Weekly Commentary: The Great 2021 Squeeze Mania

Snow-top Mountain Under Clear Sky

Yet another week for the history books. For posterity: GameStop (GME) gained 400%, AMC Entertainment (AMC) 278%, Express (EXPR) 235%, Siebert Financial 122% (SIEB), Cel-Sci (CVM) 75%, Novavax (NVAX) 74%, Vaxart (VXRT) 68%, Fulgent Genetics (FLGT) 60%, Vir Biotechnology (VIR) 59%, National Beverage (FIZZ) 54%, and Fossil (FOSL) 47%. Ominously, the VIX Index (VIX) spiked to almost 38.

Retail vs. the Hedge Funds. David vs. Goliath. Main Street Beating Wall Street. The democratization of finance for all. A Bloomberg headline from December: “Robinhood Is Not Gamifying Markets. It’s Democratizing Them.” Social media orchestrating a bloody short squeeze assault upon the hedge funds. The first month of the new year begins with chaos in our nation’s Capital and ends with market mania chaos – both manifestations of Acute Monetary Disorder. Society Out of Kilter.

Shorting and even so-called “squeezes” have been part of markets for centuries. From a 2008 Reuters article, “Short Sellers Have Been the Villain for 400 years”: “In 1609, a merchant contracted to sell shares in the Dutch East India Company in the future, sending the company’s share price into a plunge. A year later, the authorities imposed the world’s first ban on short selling.”

My first experience with a short squeeze was in 1991. I was working for a bearish hedge fund that had just wrapped up a bountiful 1990. The economy was sinking into recession, the banking system was in trouble, and the U.S. was heading into war. Prospects for our fund could not have appeared brighter. Then, seemingly out of nowhere, disaster struck. Short Squeeze.

We had a handful of positions both heavily shorted and illiquid. These were also shorted by the leading short hedge fund at the time that, trapped by the squeeze, was “blowing up.” Hedge funds had even invested in short hedge funds specifically to garner a list of short squeeze candidates. It was dog-eat-dog, ruthless, manipulative and bloody within the nascent hedge fund industry.

There was another brutal squeeze following the Fed’s Q4 1998 LTCM bailout – a squeeze that unleashed 1999 speculative blow-off “tech” Bubble dynamics. And a decent squeeze fueled record market highs after the Fed’s 2007 subprime blowup emergency measures. A big squeeze unfolded in 2009 after the Fed’s $1 TN QE-fueled market recovery. There were “mini” squeezes in 2011, 2013 and 2018.

Last March’s unprecedented Federal Reserve (and global central bank) crisis response unleashed a historic squeeze dynamic. Squeeze poster child Tesla surged about 700%, surely inflicting the largest ever losses from an individual company short position. The Goldman Sachs Most Short Index rallied over 200% off March lows, ending 2020 up more than 50%. The shorts came into 2021 significantly impaired and vulnerable.

The retail “Robinhood” online trading community strolled merrily into 2021 in the money, emboldened, and understandably overconfident. After all, the Fed last year rigged the “investing” game to ensure maximum payouts. Some during 2020 caught on to the market peculiarity that there’s no quicker way to posting hefty trading gains than to be on the right side of a short squeeze. This week the Manic Crowd discovered this phenomenon – and a spectacular mob scene erupted. I appreciate that the retail trading community especially despises the “unsophisticated” label after a year of capturing such heady trading gains. But, as a group, they have no idea the fire they’re playing with.

A well-known market pundit on Bloomberg Wednesday morning celebrated the retail traders’ defining success over the hedge funds. That the online trading community would profit from unwise and unwieldy short positions was nothing short of a marvel of Capitalism.

What we’re witnessing poses a risk to Capitalism – an out of control mania. The Madness of Crowds. I’ve been increasingly disturbed by the manic nature of online equities and options trading. These concerns were only elevated by throngs of online traders partaking in a chaotic squeeze episode. Many must be inexperienced in such cutthroat market warfare and surely do not comprehend the risk.

Squeezes are pernicious market dislocations that ensure significant wealth transfers. There are big winners and losers – the ultimate game of chicken pitting greed versus fear. Some hedge funds will not survive this ordeal. Other funds will profit handsomely from the squeeze - and likely then turn their sights on exposed retail traders. There will be winners in the retail community – that will for years enjoy bragging rights for nailing the Great 2021 Squeeze.

Hopefully I’m wrong on this, but most will be losers. Before this is all over, many will blow up their trading accounts and exit the casino in dismay – or worse. Short squeezes always have a pyramid scheme component. It’s musical chairs, and the velocity with which squeeze stocks eventually collapse will be a shock to many. There was outrage Thursday after Robinhood and other online brokers restricted trading in a limited number of stocks. But just wait until this Bubble implodes, and there’s blood in the (Main and Wall) Streets. Trading systems were stressed this week by millions of buy orders. How will the system function under the stress of tens of millions of panicked sell orders? I’ll presume worse than March.

Things get crazy at the end of cycles. To what scale of craziness during the waning days of an epic super-cycle? From this perspective, it’s only fitting that Crowds of retail traders discover the short squeeze game – the ultimate speculation. It’s also a conspicuously late-cycle phenomenon. Indeed, ears were ringing this week from sirens blaring warnings of trouble ahead.

January 27 – Bloomberg (Lu Wang and Melissa Karsh): “Hedge funds are slashing their stock exposure at the fastest rate in more than six years as a wave of volatility tied to some of their most-prominent bets forced a retreat from the market… The Goldman Sachs Hedge Industry VIP ETF, tracking their most-popular stocks, tumbled 4.3% for the worst day since September.”

A significant “risk off” deleveraging event is likely now unfolding. The dislocation in the short stock universe has inflicted serious losses across hedge fund strategies. These drawdowns dictate risk control measures, moves to reduce exposures including long holdings. Liquidation of the favorite longs (and resulting underperformance) has only exacerbated problems for long/short and some factor quant strategies. Losses along with general market uncertainty and instability have begun to force de-risking/deleveraging across strategies. Moreover, how much of the recent market advance was fueled by options-related buying (and associated leverage)? If it’s as significant as I suspect, the market is further vulnerable to self-reinforcing options-related deleveraging.

Treasuries provided a notably weak hedge this week against instability in the risk markets. Ten-year Treasury yields dipped only two bps with the iShares Long-Term Treasury ETF (TLT) gaining 0.1%. This highlights a potentially problematic dynamic for levered “risk parity” strategies, in particular. At this point, various strategies that incorporate a Treasury hedge would appear vulnerable to losses and deleveraging. Hedge fund managers – along with their investors – will now watch anxiously for the next shoe to drop. Bubbles are self-reinforcing and appear to function splendidly so long as speculative leverage is increasing. As we witnessed as recently as last March, they don’t work in reverse.

While on the subject of deleveraging, Friday from Bloomberg under the headline, “China Engineers Biggest Cash Squeeze Since 2015 to Avoid Bubbles:” “Beijing is so fearful of speculative manias that authorities are creating the biggest liquidity crunch in more than five years, roiling Chinese stocks and bonds and freezing a key funding market. The cost of overnight interbank borrowing surged 29 bps to 3.3433% on Friday, the highest since March 2015 and above the yield of China’s 10-year government debt. Earlier this month the overnight rate was just 0.6%. The real rate was even higher for some would-be borrowers, with brokers offering funds at 10% or higher... ‘The market is under huge liquidity stress,’ said Xing Zhaopeng, an economist at Australia & New Zealand Banking Group.”

The Shanghai Composite dropped 3.4% this week, with the growth-oriented ChiNext Index slammed for 6.8%. Major equities indices were down 5.5% in Taiwan, 5.2% in South Korea, 7.1% in Indonesia, 6.2% in Philippines, 9.4% in Vietnam and 6.7% in India. EM equities were under significant pressure as well in Eastern Europe and Latin America. For the most part, EM currencies and bonds suffered only modest losses, though the Mexican peso was hit for 2.9%.

Beijing has clearly made the decision to rein in some Bubble excess. Previous efforts were postponed, more recently due to the U.S. trade war and then by the pandemic. I’ll assume officials will proceed cautiously. Perhaps Beijing observes the U.S. struggling with myriad issues and believes now is opportune timing for China to take some needed medicine. I also assume that even timid tightening measures have potential to destabilize fragile Chinese and global finance.

Hedge fund de-risking coupled with Chinese tightening measures hold potential to evolve into a powerful global deleveraging dynamic. And if global “risk off” does materialize, the myth of central bank control over liquidity will again be challenged. The Bubble Thesis held that global leveraged speculation was at unprecedented extremes even prior to the pandemic. I fear leverage and speculative excess have expanded significantly since last year’s Fed and global central bank market bailouts.

I do have some empathy for our Fed Chair. This historic Bubble has been decades in the making, though his Fed has certainly orchestrated some crucial finishing touches. Powell was noticeably uncomfortable Wednesday. He clearly has no answers for fundamental questions regarding how the Fed should respond to the most speculative market environment imaginable. The Fed has been unrelenting with huge liquidity injections right into a mushrooming market mania. Aggressive stimulus measures have promoted historic leveraged speculation. Now Powell is facing the possibility of acute financial instability and crisis after a year of creating $3.3 TN of additional liquidity. He knows this, and it must be deeply unnerving.

New York Times’ Jeanna Smialek: “I was hoping that you would first react to the wild ride that GameStop stock has had this week. And then secondarily, you and your colleagues have repeatedly made it clear that you really plan to use macro-prudential tools as the first line of defense when it comes to financial stability risks, but your macro-prudential tools primarily apply to the banks. I’m wondering what your plan is, if you see some sort of large financial stability risks emanating from the non-bank financial sector in the coming months, especially as it relates to search for yield kind of activities, what do you see as the solution there?”

Chair Powell: “So, on your first question, I don’t want to comment on a particular company or day’s market activity or things like that… In terms of macro-prudential policy tools…, we rely sort of always on, through the cycle, macro-prudential policy tools, particularly the stress tests and also the elevated levels of liquidity and capital and also resolution planning that we impose on the largest financial institutions.

We don’t use time varying tests and tools as some other countries do. And we think it’s a good approach because for us to use ones that are always on because we don’t really think we’d be successful in every case in picking the exact right time to intervene in markets - so that’s for banks. You really asked about… the non-bank sector. And so, we monitor financial conditions very broadly. And while we don’t have jurisdiction over many areas in the non-bank sector, other agencies do.

And so, we do coordinate through the Financial Stability Oversight Council and with other agencies who have responsibility for non-bank supervision. And in fact…, in the last crisis the banking system held up fairly well so far. And the dislocations that we saw from the outsized economic and financial shock of the pandemic really appeared in the non-bank sector. So that’s, right now, we are engaged in carefully examining, understanding and thinking about what in the non-bank sector will need to be addressed in the next year or so.”

CNBC’s Steve Liesman: “…I wonder if I could follow up on Jeanna’s question here. I understand that you do address issues of valuations through macro-prudential policies in the first instance, but there’s a range of assets, and I know you do watch a range of assets, but from bitcoin to corporate bonds, to the stock market in general, to some of these more specific meteoric rises in stocks like GameStop, how do you address the concern that super easy monetary policy, asset purchases and zero interest rates, are potentially fueling a bubble that could cause economic fallout should it burst?”

Powell: “Let me provide a little bit of context. The shock… from the pandemic was unprecedented both in its nature and in its size, and in the amount of unemployment that it created, and in the shock to economic activity. There’s nothing close to it in our modern economic history. So, our response was really to that, and we’ve done what we could first to restore market function, and to provide a bit of relief, then to support the recovery, and hopefully we’ll be able to do the third thing - which is to avoid longer run damage to the economy.

Our role, assigned by Congress, is maximum employment and stable prices and also look after financial stability. So, in a world where almost a year later we’re still nine million jobs at least, that’s one way of counting it, it can actually be counted much higher than that, short of maximum employment. And… the real unemployment rate is close to 10% if you include people who have left the labor force. It’s very much appropriate that monetary policy be highly accommodative to support maximum employment and price stability, which is getting inflation back to 2% and averaging 2% over time.

So, on matters of financial stability, we have a framework. We don’t look at one thing or two things. We… made that framework public after the financial crisis so that it could be criticized and understood, and we could be held accountable. And… we do look at asset prices. We also look at leverage in the banking system. We look at leverage in the non-banking system, which is to say corporates and households, and we look at also funding risk.

And if you look across that range of readings, they’re each different. But we monitor them carefully. And I would say that financial stability vulnerabilities overall are moderate. Our overall goal is to assure that the financial system itself is resilient to shocks of all kinds. That it’s strong and resilient, and that includes not just the banks, but money market funds and all different kinds of non-bank financial structures as well.

So, when we get to the non-financial sector, we don’t have jurisdiction over that, so I would just say there are many things that go in… to setting asset prices. If you look at where it’s really been driving asset prices, really in the last couple of months, it isn’t monetary policy. It’s been expectations about vaccines, and it’s also… fiscal policy. Those are the news items that have been driving asset values in recent months.

So, I know that monetary policy does play a role there. But that’s how we look at it. And I think that the connection between low interest rates and asset values is probably something that’s not as tight as people think because a lot of different factors are driving asset prices at any given time.”

Liesman: “Mr. Chairman, do you rule out or see as one of your tools in the toolkit the idea of adjusting monetary policy to address asset values?”

Powell: “So… that’s one of the very difficult questions in all of monetary policy. And we don’t rule it out as a theoretical matter. But we clearly look to macro-prudential tools, regulatory tools, supervisory tools, other kinds of tools rather than monetary policy in addressing financial stability issues. Monetary policy we know strengthens economic activity and job creation through fairly well understood channels. And a strong economy is actually a great supporter of financial stability. That will mean strong, well-capitalized institutions, and households will be working. And so we know that.

We don't actually understand the trade-off between - …if you raise interest rates and thereby tighten financial conditions and reduce economic activity, now in order to address asset bubbles and things like that. Will that even help? Will it actually cause more damage, or will it help? So, I think that’s unresolved. And I think it’s something we look at as not theoretically ruled out, but not something we’ve ever done and not something we would plan to do. We would rely on macro-prudential and other tools to deal with financial stability issues.”

Bloomberg Wednesday interviewed former Fed governor and current Colombia University professor Fredric Mishkin: “I actually think that people overdo their focus on the stock market as driving things. In fact, Bubbles in the stock market, per se, when they burst are not really the problem for the economy. They can be dealt with. It’s when it involves the Credit markets. The thing that caused the problem in terms of the last global financial crisis was not the stock market – not the fact that there were changes in asset prices, per se. It was the fact that when that happened, it really affected the Credit markets and caused them to seize up. That’s not where we are right now. So, I think that people focus on the market – people could lose money, they could do stupid things, you can have Bubbles, there’s the crazy things that are happening with GameStop and so forth – but that actually very rarely has a major effect on the economy unless it interacts with the Credit markets, which I don’t think is what we’re seeing right now.”

Dr. Mishkin should spend some time with the Fed’s Z.1 report, while giving serious thought to what transpired last March. Never has U.S. Credit expanded so rapidly. Moreover, this Credit is largely non-productive. There is also strong support for the thesis that the current scope of speculative Credit is unprecedented. At this point, we’re an unexpected market-induced tightening of financial conditions away from major financial and economic issues.

Bubbles are mechanisms of wealth redistribution and destruction. And it’s generally the “middle class” that becomes most vulnerable. They have perceived wealth to lose while typically lacking the wherewithal of the wealthy to protect themselves. It’s worth recalling that Nasdaq (QQQ) lost 78% of its value in 30 months when that Bubble burst in 2000. Tens of millions suffered from the bursting of the mortgage finance Bubble. Yet never has the household sector been as exposed to a financial Bubble as it is today.

I hate the thought of devastating losses – in online trading and investment accounts and retirement savings. There will be public outrage, followed by a regulatory crackdown. It will prove further destabilizing for an already troubled society. There will be further loss of trust in our institutions.

I don’t share the sentiment that today’s short squeeze has anything to do with Capitalism. Instead, I expect to spend the rest of my life defending free markets and Capitalism more generally. Today’s fragile Bubble is a product of failed policymaking doctrine, inflationism and years of deepening Monetary Disorder. The Fed has made a catastrophic mistake in repeatedly backstopping markets, distorting risk perceptions, and perpetuating history’s greatest period of financial and speculative excess.

January 29 – Bloomberg (Alan Mirabella): “The GameStop Corp. saga is another sign of the growing intolerance among those with opposing views that’s roiling the U.S., according to Bridgewater Associates’ founder Ray Dalio. ‘What concerns me more is the general anger -- and almost hate -- and the view of bringing people down that now is pervasive in almost all aspects of the country,’ Dalio said… ‘That general desire to hurt one another’ is of concern, he said.”

The corrosiveness of unsound money is as insidious as it is today conspicuous. Inflationism has already wrought irreparable damage upon the fabric of our society. The cost of the most recent $3 TN Fed “money printing” melee is just beginning to come into clearer focus. The next few TN risk a systemic crisis of confidence and social mayhem. Their inflation and unemployment mandates will be the least of the Fed’s worries.

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Disclosure: Doug Noland is not a financial advisor nor is he providing investment services. This blog does not provide investment advice and Doug Noland's comments are an expression of opinion ...

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