Tiny Bubbles
January 31, 2021
I had a letter partially complete on another topic, but the events of the past week are just too good to pass up writing about. I have heard from several readers over the past couple of days asking me to explain the Gamestop (GME) phenomenon as it has become worldwide news. This has been one of the strangest weeks I have ever seen in the market and I too am fascinated by the story of how a group of Robinhood traders have banded together to take down a few hedge funds. It’s a contemporary David vs. Goliath and it has potential ramifications to affect all of us on the sidelines.
How Gamestop Shares Surged 8,000%
We had 4 feet of snow in Tahoe this week, so imagine you borrowed your neighbor's shovel to clean the driveway. While clearing the snow, someone drives by and offers you $50 for your neighbor's shovel. Since you know they only sell for $20 at the hardware store you agree to the sale. You can go to the store, buy a new shovel, and pocket the $30 difference. Unfortunately, when you show up at the hardware store, there are 200 people looking for snow shovels and the store only has one left. Seeing an opportunity, the owner of the store decides to auction off the last shovel to the highest bidder. Since you are obligated to replace your neighbor's shovel, you are forced to pay the highest price. You give your neighbor his new $350 shovel and return home wondering how your plan to make a quick $30 turned into a disastrous loss. Our story doesn't end here. The shovel borrower (hedge fund) and Robinhood day trader (neighbor) both have new problems to deal with.
Schadenfreude
We have two new problems. First the hedge fund has suffered a large loss and needs to find a way to pay for its misjudgment. Second, the Robinhood trader thinks their $20 shovel is worth $350. We will start with the hedge fund because their problem has the potential to affect us all. The hedge fund in this example has $1 billion of assets and allocated 1% to shorting Gamestop.
The hedge fund assumed that GME is likely worthless and was comfortable borrowing someone else's shares thinking it may never have to return them, or if it did it would be at a much lower price. They never considered the prospect of a few million day traders bidding up the price by 8,000% and they are now saddled with losses so large they have to liquidate their good investments.
I have no sympathy for the hedge fund; in fact I take some delight in seeing them suffer from the same error that has taken down numerous other hedge funds throughout history. However, the forced selling of their good investments played a big part in driving the market down 3.5% this past week, and that affects us. There is an important lesson here. In the short run the market is a voting machine, and in the long run it is a weighing machine. I agree with the hedge fund's thinking, a lousy mall-based retailer who sells used video games and hasn't made a profit in several years is probably destined for bankruptcy. When it comes to shorting a stock, your upside is 100% (stock goes to zero) and the losses are potentially unlimited. I have observed few frauds and even more grossly mispriced stocks in my career, and if I had shorted them, I would be broke. Even though my accuracy in identifying these opportunities is quite high, my ability to correctly time their demise is poor.
The market is a crowded movie theater with a very small door
I have been writing about the amateur effect in the market for several months now and it reached a fever pitch this week. The Robinhood/Reddit traders are busy taking a victory lap after driving GME shares to the moon and are now planning their next target. However, they have a serious problem, they have inadvertently created a Ponzi scheme. Their gains are only on paper and in order to get their money out, they need a bigger fool to join the scheme. The illusion that GME stock is worth $350 can only be sustained if new investors come in and buy from the old. Like all Ponzi schemes, once there are not enough new people to pay off the early investors the price will collapse. The activity of the past week has gotten the attention of the President and Congress, will there be new regulations that affect how we invest?
Tiny Bubbles
I have been observing and pointing out irrational behavior in the market since the summer. True wealth in the stock market is only created by improvements in the underlying businesses. When you take a company like Gamestop that never makes any money, and it changes hands at an enormous valuation, there is no wealth created; it is merely being transferred from one party to another. We are witnessing an enormous amount of wealth being transferred and the rising tide makes us all feel richer. But we cannot be richer unless the companies do something to become more valuable. When valuations of companies like Gamestop, AMC, and Express get bid up to levels far exceeding their intrinsic value, we are left with Ponzi scheme economics better known as bubbles. So far I am seeing bubble-like behavior in small pockets of the market but the exuberance provided by stock trading apps like Robinhood has lifted the market as a whole. Be mindful that when the economics of a Ponzi scheme are combined with a good idea like the internet in 2000, homeownership in 2007, and electric vehicles in 2021, it can turn into a full-blown speculative mania. Charlie Munger once said, "if you combine raisins and turds, it's still turds." Mixing something wretched with bad consequences with a legitimate business is still a serious problem because someone will eventually lose big in the end.
Thoughts on the Market
At this time, I am finding few businesses trading near their intrinsic value. Most I would characterize as at the high-end or just outside of what I call the "zone of reasonableness." I hope that the eventual demise of a high profile example like GME brings an end to the speculative froth. When people get stung by sudden losses, it can have cascading effects throughout the market. It is difficult to tell if these tiny bubbles will bleed into other areas of the economy, therefore I continue to exercise caution in my portfolio. I suggest paring back the additional equity exposure we took in the early days of the pandemic back to normal levels.
Reminder to stay the course, keep it simple and don't complicate the process.
With investing you don't have to do exceptional things to get exceptional results. I believe the following process is likely to produce satisfactory results over a long period of time by minimizing mistakes.
- Buy great businesses at reasonable prices. Stock valuations relative to interest rates remain the most attractive option
- If you do not know how to identify a great business or a reasonable valuation, buy the VOO (Vanguard S&P 500). Owning a piece of corporate America at low-costs will do well over the long run.
- Do not attempt to time the market
- Avoid active trading - Don’t let emotions drive decisions
- Have a clearly defined plan and stick to it. If you don't have one I can help you.
- Avoid asset classes that diminish returns - i.e. cash and gold
- Keep expenses to a minimum
This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice. Past performance of any market result is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.
