Party Like It’s 2020?
Updated
January 31, 2023
5
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I can’t find the original paper anymore, but there were experiments where a bunch of people were stuck in a room and asked to trade around a fictitious stock for a few hours. What do you think happened? Did people just decide to ignore the experiment and hang out? Did people trade frantically for no reason anyway? Or was it in between?
Well, it turns out there was a decent amount of volatility as people frantically punted on the price of a meaningless quantity, causing wild swings in the absence of any meaningful news.
It’s been like this the last week. Sure there were earnings, some of it interesting, but mostly not. At the very least, the meme stock insanity is over with rates now well above 4% right? Well… have I got news for you!
Source: Yahoo Finance
You haven’t seen the last of the Memecans. Above is the price of Lucid Motors vs the S&P. It exploded up due to a rumor of a takeover, but deca-billion-dollar stocks just aren’t supposed to go parabolic like penny stocks…unless we’re in 2020.
So what’s going on?
It’s difficult to not have FOMO when you are invested in S&P and made 6% YTD only to see TSLA do this:
TSLA is only the flagbearer for the movement however. Many other “left for dead” stocks such as CVNA, GME, and LCID have all had impressive moves, and arguably, none of their businesses have taken a material turn for the better in the span of the last few weeks.
So meme stocks are back. But how? All of the pundits were saying how obviously now that the Fed is taking away the punch bowl that these pumps were no longer supposed to happen.
The basic intuition is that as the Fed raises rates, levered financial institutions have to pay higher and higher rates, causing them to reduce their positions. Since in the aggregate everyone is net long stocks, that should depress prices as people are “forced to sell”.
While this is technically true, we have to think through who these people are and what assets they control. The most rate sensitive market participants are traders and hedge funds. They do well when funding is cheap and/or price volatility is high, since lots of price movement means more opportunities for short term gains. And what’s the best way to build leverage? Options. Well, here’s what options volume in TSLA looks like over time:
Volume in options activity has been going up because the Fed has caused forced selling, which is pushing up volatility and risk premiums across the board, making it more attractive for hedge funds despite the higher cost of funds. What’s the big deal with 4% fed funds when you can make… 36% in a month?
But that’s only part of the story… Because the Fed also has another kink in its armor, and that’s because… it doesn’t control long term rates.
Yes, short term rates are up, but as of Jan 30th, 2023, the 2 year Treasury yield is nearly identical to what it was 4 months ago, despite 200 bps of hiking. And it’s lower by 25-50 bps for maturities beyond 2 years.
Source: ustreasuryyieldcurve.com
What gives? Perhaps the market believes the Fed will be so effective that inflation will drop in a jiffy. Or they think the Fed has no idea how damaging its actions are and will break something.
Regardless of which view you have, financing conditions have been improving, volatility has been increasing, and that’s when the hedge funds come out and play.
Don’t believe me? Citadel just made $16BN in gains in their main fund. The best on record. He attributes it to… people being back in the office? Why weren’t they making 16BN a year before COVID then? But then again, you don’t get to be the best for long by actually explaining your winning strategy.
But this is not just a hunch, the data for this is publicly available! Below is a chart of the total reserves held by depository institutions. This is a proxy for leverage in the entire financial system. For each dollar you put in the bank, the bank has to hold a portion of it as reserves.
Despite having hiked over 3% since mid last year, the total reserves in the system has stopped going down. Basically people have stopped deleveraging. In fact, more interestingly, people de-levered before the onset of hikes. What do you think happens in the next few months as the Fed plans to stop hiking? Meanwhile…
While there was a flurry of data last week. The best way to describe it was, slightly worse than expected, nudging US equities up a bit. The biggest dud was PCE, which came in exactly on top of estimates.
But the estimates were for 4.4% Core PCE. Which is a full percent lower than the peak observed early last year. Furthermore, most forecasts have it dropping at a similar speed for this year, which means that we’ll be at ~3% by the end of ‘23.
Yes, that’s still higher than the 2% target. But you have to remember: the 2% target is actually just completely made up anyway. So if we did get to 3% by the end of the year, Why would the Fed bend over backwards to make sure it actually hits exactly 2%? If it did that, wouldn’t it also then have to worry that we’d be back to the chronically low inflation regime it was complaining about for nearly a decade just before COVID?
Given that it takes months to see the impacts of monetary policy in the real economy, how confident would they be of not overshooting, but this time on the downside.
The explosion in meme stocks in a tightening environment complicates things slightly and will force market participants to actually think for the first time since the financial crisis. Fed ease = buy, and Fed hikes = sell is no longer the only winning strategy.
Source: Atlanta Fed
However, in the context of the past few weeks, since we already suggested buy the dip despite a hike or 2 still priced in, any indication of them not happening would just add fuel to the fire. You just have to choose how hot you want your water to be before you jump in!
And by choice I mean, before or after this week's FOMC. See you next week!
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