Much has been made about the financial markets in recent weeks. A number of hedge funds shorting the US bricks and mortar retailer Game Stop have been seriously derailed by a horde of amateur day traders who organise on Reddit. In some narratives, this is a case of the little guy winning one over on Wall Street. In other narratives, this is a case of a serious criminal conspiracy that attempts to create a false market in Game Stop stocks. Whichever might be the case, it is worth stepping back to consider what is going on here, whether it is a portent of things to come, and how it all might end up.
What is going on here? There is no question about it, two technological trends have allowed this state of affairs to come about. One is the continued disintermediation of financial services. The growth of commission free trading, with ever lower margins on account, has increased the number of individual trading accounts. The other trend is the growth in fractional trading. Instead of buying whole shares in a company, it is possible now to buy fractions of shares, which effectively lowers the minimal value of trades that an individual can undertake. These trends were entrenched well before 2020.
What was different in 2020 was the pandemic. One of the consequences of the policy response to the pandemic was a large number of tech-savvy people with time on their hands and money in their pockets. In the UK, the furlough scheme provides employees with 80% of their salary on the condition that they don't go to work. In the US, a number of stimulus cheques have found their way into the pockets of a similar demographic. Various grades of lockdown have prevented this demographic from spending their disposable income, and the suspension of most sporting calendars have taken away opportunities for sports betting. This sets the scene - we have a body of, predominantly young, bored, tech savvy, people; who have money and time on their hands and who are looking for the thrill of the casino. Where else would they end up but in day trading?
Evidence suggests that this demographic has propelled the gravity defying rise of the S&P 500 in 2020. As a response to this, the day traders have resorted to internet forums to swap gossip about stocks over the course of the year. In some areas, it appears as if team plays have been deployed, the one in the case of Game Stop being a case in point. It is painted as striking a blow against corporate Wall Street, but it is nothing of the sort. The financial system is a complex ecosystem. Whilst some hedge funds may have taken a blow, the profits in the financial system are derived from activity, even if a trade is 'commission free'. The day traders are actually strengthening the system and pouring more profit into 'Wall Street'.
This is a situation that cannot go on for ever. There are two natural limits that need to be accounted for. The first is counterparty risk. As the trading increases in value, the potential for a default grows proportionately. In order to avoid a liquidity crunch, market makers will require trading app counterparties to lodge a larger margin against the possibility of default. This is why the trading app Robinhood had to suspend the trading of Game Stop until it secured an additional capital injection to cover this counterparty risk. Had that additional capital not been forthcoming, the bubble would have gone 'pop' at that point.
The second limit is one of fundamental value. How much is a share in Game Stop worth? For much of 2020, the market value was about $4.00 per share. That was seen as fair value given the underlying assets of the company and the prospects for the business. Trading volumes in the shares started to increase in September, leading to a frenzy of purchasing in January 2021, when the price rose to $347. At that point, there had been no material improvement in the assets of the company and the prospects, if anything, have worsened. Since the peak, the share price has fallen back to around $60 per share. This is despite that underlying assets probably being worth less than $4. At some point, those fundamentals will assert themselves, and when they do the share price will fall both dramatically and rapidly.
For this reason, it is not a portent of things to come. You can pay $60 for something worth $4 for only so long. In the last day trading frenzy - the Dot Com Bubble - the half life of a day trader was only nine months. This means that half of the number of day traders had lost all of their capital in less than a year. This is not a long term trend.
We need to be concerned at where this will all end. The case of Game Stop is neither really here nor there. We should be more concerned at the degree to which the day traders have inflated the S&P 500 over 2020. They are buying stock at inflated values and eventually the fundamentals will re-assert themselves. This is likely to be on the other side of a liquidity crunch that exposes counterparty risk. With the volumes of QE being pumped into the financial system, this isn't that much of a challenge just yet. However, should inflation start to rise, the QE money-go-round will slow, and at that point the whole system looks vulnerable to a major correction.
It is at that point we shall hear a vast amount of popping, and it won't be champagne corks making that noise!
Stephen Aguilar-Millan
© The European Futures Observatory 2021
No comments:
Post a Comment