(About five years ago, my friend Michael Mann – not the Miami Vice one -- and I wrote an article for the magazine International Economy entitled Whom Do Today’s Capital Markets Serve? This post is based in large part on the thinking in that piece. You can see it here: http://www.international-economy.com/TIE_F16_EhrlichMann.pdf if you really want to. Or skip it.)
The current imbroglio between a group of hedge funds and a crowd of Reddit-linked insurgents is now the Outrage of the Week, albeit for different reasons to different sides of the subject. The hedge funds see the insurgents as a coordinated herd of malcontents cannibalizing wealth to make a vitriolic point. The insurgents see the hedge funds as pathetic whiners who dislike the taste of their own medicine.
At some level, both are correct. But more vitally, both miss the point completely.
A quick review. A gaggle of relatively skinny-pocketed, web-based market-watchers saw hedge funds "short" shares in video game chain store GameStop, a company that smells uncomfortably like Blockbuster with joysticks. “Short-sellers" believe the price of a stock is about to fall, but they pursue their reward at great risk; they borrow shares and promise to return them in the future when their price drops, which works as a strategy if they were right. (That is, they “borrowed” shares at $5, immediately sold them and kept the $5, then later bought new shares to “return” them at $3, making a profit of $2.) But if they’re wrong, short-sellers get ‘squeezed” – they must replace their borrowed shares with more expensive, not cheaper, ones, (substitute $10 for $3 in the example) and their clock gets cleaned. Folks on the street (financial professionals, that is, not the homeless) tell the joke about the short seller who gets ruined and decides to kill himself, so he jumps out the window and falls up, which works as both a joke and an insight.
The Reddit insurgents – call them that, or speculators, or gamblers, but please, not investors – saw this shorting activity and ganged up on it, using their own (and sometimes borrowed) money to bid up the price of shares and forcing the short-sellers to scramble to buy the shares they promised to return, driving prices higher. And the hedge funds speculators, seeing and disdaining the rabble who bid the price up, shorted all over again. After all, they were up against a crowd of social media riffraff, not the sophisticated, algorithm-based, savvy practitioners of finance theory they knew themselves to be. And they got killed all over again. The sin of hubris is not lightly visited -- their losses have been estimated at $20 billion, and some of the leading hedge funds in this battle have lost as much as 30 cents on every dollar of their clients’ money. But at least they can look at their MBAs and homes in Greenwich and retain a feeling of moral superiority.
Who’s entitled to wear a white hat here? Nobody. The Reddit insurgents are right to argue they’re just giving their hedge fund counterparts a taste of their own medicine. And their case never looked better than after grouchy hedge fund titan Leon Cooperman’s recent diatribe that the Reddit crowd was “sitting at home getting their checks from the government” (was one of them the 400 pound Jerseyite lay-a-bed Trump blamed for the DNC hack?) and, while he was at it, taxing the wealth of the rich was “a bullshit concept.” In other words, whiny bitch. (And there’s not enough time, space, or your attention to discuss RobinHood, the Reddit crowd’s favorite trading platform, but let’s just say you should only be able to use Robin Hood’s name with written permission from Pope Francis or the Dalai Lama.)
But the Reddit crowd have for the moment beaten the hedges at their own game, even if they did so using mob tactics instead of computer algorithms. It’s as if the Ethiopians beat Mussolini. But their victory is temporary – there are now lots of owners of GameStop shares priced in the hundreds but likely worth tens or less. (And say this for the hedge funds -- they shorted GameStop because the underlying numbers showed that even tens seemed high. It’s the hedges who are acting “rationally.” The insurgents are simply “getting away with it.”) But Newton had it right – what goes up must go down if there’s nothing to keep it up, and the end of the Reddit crowd’s story is yet to be written. Come back next week, when Wily E Coyote realizes he’s raced off the cliff and there’s nothing but air below him. Cue sound effect.
You could justifiably see all this as being an amusing incident in which $20 billion was lost while some dudes turned $50,000 into $40 million -- whom does Matt Damon play in the movie? After all, there was something schadenfreudishly funny about Enron, right? But this “pick a side” mentality is starting to drive policy proposals, and that makes the matter more serious.
The hedges see the insurgents as a conspiracy of market manipulators and want to attack “market manipulation,” although the real problem is not that the insurgents communicate, but that they do so on Reddit, not through analyst “buy/sell/hold” recommendations, or the Wall Street Journal, or the Motley Fool. The insurgents, on the other hand, see hedges betting that a stock’s price will fall as socially-wasteful gambling, but betting that it will rise is somehow philosophically different, as if betting on Ali was virtuous but betting on Frazier despicable. There are no white hats in this mix. There are only gamblers differentiated by culture and technique and, more importantly, who’s up or down or down at any moment.
And that’s why the GameStop debate misses the point entirely. The point is not to find heroes and villains in what markets are doing. The point is to remember what markets ought to be doing.
Think about it. If you asked virtually any market participant why we have capital markets, whether hedges or insurgents, you’d likely hear something about making money and pursuing the American dream of becoming luridly rich, or exercising our God-given freedoms to do WTF we want, or some other tired platitude. Those answers are wrong. The purpose of capital markets is to direct societal savings towards their best uses. Capitalism lets capitalists keep the profits they make, and capital markets are there to sort out what they do with them. They weren’t set up to give the public an alternative to Lotto or Powerball. But rather, ever since two dozen brokers met under a Wall Street buttonwood tree in 1792 to found the New York Stock Exchange, those markets have existed so that companies seeking to fund productive expansion could find the resources to do so, while letting savers review those companies on a consistent and even-handed basis. If that sounds like Sunday School banality, then you see how far we’ve gotten from that original intent.
You can’t blame markets or their practitioners from becoming more sophisticated than the 1793 crowd ever imagined. But as they have, they’ve transformed markets into the beleaguered but valid metaphor of a casino. Derivatives – futures, options, and the like -- stuff that’s derived from the value of some underlying asset – were created to let folks with an interest in the underlying asset manage their risks. For example: a farmer uses futures to lock in the price of the wheat he’s growing; an airline locks in a price for jet fuel for the coming year; a pension fund with big gains can buy an “option” to sell its stocks to you at a fixed price down the line in case their portfolio sags between now and then. That’s all legit stuff, because it helps folks with interests in an asset – wheat, jet fuel, stocks – manage their risks. But what was designed to help the farmer, airline, or pension fund manage their risks is now the $2 window at the track – you can bet on futures or options instead of owning an issue, the diametric opposite of their original intent. And as computers replace abaci and adding machines, program trading has become the dominant motif in the markets, as supercomputers program-trade stocks to capture nanodiscrepancies in prices. All of this activity – derivatives, program trading – is generally thought of by financial theorists as stabilizing, as helping markets find the “true” price of things, as if they created a bigger lake to absorb ripples. But, in reality, they have left us with a world in which the value of what is traded continues to rise in proportion to the underlying value of the actual things on which they’re based, much as, in Dylan’s Leopard-Skin Pill-Box Hat, “a mattress balances on a bottle of wine.”
And so both sides, the hedges and the insurgents, are wrong. Their opponent does not represent a new malfeasance or a novel financial coronavirus. Rather, both sides are symptoms of a larger unmooring of our financial markets, as they once drifted, and now race, away from their original social purpose and become a way to gamble in the world’s largest legal casino.
What is to be done? First, we need to agree the original intent of markets – to guide investment and create economic growth – is the right one. Much as every parent at some point tells their child “just because you can do something doesn’t make it right,” we need to stop thinking that every market strategy that can be implemented, should, despite the inevitable bullshit about people’s economic freedoms. We need to stop thinking about which “side” is a hero or a villain, and instead, which activities make markets less stable or distract them from their purpose. Let’s stop searching for sinners and instead think about what constitutes a sin.
What policies get us there? It’s a long conversation, but here are elements of it: perhaps limits on synthetics divorced from underlying stock ownership, (restricting the $2 dollar window); perhaps limits on program trading, whether minimum durations for holding a stock or a “Tobin Tax” imposed each time a share is traded before it has been held for some period of time; perhaps a sharper time profile of capital gains tax rates to compel a longer-term perspective; perhaps limiting the use of borrowed money in some of these market gambits. All of that needs to be on the table.
But until then, as grimly amusing as the GameStop controversy is, the right response to it is Mercutio’s condemnation of the Montagues and Capulets in Romeo and Juliet – “a plague o’ both your houses.”
Comments