It's A Mad World

 While the European Central Bank did not change its monetary policy last week, the US Federal Reserve followed this week. Unsurprisingly, Powell stated that the Fed will stick to the plan but became more dovish on the near term outlook. Again he claimed that the Fed hat to 'make sure that markets are functioning' in March 2020 through its' monetary policy measures. I consider this statement 'questionable', at least if you observe the recent side effects of those policies...

I observe the ongoings in the financial markets for several years now and the more I watch the things which take place there, the more I feel that something within the system went terribly wrong. However, the market itself does not seem to care. Participants are well trained to adopt their narrative if the situation is changing. Buy the dip still works fine. Maybe this is the surrounding that John Maynard Keynes (with whom I agree very rarely) described as 'herding'. At least we can quantify the theory of perfect information of markets participants as false; at least in times like these. 

The last bull market after the GFC of 2008 which lasted about 12 years did not happen because firms increased their profits. While profits remained constant throughout the years, valuations doubled. I would consider this an unhealthy development already. 

We got used to such developments though. As nobody knows how long markets can continue to be irrational, it could be very dangerous to bet money on the obvious as long as the majority (or the herd) expects otherwise, no matter what the reasons are. Therefore it's better to ride the wave until it is broken and to collect some profits while doing so. 

Last week I wrote that the current situation reminds me of what I have read about the dot-com boom (I was too young to participate): Back in the days retail traders where as euphoric as professionals were. The same is true for today but something is different: There is social media and there are trading-apps which makes stock trading super easy (on your phone!).

Although everything started pretty harmless compared to what it has become. As everyone got locked down at home last year, the RobinHood trading app caused a strong hype in equity and equity options trading. The prospect of 'getting rich asap' lead to an explosion in call options on single equities. On January 8 more than half a trillion dollars worth of individual stocks were traded according to Goldman Sachs (Source: Wall Street Journal). Firstly the trading concentrated on well known companies like Amazon, Tesla, Apple or Nvidia.

However those actions have been much more rational than the events of the last several days. Now, retail traders organize on the social media website Reddit to organize something I would call a 'financial flash-mob'. Roughly explained that means that users find out that some hedge fund has built up a short position on the stock and by mass-buying of retail traders, the price gets bid up. As short-sellers need to cover their positions the bid up the price even further. This is what is called a 'short-squeeze' and according to the initiators on Reddit there is also something rebellious about it, some kind of 'paying it back to the elites' or so. 

Most talks have concentrated around the big rise in GameStop (GME) which exploded upwards from below 50 to more than 350 dollars recently. Some people like Elon Musk and Chamath Palihapitiya put more fuel to the fire (the latter even noted that his firm bought call options). 

Though, not enough: Have you ever heard of a company called BB Liquidating Inc.? No? Me neither, at least until Wednesday this week. The company went bankrupt in 2010 with only one shop left (Bend, Oregon). The shares were worth about 1 cents before redditeers pushed it up to 10 cents. 

This seems more like Hollywood than real life. Comparable to Billions, Bobby Axelrod again provokes a short-squeeze to make a former employer suffer because he's left his company because it has hurt his ego. 

The scale of market distortions becomes obvious if you compare the SPDR S&P Retail ETF to the SPDR S&P 500 ETF:

Many market observers may argue that this is just a natural phenomenon. Partly, they are right: Hypes are naturally and a part of human life itself. On the other hand I think that the respond to the crisis have very well played a role to create such extreme distortions. If your stimulus-check doubles quickly or even triples, when rates are low you may think about taking a loan to speculate with it to make some real money. Imagine: All your problems would be washed away if it would work. Nevertheless, it is still too early to evaluate if such things are happening broadly. 

Further there are other parallels between the dot-com boom and this market mania: Firstly, both were induced by easy monetary policy (pre dot-com because of the 'Tequila Crisis', now because of Covid). Secondly, projections of some sort of 'Golden Future' because of the internet/vaccine. 

On Thursday another strange thing happened: Robinhood Users weren't able to buy additional shares of Gamestop and alike stocks and some allegedly were forced to sell. I am not a lawyer, but if a third party sells something that another person possesses I would consider this as theft. Members of both US-Parties, Democrats and Republicans already call for an investigation on the matter. 

Michael Every from Rabobank wrote in his daily commentary: 

"What we are currently seeing, as a wag on Twitter put it, is how to REALLY Occupy Wall Street; and you get their attention and you get the whole system’s attention."

In his commentary, Michael also addresses the argument, that this has nothing to do with the pandemic:

"Yes, on one level this is what happens when tens of millions of people are locked down and given stimulus cheques to play with. But it’s also what happens if tens of millions of people grow up seeing that outside of Wall Street (and Tech), there are no jobs that pay as well and tax as little as playing with asset prices; when TV is full of ads for stock-trading and how amazing it is to be rich, rather than anything about public service and communities or culture; when homes and rents are unaffordable, and quality public housing no longer gets built; and when even Joe Public talks about the fact that Wall Street has had central banks channel billions of dollars at them every day for years, and get bailed out when things go wrong."

It is some kind of revolution: Small retail traders want to screw the big guys, David vs. Goliath so to say. However, as Michael notes, everyone knows who will win in this game: 

"Yes, what is happening will end in tears. Revolutions eat their own young - and so do asset bubbles, which this certainly is."

All those observation show that something within the system is broken. What I fear is the massive amount of distortions within the stock markets which keeps increasing from crisis to crisis. Obviously risk is priced completely wrong by the markets, especially in the bond market. And this is caused directly by easy monetary policy. 

Let's have a look at Europe where Italy is probably getting a new government after the current one could not agree on where to put the money that Italy receives through the EU recovery fund. During the last Italian government crisis the BTP-Bund Spread widened by 200 basis points. A similar widening happened in March 2020 when the pandemic hit us. Now the spread is dead and did not move more than by 20 basis points. Everybody counts on the ECB to fix things.

Since the EU-sovereign debt crisis the ECB never went off of Draghis' 'whatever it takes' route, they even intensified it. Most countries within the Euro Zone get paid for borrowing money, Italy pays a yield of well below 1 %. Why investors buy those bonds at such a low rate? Because you know that you can always sell it to the ECB. 

But the ECB already found another playing field: Attacking climate change. Fighting climate change will be the next scapegoat why the ECB needs to intervene and distort markets, mark my words. Interestingly Madame Lagarde stated that the ECB will invest directly into a Green Bond ETF issued by the BIS. 

In emerging markets, its' governments and companies also take advantage of low interest rates to issue new debt to lower their credit costs. Sergey Goncharov, emerging markets portfolio manager at Vontobel Asset Management said to the Financial Times: "for all intense and purposes, this is a tsunami we are facing now". 

We will see how this events will unfold in the coming weeks, although there is no end in sight as far as I am concerned. JP Morgan Quantitative Strategist Marko Kolanovic still advices investors to buy the dip, as he told Bloomberg because their equity exposure is still low and this will drive up the price eventually. 

Crazy events will continue too. People are very slow in changing their behavior on the one hand, and on the other hand there is too much talking about a potential bubble. However: If your risk-free rate is at -0.5 in Europe and at around 1 % in the US, some things are broken. 

If Junk-bond spreads are at all time lows within the US and the step down of an Italian prime minister is without consequences to the country's 10 year yield even though Italy's outlook is already 'no bueno', this signals a sign of false security. Investors are pushed into risk and this trend will continue until the last bear has turned into a bull. Then we may see a turning point...

Have a great weekend!

Fabian Wintersberger

 

Disclaimer: This is a personal blog. Any views or opinions represented in this blog are personal and belong solely to the blog owner and do not represent those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity.