January 2021
When the “smart guys” aren’t so smart
“If Goldman Sachs were doing this, it would be called ‘arbitrage’ ”
GameStop, explained in a way that even a 5 year old can understand
Please, please, please, ignore this article
57 Percent
GameSkill
It’s only January, and GameStop could Likely be the story of the year.
Jaydyn Carr, a 5th grader from San Antonio, struck gold. In 2019 his mom, Nina Carr, bought him 10 shares of GameStop at $6/share. Prudently, amid the recent meme stock mania, he cashed out a $3,200 gain on his $60 investment. How should we think about this outcome?
There’s the explanation of market (in)efficiency with GME. I think about the market efficiency debate as a Closed System, one in which each side has not only staked their claim to their answer, but they can also explain away any counterevidence within the loose ends of their reasoning.
What is perhaps lost is the obvious confounding variable of supply and demand. There need not be a change in company fundamentals to explain a change in demand for the company’s shares. Small price gyrations occur naturally in distributed systems. But larger price gyrations can sometimes be unexplainable even by the same company’s executives.
The worst possible outcome for a new investor is to get lucky on their first trade.
To what extent is a company’s Likelyhood of becoming a meme stock “publicly available information” that is already priced into the shares? What good luck to be a shareholder of a meme stock long before it becomes a meme stock! Just don’t confuse that luck with fundamental analysis.
Then there are the more dangerous self-reflections among meme stock shareholders as they make sense of their overnight riches. “I’m a natural at stock picking!” they might conclude, or “I knew GME had a bright future!”, or countless other outputs of the Fundamental Attribution Error. Natural next beliefs include that their stock picking decision-making process is replicable in the long run. Non-rigorous decision-making processes have a well-documented negative expected value in the long run.
The worst possible outcome for a new investor is to get lucky on their first trade.
Losing their shorts
When Bill Ackman takes a short position in Herbalife then publicly trashes Herbalife to profit from an induced price drop, Carl Icahn took the other side and delivered to Ackman an historically epic short squeeze.
Is WallStreetBets the new Icahn? This is a Public Service Announcement to short sellers: beware the WallStreetBets hedge fund. It is Likely that the short-selling pain from the epic GME short-squeeze, and the uncertain threat of WallStreetBets targeting other stocks with high short interest, will reduce the willingness of short-sellers to engage in this necessary process of price discovery and therefore be a tailwind to stocks for some time to come.
Investors must constantly look for fundamental changes in demand. Reduced appetites for engaging in price discovery via shorting is one such change.
Game Theory of GameStop
Game Theory is the lively branch of economics that studies strategic interactions among players. Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life gives readers an accessible introduction to Game Theory through familiar real-life encounters. A central tenet of Game Theory is the assumption of optimal decision-making from rational players. Player 1 anticipates what player 2 will optimally do, who then anticipates what player 1 will optimally do, who then anticipates what player 2 will optimally do, in an infinite recursion of endgame strategery.
Seeing the world through Game Theory is illuminating! Like when, hypothetically, a shrewd group of retail traders take on vulnerable hedge fund managers at their own game. The Prisoner’s Dilemma, the classic game of incentivized defection versus cooperation, can help investors plan their GameStop endgame.
Several influential Wallstreetbets folks have publicly set a target of $1,000 per share on GME - classic signaling. The key to any signal is the credibility of the signaler, otherwise the signal is bluffing, noise, or meaningless empty talk. Typically signals have credibility based on the cost of the signal to the signaler. If the signaler loses value from making their signal, who is on the other side? Capturing this value from the signaler is an opportunity!
Given the $1,000 sell limit, who would buy at $1,000 with such a viral, widely publicized ceiling? The strategic investor would use this information to their advantage by setting their own sell limit at $999 to ensure execution ahead of the other sellers. But who would buy what others are selling at $999 for a measly $1 upside? With strategic investors selling at $999, other strategic investors submit sell limits at $998, inducing others to submit sell limits at $997, you get the idea.
In this endgame recursion, anticipated selling pressure leads prices to converge to an equilibrium, which results from the self-interested incentives of each player to defect from the strategy before other cooperating players. Psychologically, to what extent do WallStreetBets folks trust each other to cooperate in driving the price to $1,000? That equilibrium is anybody’s guess, and volatility will Likely distort this equilibrium. Ultimately however, I expect that self-interested profit-taking defections will trump game-theoretic cooperation, and prices will settle toward an equilibrium that is much lower than the $1,000 price target.
Another important concept in Game Theory is repeated games, in which players continue to have strategic interactions with each other through subsequent “base games”. As WallStreetBets folks rally themselves around new targets, it remains to be seen how tightly this community remains committed to cooperation and not the incentivized defection that Game Theory would predict. If a few high profile community members buy at the top and get burned, this could lead to viral defections and the community to lose their size and therefore influence just as quickly as they found that influence. Or, the community commitment (diamond hands!) could remain resolute, the community can grow for longer than short-sellers can remain solvent, and induce a self-fulfilling cycle of attracting even more new retail investors and growing the community beyond what seems possible today.
Speaking of defections, Chamath Palihapitiya strategically defected by 1) validating the retail investors’ movement, then 2) donating his GME profits. Not a bad way to take profits from followers in a movement you fueled.
IsTheSqueezeSquoze
There are other dynamics in play also. IsTheSqueezeSquoze explained the squeeze this way:
if you don't know this you shouldn't be gambling, but
robinhood didn't halt trading just because they hate you, they did it because Citadel made them. Robinhood can't actually place your order themselves, they need to go to a market maker to find a counterparty for you. Citadel actually pays robinhood for this, because your trades are free money for them - they overcharge you on the spread, and they place their own trades immediately before yours to take advantage of price movement. They're the ones who want you to lose money: they bailed out the biggest hedge fund shorting Gamestop, Melvin, so now they own a huge chunk of that fund. So now that they want the shorts to win, and the retail traders (you) to lose, they told robinhood to get lost, they just wouldn't be accepting buy orders on these stocks. Just sells. (This has never happened before.) Only then did Robinhood turn around and stab its retail traders in the back - because, of course, you're not their customer. Citadel is their customer. You're their product.
When you are losing to indexing…
Ron Lieberman of the New York Times wrote this gem last month on direct indexing: A New Way to Invest for the Vengeful and the High-Minded. Matt Levine of Bloomberg recently summarized direct indexing in Money Stuff as You Can Make Your Own Index:
Loosely speaking I would say there are three kinds of investing:
1. In passive investing, you buy all the stocks in the index.
2. In active investing, you buy the stocks you want.
3. In direct indexing, you buy (1) all the stocks in the index, (2) except for the ones you don’t want, (3) plus any other ones that you do want.
As a matter of formal logic it is easy to prove that direct indexing is exactly equivalent to active investing: If you start with the index, delete the stocks you don’t want and add the stocks you do want, you end up with a list of stocks that you want, which is where you end up in active investing too.
Active investing usually underperforms passive indexing, but not only because stock picking sacrifices diversification. Human fallibility, overconfidence, flawed decision-making processes, and countless other psychological biases also erode performance.
The belief that one can actively select market-beating sectors, factors, themes, or other strategies causes the same underperformance as the belief that one can actively select market-beating companies.
The debate between active and passive management is often framed as a binary choice. Not surprisingly however, there is a continuum between these approaches and direct indexing is one of multiple strategies on that continuum. The point is that the more active one gets, the more they subject themselves to the root causes of underperformance.
A good problem to have
As Democrats take control of Washington, concerns abound among investors over tax increases. Will increasing capital gains taxes suppress interest among investors? Will suppressed demand for equities cause a bear market? Likely not.
I have nothing to add to Warren Buffett’s assessment in 2012:
“Suppose that an investor you admire and trust comes to you with an investment idea,” Buffett wrote in an opinion article Monday in the New York Times. “ ‘This is a good one,’ he says enthusiastically. ‘I’m in it, and I think you should be, too.’ ”
“Would your reply possibly be this? ‘Well, it all depends on what my tax rate will be on the gain you’re saying we’re going to make,’ ” Buffett continued. “ ‘If the taxes are too high, I would rather leave the money in my savings account, earning a quarter of 1%.’ ”
Buffet said such a response exists only in the imagination of Grover Norquist, president of the fiscally conservative Americans for Tax Reform, whose group asks lawmakers to sign a pledge never to increase taxes in exchange for its support.
...
Buffett noted that he and other investors did fine when that [capital gains] rate was as high as 27.5% in the 1950s and 1960s.
“Never did anyone mention taxes as a reason to forgo an investment opportunity that I offered,” Buffett said, noting that the top marginal tax rate from 1956 to 1969 was 70%.
...
“In the meantime, maybe you’ll run into someone with a terrific investment idea, who won’t go forward with it because of the tax he would owe when it succeeds,” he continued. “Send him my way. Let me unburden him.”
ONE MORE THING…
When the “smart guys” aren’t so smart: GameStop traders outsmart the smart guys, leaving a lasting mark on the Street
“If Goldman Sachs were doing this, it would be called ‘arbitrage’ ”: This is how Wall Street thinks the Reddit-fueled GameStop trade unravels
GameStop, explained in a way that even a 5 year old can understand: NY Times' Tom Friedman on Reddit retail traders going up against Wall Street
Please, please, please, ignore this article: It's Time To Go To Cash For The Next 7 Years
57 Percent: “Short sellers were down $245 billion last year after 57% of all shorted stocks ended being losing propositions.” 2020 Was a Rough Year for Short Sellers
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