Q4 2019: "Surviving an Equities Melt Up”
Over the years, I’ve often fielded these kinds of questions: “Doug, this stock or sector has gone up so much, why isn’t now a great time to short.” Or, “The market is overvalued – PE ratios extended – why aren’t you aggressively short?” And there’s the question I’ve fielded previously during these quarterly calls. “Doug, why are you reducing short exposure when the market is moving higher? Isn’t a rally an opportunity to boost exposure and profit from market excess?”
Well, these reasonable questions pose a challenge to answer, as intuitively it makes sense to short rallies and reduce short positions during pullbacks – sell high and buy low.
The dilemma is that these short squeezes and speculative blow-off episodes tend to occur after the market has experienced a period of momentum. Even more challenging, they also regularly unfold even as underlying fundamentals are deteriorating. I’ve witnessed this dynamic throughout my career - and it repeated itself during the 4th quarter.
While we employ investment analysis and adhere to a disciplined investment processes, when it comes to managing short exposure we view the endeavor as more akin to professional speculation. As I’ve done in the past, I’ll share a gambling analogy. If you are sitting around a poker table and a couple fortunate players have accumulated big piles of chips, you better anticipate that they will now assert their financial advantage to dictate the size of the bets and the character of the game. You’d best be prepared for more bluffing and horseplay. If you choose to just sit there at the table, stare at your cards and play as if it’s a routine and fair competition – this disregard for game dynamics places you at a huge disadvantage.
Our risk discipline is to get more defensive when the market is going against us. We don’t want to see a market turn increasingly speculative – because speculative bubbles tend to take on lives of their own while creating a lot of uncertainty. I’ve lived through it: rallies and short squeezes can evolve into manic episodes of market dislocation. Q4 in a nutshell.
Tesla, one of the most heavily shorted stocks in the marketplace, surged 73.7% for the quarter. Advanced Micro jumped 58%, Tiffany 44%, Nvidia 35%, and Apple 31% - and those are all highly liquid big caps. Prices for forty members of the small cap Russell 2000 index at least doubled during the quarter – many with notable short positions. The NYSE Arca Biotechnology Index surged 20.3% during Q4, the Philadelphia Semiconductor Index 19.2%, and the Philadelphia Oil Service Sector Index 20.3%. Most of these outperforming stocks and sectors had significant short interest.
I’ll highlight Tesla. Tesla’s stock began the quarter at $241 with short interest of 36 million shares. By the end of the quarter, the stock was up 177 points and the short position was down to 26.3 million shares. With short interest averaging about 31 million shares during Q4, the loss on this short surpassed $5.5 billion. The stock then began 2020 by surging another $170 – pushing the loss on the short to $10 billion – the bloodiest short squeeze I can recall.
Many of the best short analysts in the business have been short Tesla. In a more normal financial environment, the company could very well have been a bankruptcy candidate. But this is an abnormal period of extremely loose financial conditions – and Tesla achieved a market capitalization of $106 billion. It’s 5.3% coupon bonds maturing in 2025 that were trading at 80 cents on the dollar in May are back above par.
I don’t like the risk vs. reward calculus of shorting individual company stocks when financial conditions are this loose. Moreover, the risk of shorting financially weak companies with negative cashflows and unsound balance sheets in an unstable macro backdrop - can be extreme. Only in such a backdrop would you see aggressive monetary stimulus in the face of a highly speculative market environment – with resulting intense short squeezes. And once the short community is impaired with heavy losses in a squeeze, contagion takes hold and the entire short stock universe turns problematic. I’ve likened this circumstance to walking through a minefield.
Tesla is the poster child of a company that has feasted on ultra-easy finance, in the process creating vulnerability to any tightening of financial conditions. Understandably, this fragility attracted a huge short position. But the Fed’s 2019 rate U-turn and aggressive fourth quarter QE program incited a dramatic loosening of financial conditions. Resulting panic-buying short squeezes erupted in shares of Tesla and others. To be sure, there’s no faster way to make money in the markets than squeezing susceptible shorts. And a highly speculative marketplace eagerly pounced. Monetary stimulus ensured dramatic outperformance by the fundamentally suspect stocks and sectors, playing an integral role in stoking a crazily speculative market environment.
For our risk-focused approach, the risk of Tesla-like short positions is much too high. Throughout most of my career, I really didn’t have much choice: We had to maintain a portfolio of individual company shorts. Going forward, I was determined to have the flexibility to avoid shorting stocks in unfavorable environments. After all, the primary defense on the short-side for surviving an equities melt-up is to avoid getting caught in squeezes.
Over the years, I’ve had many conversations where I explained my philosophy of adjusting the level and composition of short exposure based on the risk vs. reward calculus in the marketplace – increasing short exposure “beta” when the environment was more favorable for shorting and reducing exposure when less favorable. I would contrast my approach to other short products that were either always 100% short or exclusively short individual company stocks. Often I would get the response: “What you’re saying seems rather obvious. Why don’t the others manage this way?”
Well, the reality is that it’s a whole lot easier to just keep your short exposure rather constant. It’s easier from a marketing standpoint to stick with the shorting stocks story – employing so-called “forensic accounting” to successfully identify short candidates. Even in a up market, every year there are plenty of stocks that go down. It’s just a matter of shorting the right stocks, isn’t it?
Those that focus only on shorting stocks are understandably hesitant to admit there are times – sometimes protracted periods – when shorting company stocks just doesn’t work. There’s also the issue of adjusting short exposure. If you do decide to adjust your exposure based on market risk versus reward, what is your analytical framework and investment process for establishing - and then recalibrating - the level of short exposure? What is the framework and process for adjusting - the composition - of short exposure?
These questions get to the heart of a great challenge that I’ve been pursuing now for three decades. Lots of hard lessons learned the hard way - in incredible market environments – all providing invaluable experience. I’ve come to believe passionately that top-down analysis of financial conditions and market dynamics is critical on the short side. Discipline, patience and determination are fundamental. Keep a tight rein on risk.
So, let’s delve a little into financial conditions analysis: In this regard, 2019 was historic. Recall that the year began with expectations for Federal Reserve rate and balance sheet “normalization.” But the Powell Fed did an abrupt U-turn on rate policy that saw three rate cuts during the year. It’s worth noting something unique: these cuts came with stock prices at record highs and the unemployment rate near 50-year lows.
Normalization of the Fed’s balance sheet faced a similarly dramatic U-turn in September following the eruption of repo market instability. Federal Reserve credit expanded $400 billion in less than four months as the Fed’s balance sheet inflated back above $4.1 TN.
Aggressive monetary stimulus was administered in the midst of rapid money and credit growth. M2 “money” supply surged $1.024 TN, or 7.1%, in 2019, easily surpassing 2016’s record $880bn expansion. Moreover, M2 growth accelerated to an 8.6% rate during Q4. Institutional Money Fund Assets - not included in M2 - jumped $407 billion, or about 22% - in what was the strongest money market fund expansion since 2007. In a year of strong overall Credit expansion, total third quarter U.S. Credit growth surpassed $1.0 TN, the strongest quarterly gain since Q4 2007.
Fed officials and other central bankers refer to “insurance” rate cuts and monetary stimulus. I believe this will go down as one of the most dangerously misguided policy moves in history. Instead of “removing the punchbowl” or even “leaning against the wind,” central banks have aggressively administered stimulus during what I refer to as the “Terminal Phase” of late-cycle Bubble excess. Things get crazy at the end of cycles. This has turned insanely crazy.
The upshot has been acute Monetary Disorder manifesting across asset markets - at home and abroad. “FOMO” – fear of missing out. The “everything rally.” Don’t ask why – pay no heed to risk and just buy. I’m convinced we’re late in the culmination phase of a historic multi-decade global financial bubble. I look at 2019 developments and see nothing but corroboration of the bubble thesis. And, importantly, at this critical juncture there is a thin line between a faltering bubble and a policy-induced, rip-roaring speculative blow-off.
2019 experienced a historic melt-up in global sovereign debt markets that over the summer saw an unbelievable $17 TN of negative-yielding bonds. Ten-year Treasury yields traded to a low of 1.46%, as the yield curve inverted. German bund yields collapsed all the way to negative 0.71%, with Swiss bonds down to negative 1.12%. The world had never experienced anything like it. Ever.
The year then ended with a risk market speculative melt-up – equities as well as corporate credit and derivatives. As we’ve already discussed, equities surged to all-time highs and a major short squeeze unleashed intense speculative excess. In corporate credit, credit spreads narrowed to multi-year lows. Major credit default swap indices saw prices sink to lows since 2007 – both for investment-grade and high-yield. After trading as high as 131 bps on January 3rd 2019, Goldman Sachs CDS closed last week at 46 bps – the low since September 2007. After recurring spikes throughout the year, the VIX equities volatility index dropped down below 12.
My mosaic of financial conditions indicators has been signaling “risk on” liquidity abundance, guiding our cautious approach with short exposure. Financial conditions this loose are conducive to speculative melt-ups. In such an extraordinary backdrop, it is imperative to avoid stocks with significant short positions, the higher beta sectors and momentum in general.
We took short exposure down to the bottom of our typical 50 to 100% range of short exposure. Because of the extreme degree of downside market risk, I hesitated taking exposure much lower. During October’s call, I spoke of what I believed was an unfolding excellent put option buying opportunity. Fortunately, we went through yet another quarter without option purchases. We are nothing if not disciplined and patient – waiting for a more favorable environment.
Melt-ups are a dangerous market dynamic – first for those on the short side and later for the overall market. By their nature, speculative blow-offs create acute vulnerability. The final euphoric outburst ensures excessive underlying speculative leverage. Trend-following money floods into the ETF complex. Derivatives markets malfunction, spurring self-reinforcing buying to the upside. Price momentum becomes unsustainable, setting the stage for an inevitable reversal triggering de-risking/deleveraging dynamics. Derivatives then risk malfunctioning to the downside. Some degree of market illiquidity is unavoidable.
From a policy standpoint, progressively powerful policy responses are required to suppress panic and crisis. And that’s where we begin 2020: They’ve really gone and done it this time. I can confidently state that global central banks are inescapably trapped by market bubbles. Myriad indicators – from stock prices, corporate credit spreads, CDS and equities option prices – seemingly signal an extraordinarily low-risk environment.
But we would argue that Monetary Disorder has grossly distorted markets. Over the past year in particular, extreme price distortions have come to pervade global securities and derivatives markets. In a replay of 2007, the risk markets disregard the possibility of a bursting bubble, instead focused more so than ever on the inevitability of central bank actions to thwart escalating systemic risks.
The probability for a financial accident in 2020 is unusually high. Today’s degree of distortion and excess is difficult to sustain. It was no coincidence U.S. “repo” market instability unfolded following the reversal of market yields after the summer’s speculative blow-off.
It’s also worth noting the problems that afflicted WeWork, some of the other “unicorns” and the IPO marketplace more generally. There are scores of negative cash-flow and loss-making businesses that owe their existence to ultra-loose financial conditions. I would argue these companies and related industries have come to comprise a meaningful share of U.S. economic growth. You can call it “tech bubble 2.0” or an even greater technology arms race, but the current boom greatly dwarfs late-90’s excesses.
In the not too distant past, we’ve experienced two bursting bubble episodes that saw abrupt destabilization of the market liquidity backdrop - with major ramifications for company, industry and economic prospects. Scores of companies went bust when finance tightened between 2000 and 2002. When mortgage credit growth collapsed in 2009, the broader economy fell into a tailspin.
With financial conditions currently so loose and perceived wealth having inflated so dramatically, I expect maladjusted U.S. and global economies to keep chugging along – for now. In particular, U.S. housing has attained significant momentum. However, bubble economies grow progressively vulnerable to market and liquidity shocks. Fragile U.S. and global systems are today acutely susceptible to any tightening of financial conditions – and that is precisely why markets are today priced in anticipation of unrelenting central bank support.
The year is young, yet the risk backdrop has already shown itself. The U.S. assassination of Qasem Soleimani and Iran’s response has the clear potential to escalate into a major geopolitical crisis. Markets quickly recovered, but S&P500 futures were down about 2% in overnight trading on initial fears of escalation. It might be a very different market environment today had Iran’s retaliation against U.S. forces ended in American casualties.
Geopolitical risks have escalated further since our last quarterly call. And while U.S. and China cobbled together a “phase 1” trade deal, many analysts see this as little more than a temporary truce in an unfolding battle for global superpower dominance. I believe the odds of further confrontation with China are high – trade, Huawei, Hong Kong, Taiwan, the South China Sea and so on.
Beijing responded aggressively to bubble fragilities in 2019. After finally moving in 2018 to rein in excess, Chinese policymakers last year orchestrated their own U-turn – compelled once again to hit the accelerator as their economy faltered and banking system wavered - right in the face of a deepening U.S. trade war.
China’s broad measure of credit expanded a record $3.7 TN in 2019, another year of compounding double-digit credit growth even as their economy downshifted. Systemic risk continues to rise exponentially, with accelerated expansion of increasingly unsound credit. Both China’s massive banking system and maladjusted economy became only more vulnerable the past year. In particular, I would add that last year’s stimulus measures ensure only more problematic Chinese mortgage and housing bubbles along with perilous resource misallocation and deep structural maladjustment.
I have my doubts China will make it through 2020 without a bout of financial instability. The country’s small banking sector suffered liquidity issues in 2019, and I would expect similar fragility to begin spreading from the “periphery” to the “core” of Chinese finance.
Let’s hope this new coronavirus proves to be no big deal. But it is an example of how any development that puts China’s fragile system at risk will quickly become a global market concern.
China is one of the more obvious examples of the current era’s interplay between bubble fragility and geopolitics. I have long feared that Beijing would respond to a bursting bubble in a geopolitical context – seeking scapegoats, villains, distractions and nationalism. The odds of a crisis involving Taiwan are rising.
In the meantime, Beijing faces quite a balancing act. There is never a convenient time to deflate a bubble – and now would certainly be inopportune timing for China. Yet officials recognize the escalating risks associated with protracted credit excess and an inflating housing bubble. The credit and liquidity floodgates that were flung open in 2019 will need to be addressed – in China and around the globe.
I believe the Fed’s “repo” market operations have been especially dangerous. A decade of extraordinarily loose global monetary policy ensures unprecedented speculative leverage has accumulated around the globe. I don’t believe it’s coincidence that “repo” market instability in the U.S. soon followed money market liquidity issues in China. Over this protracted cycle, global markets have become intricately interconnected, with securities finance, speculative leverage and derivatives markets evolving into one unified – and highly levered – speculative bubble.
Global “repo” markets, “carry trades,” FX-swaps, and speculative leveraging more generally evolved into a major source of liquidity creation for the markets and the global economy overall. How much essentially free finance originated in Japan, Switzerland, and the eurozone to speculate in higher-yielding securities in China, the U.S. and the emerging markets? How large of a role have the so-called “off-shore financial centers” played in the liquidity onslaught stoking securities market bubbles around the globe.
Over the past year, there have been hints of the scope of latent fragilities. Reminiscent of 2007 as well as 1929 – it poses grave systemic risk when speculative leverage becomes a major source of liquidity driving asset markets and real economies. During the upcycle, it progressively fuels dangerous self-reinforcing financial excess and unsustainable investment and spending dynamics. Over time, market and economic structures hinge on liquidity abundance and inflating asset prices.
But at some point, speculative flows reverse, finance tightens, risk aversion sets in and bubbles falter. Importantly, de-risking/deleveraging dynamics lead to a cycle of waning liquidity, fragility, fear, market dislocation and crisis. The consensus view holds that with 2020 being an election year, financial, economic and geopolitical crises will surely be held at bay. I wouldn’t bet on it.
I view Federal Reserve operations as only inflaming financial leveraging and speculative excess more generally. I believe highly levered global bond and fixed-income derivatives markets are vulnerable to a surprising jump in yields. The scope of flows into the fixed-income ETF universe at this late-stage of the cycle is deeply alarming, only further boosting the risk of an abrupt reversal of flows and liquidity crisis. I ponder the scope of leverage that has accumulated in higher-yielding Chinese credit and EM debt.
In no way do I believe today’s ultra-loose global financial conditions are sustainable, and there are today myriad potential catalysts. Since it is such a big election year, I’ll end with a final related thought. The President is vulnerable, a vulnerability that would increase in the event of a market, economic or climate shock. Booming markets currently envisage a second Trump term. Things turn dicey if a geopolitical development, market disruption or some political drama throw the election into disarray. Abruptly, the pro-market Trump candidacy could be weakened, boosting the odds for the democrat – potentially an anti-market nominee.
Markets are today highly confident in a pro-market outcome in November. But there is a scenario where the diametrically-opposed unfolds. Similarly, markets are widely anticipating a year of “risk on” liquidity abundance. Of course, central bankers have everything well under control. Here as well, there’s a distinct possibility for the opposite end of the spectrum – “risk off” de-risking/deleveraging and resulting illiquidity that I view as unavoidable at this point. 2020 is poised to be a fascinating year of challenges and opportunities.