I wrote a little bit about the mechanics of shorting stock and naked shorting of stock. Some version of what I described in Scenario C happened to a hedge fund called Melvin Capital. Melvin Capital was heavily short GameStop (GME). The price rose rapidly and it sounds like they didn’t have enough money to close their position. According to the New York Post, “Hedge funds Point72 Asset Management and Citadel gave a $2.75 billion capital infusion to Melvin Capital earlier in the week, enabling it to close out that position with a large loss.”
Remember that name: Citadel. Citadel is a huge client of the trading platform Robinhood. Robinhood sells trading information to Citadel.
The retail traders on Robinhood trade for free. On platforms like Google, Facebook and Twitter where you get something for free you are the product.
Citadel is Robinhood’s customer. Without clients like Citadel Robinhood doesn’t make any money. So there is motive for Robinhood to want to keep Citadel happy.
Was there any hanky-panky between Citadel and Robinhood? Did Citadel tell Robinhood to halt trading so a hedge fund they sank billions into could close their positions? I don’t know. I don’t have evidence that this happened. But the motive is definitely there. Motive by itself isn’t sufficient though.
Should someone look into what happened? Don’t worry: Treasury Secretary Janet Yellen is on it! She is the first female Treasury Secretary and she is on the case.
Treasury Secretary Janet Yellen
Former Fed Chair and now Treasury Secretary Janet Yellen did very well for herself while between jobs. She has made at least $7.2 million in speaking fees. This number includes some $800,000 paid to her by Citadel. The same Citadel who is a huge client of Robinhood and bailed out Melvin Capital.
But guess what, despite what I think is a clear conflict of interest. Treasury Secretary Janet Yellen will be presiding over a regulatory hearing regarding the GameStop saga. So what are the chances that the Hedge Funds come out the loser in all this? I don’t think they are very good.
I don’t think regulations help that much anyway. Many do more harm than good. But let’s say you believe we need strong financial regulation. How is that supposed to happen when the regulators are getting millions from the people they are supposed to be regulating?
If anything happens, I suspect some of the more prominent “redditors” will be accused of something and trotted out as the scapegoats and the hedge funds will get away free. Even though the hedge funds were the ones who lost money due to them having poor risk management and being incredibly short a stock.
I’m not an attorney but from an ethical perspective I don’t see how the redditors buying the stock did anything wrong in seeing hedge funds were over-short a stock and taking advantage of what Melvin Capital were doing.
So what is the Lesson Here?
This is just one example of how the foxes are guarding the hen house.
Going back to the GameStop drama: some people probably made money buying GME but as of writing this it is back under $55. I suspect most redditors lost money on GME. GME peaked at around $483. I’d like to know how many people knew to buy GME at say $20 or less and then decided to sell at $400 or even $300.
Maybe some of the folks who lost money on the GME trade believe it was worth it just for the chance to stick it to a hedge fund. As for myself I’m not in favor of cutting off my nose to spite my face.
It is really hard to bet against the house at their own game and win. The hedge funds are too powerful and they pay the regulators’ speaking fees. Even the folks in the “big short” of 2008-2009 were gutsy insiders.
That is one of the reasons why I like a 10-20% allocation to physical gold and silver. Despite manipulation in the futures markets for these commodities, you are still opting out of the tradition financial system.
A naked short is when you sell a stock without owning it or having borrowed it first. Naked shorting stocks is supposed to be illegal in the US.
But what is shorting a stock?
Normally, if done legally, one shorts a stock by finding someone who owns, the stock, borrowing it from them (at an interest rate) selling it into the market, then if the stock goes down, one can buy it back and return the stock to the lender. In doing this the number of shares outstanding remains the same.
A naked short is when one sells a stock without first owning it or borrowing it from someone else. The the rest of the process is the same, expect one closes it out by buying the stock back.
So let’s look at a basic example I’m using simple and small numbers to highlight the concept but, if you increase the number of traders and prices and shares, the concept still applies.
Scenario A Example: Short
Acme Co. stock is trading at $1 per share and there are only 100 shares in existence. Person A owns 10 shares of Acme Co. Other people own the remaining 90 shares. They loan the 10 shares to person B so Person A now has 0 shares of Acme Co., person B pays person A interest for the duration they are borrowing the stock, and person B sells that stock into the market at a price of $1 per share to Person C. So they pocket $10 less the interest they paid. There are still 100 share in existence, 10 of which are held by Person C.
Now let’s say the price of Acme Co. stock drops to $0.90. Person B (the short seller) then buys 10 shares of Acme Co. from some other shareholder who is willing to sell for $9 in total. They give those shares back to person A to close their short. And they have just profited $1 less any interest paid.
Now some people don’t like that people can short stock because it is “betting against a company.” Now there are plenty of things I don’t care for but I don’t want to be illegal. I don’t like most of the “popular” music produced today. But I think people should be free to produce music even if I don’t like the result.
I think if I own stock, I should have the right to loan it to others to collect interest. I also think that people have the right to borrow stock from a willing lender. And if someone has borrowed stock, they should be able to sell it (provided both parties agree that the borrowed stock could be sold, and provided the shares are paid back). Since I believe in those two things it follows that people can choose to short stock.
It’s also interesting that people don’t seem to have a problem with borrowing a stock in the hopes that it goes up. Some people essentially borrow stock (using margin accounts) in the hopes that it goes up in value and they can sell it at a profit. You can’t allow people to bet on a stock going up if there isn’t someone taking the other side of the trade essentially betting it will go down.
Now, what I do think should not be allowed (because I believe it is fraud, very much akin to fractional reserve banking), is naked shorting of stock. A naked short is when you sell stock that you don’t own and didn’t borrow from someone else. This essentially introduces new shares of the stock into the financial system that never existed. A company has the right to issue stock, but a random person doesn’t have the right to issue stock in a company they don’t own or control.
So let’s look at our other example only this time it is a naked short. Again, this is illegal in the US in Europe. But it does happen through various loopholes I don’t pretend to fully understand.
Scenario B Example: Naked Short
Acme Co. stock is trading at $1 per share and there are only 100 shares in existence. Various people own the 100 shares. Person B’s broker allows person B to sell 10 shares of Acme Co. stock in exchange for a fee and/or interest. The broker does not own any shares of Acme Co.. Person B sells that stock into the market at a price of $1 per share to Person C. So they pocket $10 less the interest they paid. There are now 110 share in existence, 10 of which are held by Person C.
Now let’s say the price of Acme Co. stock drops to $0.90. Person B (the short seller) then buys 10 shares of Acme Co from some other shareholder who is willing to sell for $9 in total. By buying 10 shares, this closes out their short position. And Person B has just profited $1 less any interest paid and/or fee.
So that is my understanding of you could short a stock beyond the number of shares issues by the company, through naked shorting.
Now the actual mechanics of stock trading behind the scenes is more complex. Trades don’t settle on the same day. Once a trade is closed, it still takes a few days before the trade is settled. Brokers allow buying and selling and they don’t true up their books until later. I don’t pretend to understand all these mechanics.
Scenario C: Short Squeeze
So let’s look at scenario B, only the price of Acme Co. goes up.
The first part is the same:
Acme Co stock is trading at $1 per share and there are only 100 shares in existence. Various people own the 100 shares. Person B’s broker allows person B to sell 10 shares of Acme Co. stock in exchange for a fee and/or interest. The broker does not own any shares of Acme Co.. Person B sells that stock into the market at a price of $1 per share to Person C. So they pocket $10 less the interest they paid. There are now 110 share in existence, 10 of which are held by Person C.
But now: let’s say the price of Acme Co. stock rises to $1.10. Person B (the short seller) then buys 10 shares of Acme Co from some other shareholder who is willing to sell for $11 in total. By buying 10 shares, this closing out their short position. And Person B has just LOST $1 less any interest paid and/or fee. Now $1 isn’t a big deal and Person B in case case can come up with the money to pay it. But on a large scale this can be a big problem.
If the price of Acme Co. had risen rapidly to say $20. Short Seller Person B would need to come up with $10 to close out their short position. If instead of being short $10 worth of stock, perhaps they were short hundreds of thousands of shares and the losses are now in the millions. There is also a problem of liquidity. Maybe no one wants to sell their stock in Acme Co., they are happy to hold it and see if it goes higher. Maybe more buyers come in and are willing to buy in at $20, driving the price up even further. Person B might get into trouble because they might not be enough shares available to buy back and close their short position.
Brokers will often hike margin requirements when markets move quickly in one direction or another to protect themselves. The broker in scenario C where Acme Co. went to $20 might have said to the Short Seller Person B, “you have to deposit another $10 into your account or we will liquidate your position at the current market price.”
stonk: A term to express a financial decision that resulted in financial gain. Mostly used ironically.
For those of you not familiar GameStop is a brick and mortal video game retailer. Its stock had been heavily shorted by hedge funds. I heard that hedge funds were at one point short 150% of the GME stock in existence. How that is legal or possible is beyond me. That was the background. If the hedge funds had not been so short GME, this would not have happened.
But that is just the scene. Enter the main actors: a group of people on the reddit forums decided, for various reasons, to buy GME. The result triggered a massive short squeeze and stock price melt-up. In the course of 10 trading days GME went from around $30 to as high as $513 per share. It has cost hedge funds a lot of money as they’ve been forced to cover their short positions and buy the stock at the higher prices.
Several brokers halted GME trading or placed restrictions on the types of trades that could be made, angering (rightfully so) their “customers”.
I don’t know the reason reason why trading was halted by some of these brokers. It could have been for very innocent and good reasons on the part of the brokers to limit their risk. Other theories alleging nefarious intent abound. Did some of these hedge funds call in a favor? Was trading halted to tank the price so the hedge funds could cover their shorts? Who knows?
The volatility seems to have spilled into other markets as well. Major indices were down on the week–seemingly because hedge funds had to liquidate other holdings to cover their short positions.
It’s been a crazy week.
Here is an anecdote: I was in a company meeting (at my day job which has nothing to do with finance or investing) and the CEO was talking about GameStop. One employee mentioned a friend who was up over $100,000 in GME gains.
I hope they know when to sell.
Is the GME situation an extreme example of the broader trend?
While the GME stock melt-up, and even the other “reddit stocks” like AMC are extreme examples, I think they are indicative of the times: a lot of unemployed people at home, bored, angry, frustrated, armed with stimulus checks, low interest rates, and margin accounts buying up stocks. I think that is a bad sign. The rampant speculation devoid of fundamentals isn’t a good thing. A large number of unemployed people isn’t a good thing. Rampant speculation isn’t a good thing.
Of course it isn’t just retail investors. Institutional investors have low interest rates, are seeking returns, and have driven up asset prices beyond what I think the fundamentals would otherwise warrant. Sure, the institutional investors are supposed to be the “smartest folks in the room”. But they were also behind the dot com bubble and the housing bubble. So don’t tell me they don’t chase returns or make irrational decisions.
I have many reasons for believing assets are overvalued. I’ll just share one at this time, the Shiller PE ratio for the S&P 500 (shown below). The only time it has been higher is at the peak of the dot-com bubble in 2000.
I do think this short squeeze is a healthy thing. Some of these hedge funds are getting beat at their own game and getting taught an important lesson in risk management. It’s also got to be humbling for these hedge fund types to get beaten by the retail investors that they seem, in general, to have a lot of contempt for.
The GME Price Rocket is Still Absurd
On the flip side it is absurd. As of writing this GameStop now has a market capitalization of $22.6 billion. The market cap was just $1.3 billion on December 31, 2020.
The rapid increase in market cap has nothing to do with GameStop as a company. As billionaire hypocrite Warren Buffet once said: “In the short-run, the stock market is a voting machine. Yet, in the long-run, it is a weighing machine.” So what we’re seeing right now is many people voting for GameStop. But the “weight” of the stock has not changed.
Maybe people start buying more video games at GameStop. Maybe GameStop issues more shares at these high prices to raise capital, revamp their business model and they become a company whose fundamentals support a $22 billion or more valuation. I think this is unlikely.
But maybe none of that matters. People can subjectively value whatever they want. I don’t think that Bitcoin’s market cap of $645 billion makes sense but the market disagrees with me. Those buying into bitcoin back when it was just a few bucks and held to this point are sitting on tremendous profits. Bitcoin means a lot of different things to different people and as long as there is demand for BTC the price will be what it will be. If there was a special kind of dollar bill, people might be willing to pay $2 for it. Maybe GameStop will represent sticking it to the man and people will buy it just to participate in that movement. Maybe people will just buy it “for the lulz”.
As long as people value GameStop it can stay high.
What Does it All Mean?
In the short term fundamentals don’t matter. GME is exhibit A. People can subjectively value whatever they want. But in the long term I believe fundamentals do matter. What we are seeing, and have seen, is a lot of price action devoid of fundamentals. GameStop is an extreme example of this price action, but I think the same principle applies in a variety of markets and assets.
But for someone blessed enough to have assets to invest, what can you do?
Cash and even bonds are going to get destroyed by inflation over the long term. I like gold and silver as an asset and I think having a 10-20% allocation to these assets makes sense but they don’t provide growth or income in the way stocks do. Real estate, particularly residential and farmland, could be a good play, but there is a high cost of entry. There are REITs, but a lot of the tax benefits from investing in real estate come from directly owning the property and you can’t buy $10,000 worth of an apartment complex. (Although if there is a way with WITH the tax benefits please let me know!)
I think there is a place for cryptocurrencies although it is still a very young and volatile market segment.
The “big three”: S&P 500, Nasdaq and Dow Joes are all negative for 2021. There is reason for caution. But I’m looking for opportunities to buy into stocks. I think stocks are overvalued. But I don’t think avoiding stocks is a viable option. If stocks do tank, I believe the Federal Reserve will print as much money as possible to prop up prices, even if it means it destroys the value of the dollar.
Although it might sound trite, the best investment might be in yourself and those around you. There is a lot an individual can’t control but you can do a lot to learn, grow, and take care of your physical, mental, and emotional health.
I was wrong in my prediction regarding the 2020 election season. I thought it was most likely the red team would retain the senate with Biden in the oval office or what I called “Scenario 3”. I wrote “Scenario 4” was second most likely and that is what happened: Biden in the White House with the blue folks in control of the Senate.
My understanding of the Senate also lacked nuance. While the blue team does have a simple majority in the Senate thanks to 50 members plus Vice President Harris breaking ties, only certain legislation can be passed without a 60 Senator majority. With a simple 51 vote majority the Senate is (somewhat) limited in what legislation it can pass to what is authorized in the budget reconciliation process.
My very superficial understanding of the reconciliation process is that it must pertain to spending and revenue and can only be used once per year. It could be used to raise or lower taxes (for the blues it would be raise) and who knows what other tomfoolery.
Taxing and Spending
But even with the blue group being somewhat limited by the reconciliation process, I can guarantee new taxes and more spending. Perhaps Wall street either likes the tax and spend approach, or the market had already priced in a Biden-Harris Administration, or perhaps it is simply the removal of the election uncertainty for the next two years, combined with vaccine optimism, regardless of how the election turned out.
In any case the S&P 500 is up nearly 9% since November 5th.
Wall Street does seem to love spending, and doesn’t seem to care about the national debt. So while I wouldn’t expect the stock market to crash because of Biden’s tax and spend approach, I do think the economy would fare better under low taxes and fiscal discipline.
Perhaps Trump will say the stock market is magically back in a big, fat, ugly bubble again now that he isn’t in power. I think the stock market has been in a bubble for a while. However, the ability of the powers that be to keep the bubble inflated has far surpassed what I believed possible.
Debt
Even though the blue team is known for spending, their tax hikes don’t cover the bill. To be fair red team doesn’t have many fiscal conservatives either. The national debt goes up regardless of who is in power.
I predicted back in January of 2017 that the US nation debt would go to $40 trillion under Trump. However, under the Trump administration, the debt only went from about $19.9 trillion to about $27.7 trillion. Granted I thought Trump would win reelection at the time I made that prediction and he would have 8 years to run up the debt by over $20 trillion.
Unless Trump runs for office again and wins, my $40 trillion prediction was wrong. However, I think the national debt will go to $40 trillion by the end of 2024.
I think over the next four years it will go from $27.7 trillion to over $40 trillion. It would mean about $3 trillion per year. In 2020 the national debt increased by $4.2 trillion. I’m sure Biden will be looking for a big spending package in 2021 to get his administration started off with a bang.
Government spending financed by debt reduces the value of dollars, so more dollars are required for later stimulus in order to have the same effect. For example in 2008, when the banks were being bailed out the debt went up by about $1 trillion. Then the next year the debt went up by $1.8 trillion.
Granted 2020 had COVID-19 and lockdown crisis, but that hasn’t gone away. In 2018 and 2019, with the economy supposedly humming along and no large-scale military engagements, the debt still increased by over $1.2 trillion each year.
My $40 trillion prediction is based on the national debt going up by $4-5 trillion in 2021, followed by $2.5 trillion per year after that.
This is one reason why interest rates can’t rise. The treasury issues debt at a variety of maturity rates. But as interest rates rise, that means the government has to pay out more money on the debt. The treasury is already paying about $393 billion per year in interest at current rates.
In June of 2007 the yield on a 10 year treasury was 5%. In the wake of the 2008 financial crisis it has steadily fallen. While still stupidly low, the 10 year treasury yield has been rising. In July of 2020 it was as low as about 0.5%. Since then the yield has risen to about 1%. As I said before it is still stupid low, in contrast the 10 year treasury yield was 15% in the early 1980s.
However, the market is addicted to low interest rates. If the 10 year yield continues to rise and gets to 3 or 4% I think that would be devastating for stocks. As mentioned above it would also dramatically increase amount the treasury would need to pay in interest. For example at 0.5%, $2 trillion would cost $10 billion, but at 3% it jumps up to $60 billion. But it isn’t just the new debt, as older debt expires and the borrower gets paid back, the treasury issues new debt to pay for it, which must be issued at the new rates.
I’m sure the Federal Reserve will step in and drive the yield back down before that happens. The Washington elite definitely don’t want a stock market crash to happen when the blue team is in control of the government.
Warfare
I think the Biden-Harris administration is much more likely to increase hostilities in the world. Despite all his faults, and alienating allies of the United States, Trump didn’t start any major military engagements in the world. I believe Biden-Harris will follow the Bush II and Obama approaches to foreign policy.
More war is good news for “defense” contractors, but less positive for everyone else. The loss of human life in war is the most tragic element and the most important reason to avoid military action except as a last resort. A distant second reason for avoiding war is that bombs, drones and aircraft carriers are expensive and contribute to the national debt. Surely the military action, as it always is, will be dressed up flowery rhetoric to make it seems necessary, noble and courageous.
Wealth Management
I think a 10-20% allocation to precious metals is as important now as it ever was. Gold has been down and sideways since the new high was made in August of 2020. It seems to have support at around $1,790 per troy ounce. I think this is consolidation prior to the next leg up.
Stocks only seem to go up. Valuation and fundamentals don’t seem to matter.
While I always have some exposure to the stock market, I’ve missed out on the some of the gains of the last 8-9 years since I’ve been underweight US stocks. I’ve been waiting for a buying opportunity. I was considering buying in around March of 2020, but I expected the markets to go lower.
I was wrong.
The powers that be are able to maintain the stock market prices far beyond what makes sense to me. I’m planning on averaging into various mutual funds over time. Perhaps my capitulation is a sign that the top is near!
Despite all the challenges from higher taxes, more regulations, debt and lockdowns, there are still productive businesses out there. While I think Biden/Harris and their allies on the blue team will make things worse, there are still plenty of reasons to be optimistic. Being in a “bunker mode” for the past 8 years has cause me to miss out on a significant stock market rise. At some point I think the dollar will crash and maybe stocks will go down too, but that is what the precious metals are for.
2020 has been a good year for gold. Gold is up almost 18.93% in 2020 compared to the S&P 500 which is only up 12.42%. A new high of $2,089 was made in August. This took out the previous high of $1,923 that was made back in September of 2011.
Over the past five years gold has kept decent pace with the S&P 500. Although the S&P 500 has outperformed gold during that time 77.94% to 53.12%, there have been years in which gold outperformed. In 2018 gold was down 2.61% and the S&P 500 was down 7%. And so far in 2020 (as mentioned above) gold is up 18.93% compared to the S&P 500 being up 12.42%.
S&P 500 shown in purple above, compared with gold
It’s was a tough road to get to that new high. Five years ago gold was at a low of $1,045, in November of 2015 to be more precise.
I started buying gold in December of 2012 when gold was trading north of $1,660. I dollar cost averaged in and even bought some gold when it was trading around $1,100.
Gold since 2010. The green bar is the $1,790 price level
Gold is trading at about $1,815 as I write this. I believe this is a key price. While reading technicals could be akin to tea leaves, it is one of the few tools we have when evaluating gold price.
As you can see from the chart below, within about $10-20 of $1,800 there was resistance in 2011 and twice in 2012 when gold tried to rally but sold off again. In other words, buyers would bid the price of gold up to around the $1,800 level, but then sellers would come in and drive the price back down.
Fast forward to 2020. In March when things were going crazy everyone was selling. Gold went down along with stocks. But then around the $1,500 level buyers outnumbered sellers and gold proceeded to rally up to it’s latest high of $2,089.
During this time there was resistance more around the $1,750 level. It touched $1,800 in April and then in June. But instead of selling off considerably, it just bumped around between roughly $1,700 and $1,800 before a flurry of buyers sent the price to the new high in the last two weeks of July.
The move in July was fairly rapid and aggressive, moving nearly $300 in just a few of weeks. Since then gold has been trending downwards. Buyers seem rather squeamish at these prices and gold has sold off since August and currently is hovering around $1,815.
An analogy for markets and price movement are lungs. You can’t breath in (buying) or out (selling) constantly, you need to exhale in order to breathe more. With the rapid price rise we’ve seen in 2020, it makes sense gold would sell off and exhale some.
The question is wether gold will continue to rise in price in the remaining weeks of 2020 and beyond or if it will move down or sideways.
Future Price Guesses
Gold, like any other asset, can either move up down or sideways in price.
It has been trending down over the past few months. At the $1,800 level the resistance encountered in 2011 and 2012 could serve as support and gold could consolidate in price here and make another run at a new high.
Based on the nice rally up to $1,815 that could be the more likely case.
If gold does go back down to $1,750 or lower I think it will continue to go lower until there is another catalyst. I doubt gold would go lower than $1,450.
As I’ll discuss more in the last section, I think a Biden-Harris administration coupled with COVID-19 should be a great environment for gold.
Bitcoin Makes New Highs
Bitcoin has made new highs of $19,625 in November of 2020, taking out the previous high of $19,497 back in December of 2017. It is certainly possible that Bitcoin is taking some of the bidding away from gold as a save haven asset.
Opting Out
Alternative assets like gold are a way of opting out of the traditional financial system. Gold is also often considered an inflation hedge and safe haven asset.
I think it is more likely there will be a Biden-Harris administration in the White House. I think lockdowns are more likely throughout the United States and the world. Governments are paying people to stay home and seem intent on preventing even one more COVID-19 death regardless of other deaths or consequences.
I don’t think there is enough debate or discussion on what the consequences of the lockdowns are or if they are even effective.
Small businesses going out of business, unemployment rising, and other byproducts of lockdowns such as increased depression, suicide and substance abuse should be weighed against the effectiveness and results of lockdowns.
Regardless of their efficacy and consequences, lockdowns means more spending and stimulus. Not only that, but fewer people working means fewer goods and services that are available to buy.
I believe assets like gold and silver will do well in this environment and are an important part of my diversified investment holdings. I think it is important to have 10-20% of my portfolio in precious metals like gold and silver.
Disclaimer: None of the above is investment, health or legal advice.
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