Friday, January 29, 2021

The Storming of the Bastille: The Reddit Crowd targets the Hedge Funds!

I generally try to stay out of fights, especially when they become mud-wrestling contests, but the battle between the hedge funds and Reddit investors just too juicy to ignore. As you undoubtedly know, the last few days have been filled with news stories of how small investors, brought together on online forums, have not only pushed up the stock prices of the stocks that they have targeted (GameStop, AMC, BB etc.), but in the process, driven some of the hedge funds that have sold short on these companies to edge of oblivion. The story resonates because it has all of the elements of a David versus Goliath battle, and given the low esteem that many hold Wall Street in, it has led to sideline cheerleading. Of course, as with everything in life, this story has also acquired political undertones, as populists on all sides, have found a new cause. I don't have an axe to grind in this fight, since I don't own GameStop or care much about hedge funds, but I am interested in how this episode will affect overall markets and whether I need to change the ways in which I invest and trade.

Short Sales and Squeezes

I know that you want to get to the GameStop story quickly, but at the risk of boring or perhaps even insulting you, I want to lay the groundwork by talking about the mechanics of a short sale as well as how short sellers can sometimes get squeezed. When most of look at investing, we think of stocks that we believe (based upon research, instinct or innuendo) will go up in value and buying those stocks; in investing parlance, if you do this, you have a "long" position. For those of you tempted to put all of Wall Street into one basket, it is worth noting that the biggest segment of professional money management still remains the mutual fund business, and mutual funds are almost all restricted to long only positions. But what if you think a stock is too highly priced and is likely to go down? If you already own the stock, you can sell it, but if you don't have a position in the stock and want to monetize your pessimistic point of view, you can borrow shares in the stock and sell them, with an obligation to return the shares at a unspecified point in time in the future. This is a “short” sale, and if you are right and the stock price drops, you can buy the shares at the now "discounted" price, return them to the original owner and keep the difference as your profit.

Short sellers have never been popular in markets, and that dislike is widely spread, not just among small investors, but also among corporate CEOs, and many institutional investors. In fact, this dislike shows up not only in restrictions on short selling in some markets, but outright bans in others, especially during periods of turmoil. I don't believe that there is anything inherently immoral about being a pessimist on markets, and that short selling serves a purpose in well-functioning markets, as a counter balance to relentless and sometimes baseless optimism. In fact, mathematically, all that you do in a short sale, relative to a conventional investment, is reverse the sequence of your actions, selling first and buying back later.

It is true that short sellers face a problem that their long counterparts generally do not, and that is they have far less control over their time horizons. While you may be able to sell short on a very liquid, widely traded stock for a longer period, on most stocks, your short sale comes with a clock that is ticking from the moment you initiate your short sale. Consequently, short sellers often try to speed the process along, going public with their reasons for why the stock is destined to fall, and they sometimes step over the line, orchestrating concerted attempts to create panic selling. While short sellers wait for the correction, they face multiple threats, some coming from shifts in fundamentals (the company reporting better earnings than expected or getting a cash infusion) and some from investors with a contrary view on the stock, buying the stock and pushing the stock price up. Since short sellers have potentially unlimited losses, these stock price increases may force them to buy back shares in the market to cover their short position, in the process pushing prices up even more. In a short squeeze, this cycle speeds up to the point that short sellers have no choice but to exit the position.

Short squeezes have a long history on Wall Street. In 1862, Cornelius Vanderbilt squeezed out short sellers in Harlem Railroad, and used his power to gain full control of the New York railroad business. During the 20th century, short sales ebbed and flowed over the decades, but lest you fall into the trap of believing that this is a purely US phenomenon, the short sale with the largest dollar consequences was the one on Volkswagen in 2008, when Porsche bought enough shares in Volkswagen to squeeze short sellers in the stock, and briefly made Volkswagen the highest market cap company in the world. Until this decade, though, most short squeezes were initiated and carried through by large investors on the other side of short sellers, with enough resources to force capitulation. In the last ten years, the game has changed, for a number of reasons that I will talk about later in this post, but the company where this changed dynamic has played out most effectively has been Tesla. In the last decade, Tesla has been at the center of a tussle between two polarized groups, one that believes that the stock is a scam and worth nothing, and the other that is convinced that this is the next multi-trillion dollar company. Those divergent viewpoints have led to the former to sell short on the stock, making Tesla one of the most widely shorted stocks of all time, and the latter buying on dips. There have been at least three and perhaps as many as five short squeezes on Tesla, with the most recent one occurring at the start of 2020. With Tesla, individual investors who adore the company have been at the front lines in squeezing short sellers, but they have had help from institutional investors who are also either true believers in the company, or are too greedy not to jump on the bandwagon.

The Story (so far)

This story is still evolving, but the best way to see it is to pick one company, GameStop, and see how it became the center of a feeding frenzy. Note that much of what I say about GameStop could be said about AMC and BB, two other companies targeted in the most recent frenzy.

A Brief History

GameStop is a familiar presence in many malls in the United States, selling computer gaming equipment and games, and it built a business model around the growth of the gaming business. That business model ran into a wall a few years ago, as online retailing and gaming pulled its mostly young customers away, causing growth to stagnate and margins to drop, as you can see in this graph of the company’s operating history:

Leading into 2020, the company was already facing headwinds, with declining store count and revenues, and lower operating margins; the company reported net losses in 2018 and 2019.

The COVID Effect

In 2020, the company, like most other brick and mortar companies, faced an existential crisis. As the shutdown put their stores out of business, the debt and lease payments that are par for the course for any brick-and-mortar retailer threatened to push them into financial distress. The stock prices for the company reflected those fears, as you can see in this graph (showing prices from 2015 through the start of 2021):

Looking at the graph, you can see that if GameStop is a train wreck, it is one in slow motion, as stock prices have slid every year since 2015, with the added pain of rumored bankruptcy in 2019 and 2020. 

A Ripe Target and the Push Back

While mutual funds are often constrained to hold only long positions, hedge funds have the capacity to play both sides of the game, though some are more active on the short side than others. While short sellers target over priced firms, adding distress to the mix sweetens the pot, since drops in stock prices can put them into death spirals. The possibility of distress at GameStop loomed large enough that hedge funds entered the fray, as can be seen in the rising percentage of shares held by short sellers in 2020:

Note that short seller interest in GameStop first picked up in 2019, and then steadily built up in 2020. Even prior to the Reddit buy in, there were clearly buyers who felt strongly enough to to push back against the short sellers, since stock prices posted a healthy increase in the last few months of 2020. To show you how quickly this game has shifted, Andrew Left, one of the short sellers, put out a thesis on January 21, where he argued that GameStop was in terminal decline, and going to zero. While his intent may have been to counter what many believed was a short squeeze on the stock in the prior two days, it backfired by drawing attention to the squeeze and drawing in more buyers. That effect can be seen in the stock price movements and trading volume in the last few days:

This surge in stock prices was catastrophic for short sellers, many of whom closed out (or tried to close out) their short positions, in the process pushing up prices even more. Melvin Capital and Citron, two of the highest profile names on the short selling list, both claimed to have fully exited their positions in the last few days, albeit with huge losses.  On January 27 and 28, regulators and trading platforms acted to curb trading on GameStop, ostensibly to bring stability back to markets, but traders were convinced that the establishment was changing the rules of the game to keep them from winning. GameStop, which had traded briefly at over $500/share was trading at about $240 at the time this post was written.

A Value Play?

When you have a pure trading play, as GameStop has become over the last few weeks, value does not even come into play, but there are investors, who pre-date the Redditors, who took counter positions against the short sellers, because they believed that the value of the company was higher. At the risk of ridicule, I will value the company, assuming the most upbeat story that I can think of, at least at the moment:

Note that this valuation is an optimistic one, assuming that probability of failure remains low, and that GameStop makes it way back to find a market in a post-COVID world, while also improving its margins to online retail levels. If you believe this valuation, you would have been a strong buyer of GameStop for much of last year, since it traded well below my $47 estimate. After the spectacular price run up in the last two weeks, though, there is no valuation justification left. To see why, take a look at how much the value per share changes as you change your assumptions about revenues and operating margins, the two key drivers of value.

Even if GameStop is able to more than double its revenues over the next decade, which would require growth in revenues of 15% a year for the next five years, and improve its margins to 12.5%, a supreme reach for a company that has never earned double digit margins over its lifetime, the value per share is about half the current stock price. Put simply, there is no plausible story that can be told about GameStop that could justify paying a $100 price, let alone $300 or $500.

The Backstory

To put the GameStop trading frenzy in perspective, let's start with the recognition that markets are not magical mechanisms, but represent aggregations of human beings making investment judgments, some buying and some selling, for a variety of reasons, ranging from the absurd to the profound. It should therefore not come as a surprise that the forces playing out in other aspects of human behavior find their way into markets. In particular, there are three broad trends from the last decade at play here:

  1. A loss of faith in experts (economic, scientific, financial, government): During the 20th century, advances in education, and increasing specialization created expert classes in almost every aspect of human activity, from science to government to finance/economics. For the most part, we assumed that their superior knowledge and experience equipped them to take the right actions, and with our limited access to information, we often were kept in the dark, when they were wrong. That pact has been shattered by a combination of arrogance on the part of experts and catastrophic policy failures, with the 2008 banking crisis acting as a wake up call. In the years since, we have seen this loss of faith play out in economics, politics and even health, with expert opinion being cast aside, ignored or ridiculed. 
  2. An unquestioning worship of crowd wisdom, combined with an empowering of crowds: In conjunction, we have also seen the rise of big data and the elevation of "crowd" judgments over expert opinions, and it shows up in our life choices. We pick the restaurants we eat at, based on Yelp reviews, the movies we watch on Rotten Tomatoes and the items we buy on customer reviews. Social media has made it easier to get crowd input (online), and precipitate crowd actions.
  3. A conversion of disagreements in every arena into the personal and the political: While we can continue to debate the reasons, it remains inarguable that public discourse has coarsened, with the almost every debate, no matter in what realm, becoming personal and political. I can attest to that from just my personal experiences, especially when I post on what I call "third rail" topics, specifically Tesla and Bitcoin, in the last few years. 
As I look at the GameStop episode play out, I see all three of these at play. One reason that the Redditors targeted GameStop is because they viewed hedge funds as part of the "expert" class, and consequently incapable of getting things right. They have used social media platforms to gather and reinforce each others' views, right or wrong, and then act in concert quickly and with extraordinary efficiency, to move stock prices.  Finally, even a casual perusal of the comments on the Reddit thread exposes how much of this is personal, with far more comments about how this would teach hedge funds and Wall Street a lesson than there were about GameStop the company.

The End Game
I am a realist and if you are one of those who bought GameStop or AMC in recent days, I know that there is only a small chance that you will be reading this post, since I am probably too old (my four children remind me of that every day), too establishment (I have been teaching investing and valuation for 40 years) and too expert to be worth listening to.  I accept that, though if you are familiar with my history, you should know that I have been harsh on how investing gets practiced in hedge funds, investment banks and even Omaha. The difference, I think, between our views is that many of you seem to believe that hedge funds (and other Wall Streeters) have been winning the investment sweepstakes, at your expense, and I believe that they are much too incompetent to do so. In my view, many hedge funds are run by people who bring little to the investment table, other than bluster, and charge their investors obscene amounts as fees, while delivering sub-standard results, and it is the fees that make hedge fund managers rich, not their performance. It is for that reason that I have spent my lifetime trying to disrupt the banking and money management business by giving away the data and the tools you need to do both for free, as well as pretty much everything I know (which is admittedly only a small subset) about investing in my classesMy sympathies lie with you, but I wonder what your end game is, and rather than pre-judge you, I will offer you the four choices: 
  1. GameStop is a good investmentThat may be a viable path, if you bought GameStop at $40 or $50, but not if you paid $200 or $300 a share. At those prices, I don’t see how you get value for your money, but that may reflect a failure of my imagination, and I encourage you to download my spreadsheet and make your own judgments.
  2. GameStop remains a good tradeYou may believe that given your numbers (as individual investors), you can sell the stock to someone else at a higher price, but to whom? You may get lucky and be able to exit before everyone else tries to, but the risk that you will be caught in a stampede is high, as everyone tries to rush the exit doors at the same time. In fact, the constant repetition of the mantra that you need to hold to meet a bigger cause (teach Wall Street a lesson) should give you pause, since it is buying time for others (who may be the ones lecturing you) to exit the stock. I hope that I am wrong, but I think that the most likely end game here is that AMC, GameStop and Blackberry will give back all of the gains that they have had from your intervention and return to pre-action prices sooner rather than later.
  3. Teach hedge funds and Wall Street a lesson: I won't patronize you by telling you either that I understand your anger or that you should not be angry. That said, driving a few hedge funds out of business will do little to change the overall business, since other funds will fill the void. If this is your primary reason, though, just remember that the money you are investing in GameStop is more donation to a cause, than an investment. If you are investing tuition money, mortgage savings or your pension fund in GameStop and AMC, you are impoverishing yourself, trying to deliver a message that may or may not register. The biggest threat to hedge funds does not come from Reddit investor groups or regulators, but from a combination of obscene fee structures and mediocre performance. 
  4. Play saviorIt is possible that your end game was selfless, and that you were trying to save AMC and GameStop as companies, but if that was the case, how has any of what’s happened in the last two weeks help these companies? Their stock prices may have soared, but their financial positions are just as precarious as they were two weeks ago. If your response is that they can try to issue shares at the higher prices, I think of the odds of being able to do this successfully are low for two reasons. The first is that planning a new share issuance takes time, requiring SEC filings and approval. The second is that the very act of trying to issue new shares at the higher price may deflate that price. In a perverse way, you might have made it more difficult for GameStop and AMC to find a pathway to survive as parts of larger companies, by pushing up stock prices, and making them more expensive as targets.
If you are in this game, at least be clear with yourself on what your end game is and protect yourself, because no one else will. The crowds that stormed the Bastille for the French Revolution burned the prison and killed the governor, but once done, they turned on each other. Watch your enemies (and I know that you include regulators and trading platforms in here), but watch your friends even more closely!

Market Lessons
If you are not a hedge fund that sold short on the targeted stocks, or a trader who bought in on other side, are there any consequences for you, from this episode? I do think that we sometimes read too much into market events and episodes, but this short period has some lessons.
  1. Flattening of the Investment World: Borrowing a term from Tom Friedman, I believe that the investment world has flattened over the last few decades, as access to data and powerful tools widens, and trading eases. It should come as no surprise then that portfolio managers and market gurus are discovering that they no longer are the arbiters of whether markets are cheap or expensive, and that their path of least resistance might come from following what individual investors do, rather than lead them. In a prior post, I pointed to this as one reason why risk capital stayed in the game in 2020, confounding many long-term market watchers, who expected it to flee. 
  2. Emptiness of Investment Expertise: Professional money management has always sold its wares (mutual funds, hedge funds, investment advice) as the products of deep thinking and serious analysis, and as long as the processes stayed opaque and information was scanty, they were able to preserve the delusion. In the last few decades, as we have stripped away the layers, we have discovered how little there is under the surface. The hand wringing on the part of money managers about the momentum trading and absence of attention to fundamentals on the part of Redditors strikes me as hypocritical, since many of these money managers are themselves momentum players, whose idea of fundamentals is looking at trailing earnings. My prediction is that this episode and others like it will accelerate the shift from active to passive investing, especially on the part of investors who are paying hefty fees, and receiving little in return.
  3. Value ≠ Price: I won’t bore you again with my distinction between value and price, but it stands me in good stead during periods like this one. During the last week, I have been asked many times how I plan to change the way I value companies, as a result of the GameStop story, and my answer is that I don’t. That is not because I am stuck in my ways, but because almost everything that is being talked about (the rising power of the individual investors, the ease of trading on apps like Robinhood, the power of social media investing forums to create crowds) are factors that drive price, not value. It does mean that increasing access to data and easing trading may have the perverse effect of causing price to vary more, relative to value, and for longer periods. My advice, if you are an investor who believes in fundamentals, is that you accept this as the new reality and not drive yourself in a frenzy because you cannot explain what other people are paying for Tesla, Airbnb or Zoom.
In the next few weeks, I predict that we will hear talk of regulatory changes intended to protect investors from their own excesses. If the regulators have their way, it will get more difficult to trade options and borrow money to buy shares, and I have mixed feelings about the efficacy of these restrictions. I understand the motivation for this talk, but I think that the best lessons that you learn about risk come from taking too much or the wrong risks, and then suffering the consequences.

YouTube Video


Wednesday, January 27, 2021

Data Update 3 for 2021: Currencies, Commodities, Collectibles and Cryptos

In my last post, I described the wild ride that the price of risk took in 2020, with equity risk premiums and default spreads initially sky rocketing, as the virus led to global economic shutdowns, and then just as abruptly dropping back to pre-crisis levels over the course of the year. As stock and bond markets went through these gyrations, it should come as no surprise that the same forces were playing out in other markets as well. In this post, I will take a look at these other markets, starting with a way of dividing investments into assets, commodities, currencies and collectibles that I find useful in thinking about what I can (and cannot) do in those markets, and then reviewing how these markets performed during 2020. As I do this, there is no way that I can evade discussing Bitcoin and other crypto assets, which continued to draw disproportionate (relative to their actual standing in markets) attention during the year, and talking about what 2020 taught us about them.

Investments: Classifications and Consequences

In a 2017 post, focused on bitcoin, I argued that all investments can be categorized into one of four groups, assets, commodities, currencies and collectibles, and the differences across these group are central to understanding why pricing is different from value, and what sets investing apart from trading.

The Divide: Assets, Commodities, Currencies and Collectibles

If you define an investment as anything that you can buy and hold, with the intent of making money, every investment has to fall into at least one of these groupings:

  • Assets: An asset has expected cash flows that can either be contractually set (as they are with loans or bonds), residual (as is the case with an equity investment in a business or shares in a publicly traded company) or even conditional on an event occurring (options and warrants). 
  • Commodities: A commodity derives its value from being an input into a process to produce a item (product or service) that consumers need or want. Thus, agricultural products like wheat and soybeans are commodities, as are industrial commodities like iron ore and copper, and energy-linked commodities like oil and natural gas. 
  • Currencies: A currency serves three functions. It is a measure of value (used to tell you how much a product or service costs), a medium of exchange (facilitating the buying and selling of products and services) and a store of value (allowing people to save to meet future needs). While we tend to think of fiat currencies like this Euro, the US dollar or the Indian rupee, the use of currency pre-dates governments, and human beings have used everything from seashells to rocks as currency.
  • Collectibles: A collectible's pricing comes from the perception that it has value, driven by tastes (artwork) and/or scarcity (rare items). There are a range of items that fall into this grouping from fine art to sports memorabilia to precious metals.
While most investments fall into one of these buckets, there are some that can span two or more, and you have to decide which one dominates. Take gold, for instance, whose ductility and malleability makes it a prized commodity to jewelers and electronics makers, but whose scarcity and indestructibility (almost) make it even more attractive as a currency or a collectible, With bitcoin, even its most ardent promoters seem to be divided on whether the end game is to create a currency or a collectible, a debate that we will revisit at the end of this post.

Price versus Value
The classification of investments is key to understanding a second divide, one that I have repeatedly returned to in my posts, between value and price.

If the value of an investment is a function of its cashflows and the risk in those cash flows, it follows that only assets can be valued. Though  commodities can sometimes  be roughly valued with macro estimates of demand and supply, they are far more likely to be priced. Currencies and collectible can only be priced, and the determinants of their pricing will vary:
  • Commodity Pricing: With commodities, the pricing will be determined by two factors. The first is the demand for and supply of the commodity, given its usage, with shocks to either causing price to change. Thus, it should come as no surprise that the oil embargo in the 1970s caused oil prices to surge and freezing weather in Florida resulted in higher prices for orange juice. The second is storability, with storage costs ranging from minimal with some commodities  to prohibitive for others. In general, storable commodities provide buyers with the option of buying when prices are low, and storing the commodity, and for that reason, futures prices of storable commodities are tied to spot prices and storage costs.
  • Currency Pricing: Currencies are priced against each other, with the prices taking the form of "exchange rates". In the long term, that pricing will be a function of how good a currency is as a medium of exchange and a store of value, with better performing currencies gaining at the expense of worse performing ones. On the first dimension (medium of exchange) currencies that are freely exchangeable (or even usable) anywhere in the world (like the US dollar, the Euro and the Yen) will be priced higher than currencies that do not have that reach (like the Indian rupee or the Peruvian Sul). On the second (store of value), it is inflation that separates good from bad currencies, with currencies with low inflation (like the Swiss franc) gaining at the expense of currencies with higher inflation (like the Zambian kwacha). 
  • Collectible Pricing: Most collectibles are pure plays on demand and supply, with no fundamentals driving the price, other than scarcity and desirability, real or perceived. Paintings by Picasso, Monet or Van Gogh are bought and sold for millions, because there are collectors and art lovers who see them as special works of art, and their supply is limited. Adding to the allure (and pricing) of collectibles is their longevity, reflected in their continuous hold on investor consciousness. It should come as no surprise that gold's, because it brings together all three characteristics; it's scarcity comes from nature, its desirability comes from in many forms and it has been used and valued for thousands of years.
I capture these differences in the table below:
In short, assets can be both priced and value, commodities can be roughly valued but are mostly priced and currencies and collectibles can only be priced.

Investing versus Trading
The essence of investing is assessing value, and buying assets that trade at prices below that value, and selling assets that trade at more. Trading is far simpler and less pretentious, where successful trading requires one thing and one thing only, buying at a low price and selling at a higher one. If you agree with those definitions, it then follows that you can invest only in assets (stocks, bonds, businesses, rental properties) and that you can only trade commodities, currencies and collectibles.  Drawing on a table that I have used in prior posts (and I apologize for reusing it), here is my contrast between investing and trading:

Note that I am not passing judgment on either, since your end game is to make money, whether you are an investor or a trader, and the fact that you made money following the precepts of value investing and did fundamental analysis does not make you better or more worthy than your neighbor who made the same amount of money, buying and selling based upon price and volume indicators.


With that lengthly lead in, let's look at what 2020 brought as surprises to the commodity market. As the virus caused a global economic shut down, there were severe disruptions to the demand for some commodities, as usage decreased, and to the supply of others, as production facilities and supply chains broke down. During the course of 2020, I kept track continuously of two commodities, copper and oil, both economically sensitive, and widely traded. 

Federal Reserve Database (FRED)

Note that the ups and downs of oil and copper not only follow the same time pattern, but closely resemble what stocks were doing over the same periods, but the changes are more exaggerated (up and down) with oil than with copper. Both oil and copper dropped during the peak crisis weeks (February 14 through March 23, 2020), but while copper not only recouped its losses and was up almost 26% over the course of the year, oil remains more than 20% below the start-of-the-year numbers. Note also the odd phenomenon on April 20, where West Texas crude prices dropped below zero, as traders panicked about running out of storage space for oil in the US.

Expanding more broadly and looking at a basket of commodities, we can trace out the same effects. In the graph below, I look at three commodity indices, the S&P World Commodity Index (WCI), which is a production-weighted index of commodity futures, the S&P GSCI Index, an investable version that includes the most liquid commodity futures, and the S&P GSCI Agricultural Index, a weighted average of agricultural commodity futures.

S&P Index Data

The broad commodity indices (WCI and GSCI) saw significant drops between February 14 and March 23, and recoveries in the months after, mirroring the oil and copper price movements. Agricultural commodity futures were far less affected by the crisis, with only a small drop during the crisis weeks, and delivered the best overall performance for the year.


In a year during which financial markets had wild swings, and commodity prices followed, it should come as no surprise that currency markets also went through turbulence. In the graph below, I look at the movements of a select set of currencies over 2020, all scaled to the US dollar to allow for comparability:

Federal Reserve Data (FRED)

The dollar strengthened against all of the currencies between February 14 and March 23, but over the course of the year, it depreciated against the Euro, Yen and the Yuan, was mostly flat against the British pound and Indian rupee and gained significantly against the Brazilian Real. Looking at the US dollar’s movements more broadly,  you can see the effects of 2020 by looking at the Us  movement relative to developed market and emerging market currencies in the graph below:

Federal Reserve Data (FRED)

In the crisis weeks (2/14 to 3/23), the US dollar gained against other currencies, but more so against emerging market currencies than developed markets ones. In the months afterwards, it gave back those gains to end the year flat against emerging market currencies and down about 5.5% against developed market currencies.


During crises, collectibles often see increased demand, as fear about the future and a loss of faith in institutions (central banks, governments) leads people to see refuge in investments that they believe will outlast the crisis. Given the history of gold and silver as crisis assets, I start by looking at gold and silver prices in 2020;

Federal Reserve Data (FRED)

Both gold and silver had strong years, with gold up 24.17% and silver up 46.77% during the year, but gold played the role of crisis asset better, with its price dropping only 5.19% in the crisis weeks from February 14 to March 23, beating out almost every other asset class in performance during the period. Silver dropped by 29.34% during that same period, but while its subsequent rise more than made up for that drop, on the narrow measure of crisis asset, it did not perform as well as gold.

The year (2020) had mixed effects on other collectible markets. Fine art, for itself, built around in-person auctions of expensive art works saw sales plummet in the early months of 2020, as shutdowns kicked in, but saw a surge of online auctions towards the end of the year. Notwithstanding this development, overall sales of art dropped in 2020, and transactions decreased, especially in the highest-priced segments. 


It would be impossible to complete this post without talking about bitcoin, which as it has for much of the decade, continued to dominate discussions of markets and investments. Looking at this graph of bitcoin since its inception, you can see its meteoric rise:

There are clearly many who have been enriched during this rise, and quite a few who have lost their shirts, but any discussion of bitcoin evokes more passion than reason. There are some who believe so intensely in bitcoin that any critique or viewpoint that is contrary to theirs evokes an almost hysterical overreaction. On the other hand, there are others who view bitcoin as speculation run amok, with the end game destined to be painful. At the risk of provoking both sides, I want to start with a fundamental question of whether bitcoin is an asset, a commodity, a currency or a collectible. Even among its strongest supporters, there seems to be no consensus, with the biggest split being between those who argue that it will become a dominant currency, replacing fiat currencies in some markets, and supplementing them in others, and those who claim that it is a gold-like collectible, deriving its pricing from crises and loss of faith in fiat currencies. You could argue that this divide has existed from its creation in 2008, both in terminology (you mine for bitcoin, just as you do for gold) and in its design (an absolute limit on its numbers, creating scarcity). There are even some who believe that the block chain technology that is at the heart of bitcoin can make it a commodity, with the price rising, as block chains find their place in different parts of the economy. Here is my personal take:

  1. Bitcoin is not an asset. I know that you can create securities denominated in bitcoin that have contractual or residual  cash flows, but if you do so, it is not bitcoin that is the asset, but the underlying contractual claim. Put simply, when you buy a dollar or euro denominated bond, it is the bond that is the asset, not the currency of denomination.
  2. Bitcoin is not a commodity. It is true that block chains are finding their way into different segments of the economy and that the demand for block chains may grow exponentially, but bitcoin does not have a proprietary claim to block chain technology. In fact, you can utilize block chains with fiat currencies or other crypto currencies, and many do. There are some cryptos, like ethereum, that are designed to work much better with block chains, and with those crypto currencies, there is a commodity argument that can be made.
  3. Bitcoin is a currency, but it is not a very good one (at least at the moment): Every year, since its inception, we have been told that Bitcoin is on the verge of a breakthrough, where sellers of products and services will accept it as payment for goods and services, but twelve years after its creation,  its acceptance remains narrow and limited. There are simple reasons why it has not acquired wider acceptance. First, if the essence of a currency is that you want transactions to occur quickly and at low cost, bitcoin is inefficient, with transactions times and costs remaining high. Second, the wild volatility that makes it such a desirable target for speculative trading makes both buyers and sellers more reluctant to use it in transactions, the former because they are afraid that they will miss out on a price run up and the latter because they may be accepting it, just before a price drop. Third, a currency with an absolute limit in numbers is one that is destined for deflation in steady state, in economies with real growth. I know that stories about the Silk Road have enshrined the mythology of bitcoin being the currency of choice for illegal activities, but a currency designed purely for evasion (of crime and taxes) is destined to be a niche currency that will be under assault from governments and law enforcement.
  4. Bitcoin is a collectible, but with a question mark on longevity: I have described Bitcoin as millennial gold, and you could argue that, at least for some young people, holding bitcoin resonates more than holding gold. They may be right in their choice, but there are two issues that they need to confront. The first is that while bitcoin’s allure is that it has limits on  quantity, that assumes that it has no substitutes. If other cryptos can operate as substitutes, even imperfect ones, there is no limit on quantity, since you can keep creating new variants. The second is whether the desirability of bitcoin will endure, since much of that desirability right now is built on its past price performance. In other words, if traders move on from bitcoin to some other speculative investment, and bitcoin prices stagnate or drop, will traders continue to hold it? In Bitcoin's favor, it has been able to make it through prior downturns, and not only survive but come back stronger, but the question still remains.
Looking at how Bitcoin did in 2020 can give us insight into its future. In the graph below, I look at Bitcoin and Ethereum prices through the year:
Yahoo! Finance
Both Bitcoin and Ethereum delivered spellbinding returns in 2020, with Bitcoin up more than 300% and Ethereum up 469%. It may seem odd to take issue with either investment after a year like this one, but there are two components to the year's performance that should give pause to proponents. The first is that during the crisis weeks (2/14 - 3/23) and the months afterwards (3/23 - 9/1), Bitcoin and Ethereum both behaved more like very risky stocks than crisis assets, undercutting the argument that investors will gravitate to them during crises. The second is that there were no significant developments that I know off, during the last few months of 2020, that advanced the cause of Bitcoin as a currency or Ethereum as a commodity, which leaves us with momentum as the dominant variable explaining the price run up. 

Does that mean that we are headed for a correction in one or both of these cryptos? Not necessarily, since momentum is a dominant force, and while momentum can and will break, the catalysts for that to happen are not obvious in either Bitcoin or Ethereum, precisely because they are unformed. Since the end game (currency or collectible) is still being hashed out, there are no markers against which progress is being measured, and thus, no disappointments or surprises that will lead to a reassessment. Put simply, if you don't know where Bitcoin is going, how would you know if it is getting there? Let me suggest that this confusion serves the interests of bitcoin traders, keeping its prices volatile, but it comes at the expense of bitcoin’s long term potential as a currency or collectible, which require more stability. 

The Investment Lessons

Every investing class starts with a discourse on diversification, an age-old lesson of not putting your eggs in one basket, and spreading your bets. In the last few decades, a combination of modern portfolio theory and data access has quantified this search for stability into a search for uncorrelated investments. When I was learning investments, admittedly a lifetime ago, I was told to expand my stock holdings to foreign markets and real estate, because their movements were driven by different forces than my domestic stockholdings. That was sensible advice, but as we (collectively as investors) piled into foreign stock funds and securitized real estate, we created an unwanted, but predictable consequence. The correlations across markets rose, reducing the benefits of diversification, and particularly so, during periods of crisis. The co-movement of markets during the 2008 crisis has been well chronicled, and I was curious about how 2020 played out across markets, and to capture the co-movement, I computed correlations using daily returns in 2020, across markets:

Download correlations, with raw data to back them up

If you are rusty on statistics, this table can look intimidating, but it is a fairly easy one to read. To see the story behind the numbers, remember that a correlation of one reflects perfect co-movement, plus one, if in the same direction, and minus one, if in opposite directions, and a number close to zero indicates that there is no co-movement. Here is what I see:

  1. Equities moved together across markets, with correlations of 0.89 between US large cap and small cap, 0.70 between US large cap and European equities and 0.60 between US large cap and emerging market equities. Put simply, having a globally diversified stock portfolio would have helped you only marginally on the diversification front, during 2020.
  2. The US dollar moved inversely with equities, gaining strength when stocks were weak and losing strength when they were strong, and the movements were greater against emerging economy currencies ((-0.54) than against developed economy currencies (-0.17). That may have offset some or much of the diversification benefits of holding emerging market stocks.
  3. Treasury bond prices moved inversely with stock prices, at least during 2020.  That can be seen in the negative correlations between the S&P 500 and 3-month T.Bills (-.06) and 10-year T.Bonds (-0.48). In other words, on days in 2020, when interest rates rose (fell) strongly, causing T.Bond prices to drop (rise), stock prices were more likely to go up (down). (I computed daily returns on treasury bonds, including the price change effect of interest rates changing.)
  4. With corporate bonds, the relationship with stock prices was positive, with lower-grade and high yield bonds moving much more with stocks (S&P 500 correlation with CCC & lower rated bonds was 0.60), than higher grade bonds (S&P 500 correlation with CCC & lower rated bonds was 0.47). 
  5. In 2020, at least, commodity prices moved with stock prices, with the correlations being strongly positive not just for oil and copper, but with the broader commodity index.
  6. The S&P real estate index moved strongly with stocks, but a caveat is in order, since this index measures securitized real estate. Most of real estate is still held in private hands, and the prices on real estate can deviate from securitized real estate prices. The Case-Shiller index measures actual transactions, but it is not updated daily, and thus does not lend itself to this table.
  7. Gold and silver provided partial hedges against financial assets (stocks and bonds), but the correlation was not negative, as it was in the 1970s. During 2020, gold and silver both posted positive correlations with the S&P 500, 0.17 for the former and 0.24 for the latter.
  8. Cryptos moved more with stocks than gold, with bitcoin exhibiting a correlation of 0.43 with the S&P 500 and ethereum correlated 0.45 against the same index. Interesting the correlation between cryptos and gold is low; the correlation is 0.10 between bitcoin and gold and 0.12 between ethereum and gold.
I know that this is all from one year, and that these correlations are unstable, but it is crisis years like 2008 and 2020 that we should be looking at, to make judgments about the relationship between investments and risk. The bottom line is that diversification today is a lot more difficult than it was a few decades ago, and staying with the old playbook of hold more foreign stocks and some real estate will no longer do the trick. 

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Wednesday, January 20, 2021

Data Update 2 for 2021: The Price of Risk!

Investors are constantly in search of a single metric that will tell them whether a market is under or over valued, and consequently whether they should buying or selling holdings in that market. With equities, the metric that has been in use the longest is the PE ratio, modified in recent years to the CAPE, where earnings are normalized (by averaging over time) and sometimes adjusted for inflation. That metric, though, has been signaling that stocks are over valued for most of the last decade, a ten-year period when stocks delivered blockbuster returns. The failures of the signal have been variously attributed to low interest rates, accounting mis-measurement of earnings (especially at tech companies), and by some, to animal spirits.  In this post, I offer an alternative, albeit a more complicated, metric that I believe offers not only a more comprehensive measure of pricing, but also operates as a barometer of the ups and downs in the market.

The Price of Risk

The price of risk is what investors demand as a premium, an extra return over and above what they can make on a guaranteed investment (risk free), to invest in a risky asset. Note that this price is set by demand and supply and will reflect everything that investors collectively believe, hope for, and fear.

Does the price of risk have to be positive? The answer depends on whether human beings are risk averse or not. If they are, the price of risk will be reflected in a positive premium, and the level of the premium will increase, as investors become more risk averse. If, on the other hand, investors are risk neutral, the price of risk will be zero, and investors will buy risky business, stocks and other investments, and settle for the risk free rate as the expected return.

Note that nothing that I have said so far is premised on modern portfolio theory, or any academic view of risk premiums. It is true that economists have researched risk aversion for centuries and concluded that investors are collectively risk averse, and that the level of risk aversion varies across age groups, income levels and time. Some have developed models that try to measure what a fair risk premium should be, but to arrive at their conclusions, they have make assumptions about investor utility functions that are often unobservable and untestable. I have no desire to make this a lengthy treatise about the "right" risk premium, but will instead start with two assertions:

  1. Risk premiums can be estimated: You can back out the risk premiums that investors are demanding from the prices that they pay for risky assets. Put simply, if you can observe the price that an investor pays for a risky asset, and are willing to estimate the expected cash flows on that asset, you can estimate the expected return on that asset and net out the risk free asset to arrive at a risk premium. It is true that you can make mistakes on your expected cash flows, but your output should reflect an estimate, albeit a noisy one, of what investors are demanding as a premium.
  2. Risk premiums can and will change over time: Risk premiums are driven by risk aversion, and risk aversion itself can change over time. In fact, greed and fear, two big drivers of market prices, also affect risk aversion, with investors becoming more risk averse and charging higher premiums, when the fear factor becomes dominant. 
  3. When risk premiums change, prices will move: As risk premiums change, the prices that investors are willing to pay for risky assets will also change, with the two moving in opposite directions. Intuitively, if you want to earn a higher risk premium on an investment, holding cash flows fixed, you will pay less for that investment today.
The Price of Risk: Bond Market

All bonds, including those with guaranteed coupons, are risky, if you define risk as prices being volatile, since as interest rates changes, bond prices will change as well. Most bonds, though, are exposed to a second risk, which is that the bond issuer can default on coupon payments, making returns and prices even more uncertain. This is why corporate bonds are riskier than sovereign bonds, and sovereign bonds issued by shakier governments are riskier than sovereign bonds issued by governments that are unlikely to default. 

Bond Default Spread

If you accept the proposition that a bond with default risk is riskier than an otherwise equivalent bond (same coupon and maturity) issued by a default-free entity, the price of risk in the bond market can be measured by looking at the differences in yields between the two bonds. Thus, if a 10-year corporate bond has a yield of 3.00% and a 10-year government bond, in the same currency and with no default risk, has a yield of 1.00%, the difference is termed the default spread and becomes a measure of the price of risk in the bond market. 

At the risk of belaboring the details, it is not the yield that we should be comparing, but the yield to maturity, which is the internal rate of return on the bond, given how it is priced:

To compute the default spread over a 10-year period for a specific corporate bond (or loan), you would compute the yields to maturity on the ten-year corporate and treasury bonds and take the difference. Note that even this comparison is an approximation, but it yields a close enough value to work, and that it yields a default spread for a specific maturity. You could compute default spreads for other maturities, and compute the price of risk over 1-year, 2-year, 3-year periods and so on. 

Corporate Default Spreads: Current and Look Back at 2020

Corporate bonds are traded, and as a consequence, and you can use traded prices to estimate default spreads in the market. In the chart below, I compare default spreads at the start of 2021 with the default spreads at the start of 2020:

Source: BofA ML Spreads on Federal Reserve (FRED)

At first sight, it looks like an uneventful year, with spreads in 2021 mildly higher than spreads in 2020, but that comparison is deceptive, since default spreads went on a roller-coaster ride during 2020:

Source: BofA ML Spreads on Federal Reserve (FRED)
While spreads started 2020 in serene fashion, the COVID-driven market crisis caused them to widen dramatically between February 14 and March 20, with the spreads almost tripling for lower rated bonds. Given the worries about default and a full-fledged market meltdown, that was not surprising, but what is surprising is how quickly the fear factor faded and spreads returned almost to pre-crisis levels.

Measuring against the past

Are default spreads today too low? There are two ways to answer that question. One is to look at their movement over time, and compare current spreads to historic norms. 

Source: BofA ML Spreads on Federal Reserve (FRED)

The default spreads at the end of 2020 are at the low end of the historical spectrum, and the contrast with the 2008 crisis is stark, since default spread surged in the last quarter of 2008 and did not come back down to pre-crisis levels until almost two years later. The other is to look at corporate defaults over time to see if markets are building in enough of a buffer against future defaults. 

Sources: S&P and Moody's

Default rates increased in 2020, with spillover effects expected into 2021, but the corporate bond default spreads do not seem to reflect this. One explanation is that the bond market beliefs that the worst of the crisis is over and that default rates will return quickly to pre-COVID levels. The other is the corporate bond market is under estimating both the risk and the consequences of default.

The Price of Risk: Equities

Equities are riskier than bonds (or at least most bonds), and it stands to reason that there is a price of risk bearing in the equity markets. While that price has a name, i.e., the equity risk premium, it is more difficult to observe and estimate than the default spread in bond markets. In this section, I will present both the standard approach to estimating the equity risk premium and my preferred way of doing so, with a rationale for why.

Estimation Approaches

Why is it so difficult to estimate an equity risk premium? The simple reason is that unlike a bond, which comes with specified coupons, the cash flows that you receive when you buy stocks are neither pre-specified nor guaranteed. It is true that some companies pay dividends, and that these dividends are sticky, but it is also true that companies are under no contractual obligation to continue paying those same dividends. This difficulty in observing the equity risk premium leads many to look backwards, when asked to estimate the equity risk premium. Put simply they look at a long time period in the past (50 years or even 100 years) and look at the premium that stocks earned over a risk free investment (treasury bills or bonds); that historical risk premium then gets used as a measure of the current equity risk premium. On my website, I update this historical risk premium every year, and the graph below reflects my January 2021 findings:

Download spreadsheet with raw data

Looking over a 92-year time period (1928-2020), for instance, stocks earned an geometric average return of 9.79%, giving them a premium of 4.84% over the 4.95% that you would have earned, investing in treasury bonds. If you buy into this measure of equity risk premiums, consider its limitations. First, it is backward looking and built on the presumption that the future will look like the past. Second, even if you trust mean reversion, note that the estimated premium is not a fact but an estimate, with a wide range around it. Specifically, the estimate of 4.84% for the equity risk premium from 1928 to 2020 comes with a standard error of 2.1%; the true ERP, with this error, could fall anywhere from 0.64% to 9.04%. Third, this premium is static and does not reflect market crises and investor fears; thus, the historical risk premium on February 14, 2020 would have very similar to the historical risk premium on March 20, 2020.

The alternative approach to estimating equity risk premiums is revolutionary and it borrows from the yield to maturity approach that we used to estimate bond default spreads. Consider replacing the bond price with the level of stock prices today (say, with the S&P 500 index) and coupons with expected cash flows on stocks (from dividends and buybacks), and solve for an internal rate of return:

Implied Equity Risk Premium: In General

The internal rate of return is the expected return on stocks, and netting out the risk free rate today will yield an implied equity risk premium. In the picture below, I use this process to estimate an equity risk premium of 4.72%  for the S&P 500 on January 1, 2021:

Download spreadsheet to compute ERP

It is true that my estimates of earnings and cash flows in the future are driving my premium, and that the premium will be lower (higher) if I have under (over) estimated those numbers. This approach to estimating equity risk premiums is forward-looking and dynamic, changing as the market price changes. In the graph below, I report implied equity risk premiums that I computed, by day, during 2020, in an effort to gauge how the crisis was playing out and keep my sanity.

Download spreadsheet with data

As with the bond default spread, the implied equity risk premium was extraordinarily volatile in 2020, peaking at 7.75% on March 20, before falling back to pre-crisis levels by the end of the year.

Market Gauge?

As we are engulfed by talk of market bubbles and corrections, it is worth nothing that any question about the overall market can really be reframed as a question about the implied equity risk premium. If you believe that the current implied equity risk premium is too low, you are in effect also saying that stocks are overvalued, just as a judgment that the equity risk premium is too high is equivalent to arguing that stocks are undervalued. So, at 4.72%, is the equity risk premium too low and is the market in a bubble? One way to pass judgment is to compare the current premium to implied equity risk premiums in the past:

Download spreadsheet with historical ERP

On this comparison, stocks don't look significantly over valued, since the current premium is higher than the long term average (4.21%), though if you compare it to the equity risk premium in the last decade (5.53%), it looks low, and that stocks are over valued by about 15%. There is a caveat, though, which is that this risk premium is being earned on a risk free rate that is historically low. Consider this alternative graph, where I look at the expected return on stocks (risk free rate plus implied equity risk premium) over the same time period:

For much of this century, the expected return on stocks has hovered around 8%, but the expected return at the start of 2021 is only 5.65%, well below the expected returns in prior periods.

A Market Assessment

I know that you are probably incredibly confused, and I am afraid that I cannot clear up all of that confusion, but this framework lends itself to valuing the entire market. To do this, you have to be willing to make estimates of:

  1. Earnings on the index: You cannot value a market based upon last year's earnings (though many do so). Investing is about the future, and uncomfortable as it may make you feel, you have to make estimates for the future. With an index like the S&P 500, you can outsource these estimates at least for the near years, by looking at consensus forecasts from analysts tracking the index.
  2. Cash returned, relative to earnings: Since it is cash returned to stockholders that drives value, you also have to make judgments on what percent of earnings will be returned to stockholders, either in dividends or buybacks. To this, you can look to history, but recognize that it is also a function of the confidence that companies have about the future, with more confidence leading to higher cash being returned.
  3. Risk free rates over time: While it is generally not a good idea to play interest rate forecaster, we are in unusual times, with rates close to all time lows. In addition, your views on future growth in the economy are intertwined with what will happen to risk free rates, with stronger economic growth putting more upward pressure on rates.
  4. An acceptable ERP: As I noted in the last section, equity risk premiums have been volatile over time, and particularly so in years in 2020. The equity risk premium, added to the risk free rate, will determine what you need stock returns to be, to break even on a risk-adjusted basis.

It is only fair that I go first. In the picture below, I make my best judgments on each of these dimensions, using consensus estimates of earnings in 2021 and 2022 to get started, but then slowing growth in earnings to match the growth rate in the economy, which I approximate with the risk free rate. On the risk free rate, I assume that rates will rise over time to 2%, and that 5% is a fair ERP, given history. My valuation is below:

Download spreadsheet to value S&P 500

Based upon my inputs, the S&P 500 is over valued by about 12%, certainly not bubble territory, but still richly priced. You may (and should) disagree with my assumptions, and I welcome you to download the spreadsheet and change the inputs. Ultimately though, the judgment you make on the market will be a joint effect of your views on the economy and interest rates in the next few years. The table below summarizes the interplay between economic growth and interest rate assumptions, and the effects on the index value:

Use S&P 500 valuation spreadsheet to assess value effects

As you can see, there are far more bad possible outcomes than good ones, and the only scenario where stocks have significant room to rise is the Goldilocks market, where rates stay low (at close to 1%), while the economy comes back strongly. I know that the possibility of additional economic stimulus may improve the odds for the economy, but can they do so without affecting rates? To buy into that scenario, you have to belief that the Fed has the power to keep rates low, no matter what happens to the economy, and I don't share that faith. 

As many of you who have read my blog posts know, I am a reluctant market timer, but ultimately we all time markets, implicitly or explicitly, the former wooing up in how much of your portfolio is in cash and the latter in more overt acts of either protection or bets on market directions. Going into 2021, I have far more cash in my portfolio than I usually do, and for the first time in a long, long time, I have bought partial protection against a market drop, using derivatives. It is insurance, and like all insurance, my best case scenario is that I never need to use it, but it reflects my wariness about what comes next. I am not and don't want to be in the business of doling out investment advice, and I think that the healthiest pathway for you is to make your own judgments on interest rates, earnings growth and acceptable risk premiums, and follow that with consistent actions. 

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  1. Implied ERP for the S&P 500: January 1, 2021
  2. Spreadsheet to value the S&P 500 on January 1, 2021

Data Updates for 2021

  1. Data Update 1 for 2021: A (Data) Look Back at a Most Forgettable Year!
  2. Data Update 2 for 2021: The Price of Risk!
  3. Data Update 3 for 2021: Currencies, Commodities, Collectibles and Cryptos!
  4. Data Update 4 for 2021: The Hurdle Rate Question