In the story of Jack and the Beanstalk, Jack trades a cow for some magic beans. He has faith that the beans will deliver his fortune, and he is willing to give up the value of a reliable supply of dairy to acquire them. Fortunately for Jack, his positive outlook is rewarded with a golden goose. Similarly, in the stockmarket, exchanging cash cows for growth options has delivered some golden eggs. There are numerous examples of nascent or unprofitable businesses which have delivered spectacular share price growth such as the buy now pay later (BNPL) and software as a service (SaaS) businesses.
FAKE IT ‘TIL YOU MAKE IT
Some companies have seen their share valuations rocket to dizzying heights. The power of positive thinking has driven their cost of capital so low that ‘mining the market’ via equity issuance has become a viable growth strategy. With a high enough share price, aggressive growth plans and acquisitions, the new equity is gobbled up by cashed-up investors whose focus is on the potential future growth prospects of businesses rather than financial discipline.
A high share price is a self-fulfilling means to value creation – basically the cost of growing a business (buying cash cows) is a relative bargain when a company enjoys an extravagantly valued share price (a cheap supply of magic beans). In this way, convincing investors to think positively about a stock’s future as important as delivering profits and dividends.
SOCIAL MEDIA IS A NEW BATTLEGROUND
Positive sentiment has always been a powerful market force. Stock promoters nurtured it via market releases, investment research and traditional media. Today, social media provides a new arena to communicate positive stock narratives.
A spectacular example of this was the recent surge in GameStop. The powerful force social media can exert on markets was on full display. Two factors help explain this power. Firstly, there is less friction on social media. Stock promoters can communicate direct to the crowd without needing to convince intermediaries such as analysts or journalists to communicate narratives on their behalf. Secondly, the reach of social media is broader than broker research or specialist financial publications. Stock promoters can mobilise enormous crowds across the globe.
What made the GameStop squeeze remarkable was its velocity and magnitude as stock promoters used social media to communicate their message to spectacular effect. The evidence suggests most GameStop buyers acted on a conviction that they would profit by selling to a forced buyer after the crowd drove up the stock price. There was limited evidence that these investors evaluated the fundamentals of the business. Alloyed by social media and lubricated with fiscal and monetary stimulus, the collective power of the positive narrative obliterated the fundamental-based reasoning of the established short interest of hedge funds.
Social media spectacularly demonstrated a unique capacity to influence traders and violently move markets. The power of sentiment, unconstrained by fundamentals was amplified, and volatility reigned.
WHY IS THIS NEW SOURCE OF VOLATILITY A BIG DEAL?
It is easy to imagine that easy money combined with social media’s power to promote a narrative will result in more situations like GameStop. Markets have become accustomed to central banks acting to limit downside volatility. It seems strange to consider that volatility on the upside might also upset markets, yet we just saw that happen.
Beyond the stories of sole traders making millions, the notable and immediate reported outcomes of the GameStop spike were:
- Reports of heavy losses at respected hedge funds, resulting in portfolio rebalancing, liquidation, and recapitalisation; and
- Reports of online broker Robinhood’s expedited $3 billion equity raising to meet adjusted capital buffers and margin calls.
These outcomes are indicative of the broad and meaningful implications for markets should there be a re-evaluation of volatility, even if it is skewed to the upside.
GameStop’s share price spike resulted in liquidations and margin calls. These are signals of stress we usually associate with bear markets, not rising markets.
The upside skewed volatility burst also impacted long-short strategies. These strategies commonly access leverage by reinvesting the dollar proceeds of their short sales to add investments in their long exposures. Securities lending may not be traditional bank debt, but it is essentially leverage.
If markets become more wary about unpredictable upside spikes in stocks, long-short strategies are likely to become more selective with their short positions thus generating less leverage to invest in their long positions. This deleveraging is likely to reduce market liquidity. To the extent that many of these strategies crowd the same themes and factors, it may also narrow the dispersion of valuations.
Greater volatility will also impact the activity of market makers and options traders. Options traders use volatility to determine premiums (prices). Generally, higher volatility makes options premiums more expensive. Underestimating volatility is dangerous for traders selling uncovered options. Uncovered means that the trader doesn’t own the underlying stock and is therefore exposed as a forced buyer in the event of a spike in the share price. A short option position has limited upside and unlimited downside. With this sort of payoff, you do not want to sell too cheap.
Options are generally sold by market makers with large, finely tuned portfolios which are often leveraged and highly sensitive to sudden and violent changes. Market makers are an important contributor to market liquidity and provide valuable risk management tools. Dislocations for market makers can have broad market consequences, particularly for the counterparties who use markets for the purpose of insurance rather than speculation.
EFFECTIVE MARKETS NEED SECURE COUNTERPARTIES
The margin calls faced by Robinhood highlight the importance of the trading hubs upon which the integrity of financial markets depend. Much of the counterparty risk in financial markets is managed or intermediated through an exchange or a clearing house. For example, the owner of a call option relies on a clearing house to deliver on an ‘in the money’ (profitable) contract when that option is exercised. If the seller of that call option does not post sufficient margin to settle the trade, the clearing house wears the loss.
Volatile price movements can result in extraordinary margin calls (such as those demanded of Robinhood). If additional funding cannot be secured, margin calls will result in forced liquidation and can create market dislocations and elevated counterparty risks. Layers of leverage and opacity associated with stock lending and derivatives tangles the web of counterparties. In a worst-case scenario, a sudden breakout in volatility could erode confidence in the market hubs and thus the integrity of markets.
THE CENTRAL BANK PUT
For decades investors have become accustomed to central banks providing a backstop to markets to dampen volatility. The perception is that central banks have unlimited capacity to provide adequate liquidity to overcome any market dislocation. When a systemic risk to markets emerges, we no longer hope for a central bank bailout, we expect it.
A contemporary view is that central banks should have an asymmetrical impact on markets. That is, they should support failing markets but do not need to act against speculative bubbles. An interpretation of this might be that central banks truncate downside tail risks and thus reduce overall volatility.
The GameStop saga could justify an alternative interpretation. Introducing asymmetry may skew the distribution of returns (to the upside) but not actually reduce volatility. If the impact of the ‘Fed Put’ is to skew returns as displayed in the below graph, volatility is not reduced, merely altered.
GameStop demonstrates a paradox. Did this happen because easy money actually contributed to a breakout in volatility?
If that is the case, further central bank actions might only exacerbate volatility and have the converse effect of reducing liquidity and risk appetite. That narrative would not bode well for markets.
THE IMPLICATION FOR AUSTRALIAN SMALL CAPS
This has implications for small companies in Australia. The most direct and obvious is that it elevates the risks for short interest.
A share price spike created by a social media led buying frenzy may be short lived, however margin calls and leverage mean even brief spikes can lead to forced liquidation and significant losses. Contemporary hedging strategies for example, those used to reduce exposure to market risk or ‘beta’ might need fine tuning.
A debate about the appropriate estimate of volatility may also impact the valuation gap between market favourites and less sought-after names. A feature of Australian small companies in recent years has been the increased dispersion of valuations between companies. Market realities and themes such as lower interest rates and growth scarcity explain most of this however it has also been exacerbated by long-short strategies. An unwinding of these positions may reduce this dispersion.
Higher volatility is also likely to impact valuation dispersion due to its negative impact on investor confidence in general. Volatility undermines investors’ confidence in their predictions. An investor’s willingness to buy a stock reflects confidence in their price predictions and the future, overall. Expensive stocks have baked in the most optimistic outlooks, and therefore have the most to lose from any decline in confidence.
If volatility has been under-estimated, it is indicative of a mispricing of risk across the market. Perhaps central bank bailouts have not reduced volatility by simply truncating the downside. Maybe they skew the distribution into a fatter tail on the upside, with less reduction in volatility than previously thought.
The best-performing stocks are generally companies which are sustainably building valuable businesses. However, if volatility has been mispriced as described, the best opportunities are likely to arise from contrarian viewpoints rather than pursuit of expensive momentum. To this end we continue to look for high quality businesses where recent (positive) changes have not yet been recognised by the market.
We believe the best antidote to volatility is to ensure that our investment process is balanced. Our approach is to construct diversified portfolio of quality businesses, anchored by fundamental conviction as well as a positive narrative.
Sinclair Currie is principal and co-portfolio manager at Novaport Capital.