problem with hubris is that it is a very bad source of advice, especially in the case of a money manager.

The travails of some very large hedge funds back then were a source of opportunity for many of their former partners and employees to set up shop on their own. Some of those in that generation seem to be experiencing these new difficulties. This in turn may give rise to some new opportunities for a younger generation. Perhaps allocators may learns from this short squeeze that under current liquidity conditions, the optimum hedge fund size is much smaller than they believed.  These investors may also find out that the trade-off between research resources and size, which has been a driver of industry concentration, has also produced some unwanted consequences. This conflict may be resolved by paying higher fees to smaller funds, and not the opposite, as has been the trend for years now.  One thing is for sure, there has never been a time when most people were so in need of financial advice, including those who provide it.

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