Madness
Posted on Sunday, January 31st, 2021
“We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first.”
― Charles MacKay, Extraordinary Popular Delusions & the Madness of Crowds
Bitcoin was the object investors were focused on at the dawn of 2021. This week things got turned up a notch.
So you’ve all heard of this GameStop thing. What the hell is it and what is going on? My wife listens to me talk on and on about the stock market but she doesn’t really follow it. This week she became as an expert on Wall Street Bets/Reddit and short squeezes. Diane said that the last time she followed the stock market this much was back in 1999. 1999 and the stock of America Online (AOL) is a legendary tale here in the Reilly house. Diane and I were just starting out. We had bought our first house and needed to count out change to buy a pizza for dinner. I got a bonus from work and bought the stock – AOL. In days we had enough for a new car! That car came right on time because our old Ford Escort was not going to cut it with a baby seat in the back.
Here’s what went down with this GameStop thing. A group on a social media site banded together to buy GameStop – a struggling retailer. Huge amounts of stock had been borrowed and sold short. Selling short is a bet that you can borrow someone’s stock – sell it- and buy it back lower when the price goes down. Voila! Profits. Sometimes it’s not that simple. As a short seller you know that your loss is, theoretically, infinite while your gain is limited to 100%. Short selling is a risky business. Some hedge funds got a bit out over their skis as they were convinced that Game Stop was going out of business. They became stubborn and were too leveraged as the social media types began to buy more and more driving the stock ever higher. If you recall over the last several months I regaled you with stories how some investors had found the Holy Grail of investing – or for the younger crowd – they found a cheat code in their video game. If the social media crowd stuck together and bought enough call options on this one stock it would force others to buy – and did it ever!! GameStop went from $20 to $500 in three weeks. Reilly’s Rule #1 – Never be forced to do anything when investing. These short sellers are being forced to buy at ever higher prices and it is very painful.
This puts pressure on the part of Wall Street you never see. It’s in the back office that the risk managers go about their work. In the case of Robin Hood I am not sure that anyone in the back office was paying attention. Here is the simple version of risk management. If a brokerage has $100 billion worth of buy orders and $100 billion of sell orders and they all match up then fine it’s all good. What if they don’t? What if you have a 1% error rate? What if 1% of those sellers say “Sorry, I don’t have that kind of cash lying around”. The broker (Robin Hood in this case) is responsible for coming up with the difference. That is why they started shutting down trading and demanding more collateral and raising margin requirements. It is not David vs. Goliath as it has been portrayed in the media. It’s simple risk management that has been practiced by Charles Schwab and others for a hundred years. Robin Hood was new at the game and perhaps their risk management systems were not as robust as other more established firms. That is why Robin Hood raised $1 billion in new capital on Friday. The system is working just as it should and it is not some evil manipulative game played by Wall Street. The fascinating part for Diane was the human emotion component. Some of these social media followers refuse to ever sell their stock as they are making more money than they ever have and see this as “sticking it to Wall Street”. It is bound to not end well for most of them. Bulls make money. Bears make money. Pigs? They get slaughtered.
Emotions are not something that we can eliminate when investing but in order to be successful we need to understand them and not let them control our investing decisions as it seems to have infected the Wall Street Bets crowd.
The price of assets is driven by supply and demand. That supply and demand is driven by fear and greed. That fear and greed is driven by 100,000+ years of evolution. Our brains were not built for this.
And that’s where the arb comes in. We KNOW that we have our flaws. That recognition and acknowledgement alone gives us a huge advantage over others who are completely unaware.
As investors, what we’re actually doing is taking advantage of the fact that we have slightly better control of how we act on our emotions than those who are unaware.
– JC Parets All Star Charts
The CNN Fear and Greed Index is currently at 38. We have very quickly entered Fear territory. Understand that I do not invest based on the CNN Fear/Greed Index. I point to it as a data point for my readers to understand their own fear and greed. I want my readers to use this knowledge to make better investing decisions or, at the very least, not let it negatively impact their investing, At the very best I wish to help my readers understand others fear and greed and profit from it.
First the crowds chased bitcoin then GameStop. What’s next? The chat rooms say it could be silver. History would show a decline for stocks from here into March. It is beginning to look like that is going to happen. Large investors are deleveraging quickly. We still believe that a selloff will be sharp and not be long lasting. We just don’t see the type of complacency that we would see at a longer term top. That is subject to change as things evolve but the deleveraging tells us that the downside may be limited. We would love to see a correction of 10 -15% which would act as a relief valve to the speculative pressure building from the bulls. The S&P 500 is already down 4% from its highs. Draw downs of 10% in equities usually happen once a year. Expect it. Prepare for it. Profit from it. We are prepared. According to Goldman Sachs we are on track to have 50% of America vaccinated by May. Woohoo!!
I think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd Blankfein
A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill
To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .
Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.