Blog

Posted on

The Short Game – 2/3/2021

There has been much in the news about the Reddit crowd beating the hedge funds at their own game.  GameStop Corp (GME), the retailer of video games and consumer electronics received the most attention.  For the most recent twelve months that were reported ending in October 2020, the company had revenue of $5.16 billion and a net loss of $274.8 million.  Revenue for the October quarter had declined by 30.2% from the prior year’s comparable quarter and the company had $446 million of cash and short-term investments.  The declining fundamentals attracted short sellers.  GME has a 52-week low price of $2.57 per share and a 52-week high of $483.00, achieved during its spectacular run-up last week.  As recently as January 12, GME closed at $19.95 per share.

GME has 69.7 million shares outstanding.  The float, which excludes restricted stock that cannot be sold to the public, is 49.3 million shares.  In mid-January, there were 71.2 million shares of GME that had been sold short, or 144.3% of the float.  Technically, shares which are sold short must be borrowed from a brokerage firm that holds the shares in the margin account of customers.  Short sales generate additional business for brokerage firms.  The cost of borrowing shares of GME stock exceeded 20%.  When a brokerage firm lends shares that it does not hold in a customer margin account, it is called a “naked short” and the brokerage firm is taking a financial risk.

Call options contributed to the price action in GME stock.  Some speculators buy options instead of the stock to get more leverage.  Options dealers who sell the call options usually purchase the stock to hedge their exposure on the call options.  So, the options dealers become another source of demand for the stock.

The large GME short position attracted some attention and the Reddit/WallStreetBets crowd, with over 8 million members, pushed the idea of buying GME stock and its call options en masse to force additional buying by the shorts to cover their losses.  It worked!  According to some traders, as older shorts incurred large mark-to-market losses and were forced to buy shares to meet margin calls during the last week of January, new shorts who were able to find shares to borrow established new short positions.  The shorts were then aided by several brokerage firms who forbid the purchase of GME shares by retail investors late last week.  The hedge funds and other short sellers were able to cover their short positions (buy shares) without competition from the Reddit crowd, many of whom were unable to buy shares but were allowed to sell shares.  By Monday, February 1, the GME short interest had declined to 39% of the float.

Other heavily shorted stocks benefitted from the market action.  AMC Entertainment (AMC), BlackBerry (BB), and Nokia (NOK) all had similar but less exaggerated price action.  AMC and American Airlines (AAL) used the price spike to sell additional shares to the public to raise some cash for their businesses.

Some media commentators, professional investors, and politicians have called for a Congressional investigation and additional regulatory intervention.  Jack Inglis, CEO of the Alternative Investment Management Association (AIMA), said, “What is dangerous, amid this trading frenzy, is that retail investors have been chasing prices so far above any sane valuation and that many well end up nursing losses.”  True, but many are skeptical that an organization that includes many hedge fund managers is concerned about small investors.

Hedge funds that shorted Gamestop and other companies with poor fundamentals have large losses for the month of January.  ZeroHedge.com estimates that one hedge fund, Melvin Capital, lost over $7 billion or 53% of its capital in the month of January.  The Wall Street Journal reported that another smaller hedge fund, Maplelane Capital, started the year with $3.5 billion and had a loss of 45% by the end of January.

Regarding potential changes in the regulatory environment to rein in the Reddit crowd, Ryan McMaken, senior editor at the Mises Institute wrote this:

This “exemption from free market discipline” is what Wall Street is all about these days.  The financial sector has become accustomed to enjoying bailouts, easy money, and the resulting financialization which puts ever greater amounts of the US economy into the hands of Wall Street money managers. The sector is now built on corporate welfare, not “free markets.” No matter what happens, Wall Street expects the deck to be stacked in its favor.

One question that has not been addressed in all the media coverage of the GME saga is the function of short sales in the financial markets.  It generates more commissions and fees for brokerage firms, and the hedge funds claim that it is a strategy that justifies their generous fees.  But short sales shift capital from a productive economy that produces goods and services to a speculative economy that does not provide capital to produce anything but has a lot of activity to support a zero-sum game where market participants place bets against each other.  Is it any wonder that the US now has large trade deficits every month?  For the last reported month of November 2020, the US trade deficit was $68.1 billion.  Maybe our financial markets should put a greater emphasis on providing capital to companies that can provide goods and services at a profit.

If you have any questions or comments, please contact me.

Robert G. Kahl
CFA, CPA, MBA

Posted on

Schwab 2021 US Market Outlook

This month, I will refer investors to the Schwab 2021 US Market Outlook by Charlos Gary as I believe it offers a good summary of the economy and financial markets.  Some key takeaways:

  • Gross domestic product (GDP) has not fully recovered from its contraction since the first calendar quarter.
  • Consensus economic forecasts for GDP growth in 2021 are in the 3.1-3.4% range.
  • Permanent job losses have increased steadily during 2020.
  • Unemployment has declined from a peak of 14% in the spring to under 7% now.
  • The most frequent questions on Schwab webcasts are related to the federal budget deficit, debt, and inflation.
  • The Big 5 stocks (Alphabet, Amazon, Apple, Facebook, and Microsoft) account for 25% of the capitalization of the S&P 500 and their year-to-date performance exceeds the other 495 stocks of the S&P 500 by over 40%.
  • The forward price/earnings ratio (based on a forecast for the next 12 months) of the S&P 500 is currently at 26, matching the peak level of the “tech bubble” of 2000.  However, the P/E of the Big 5 stocks now is nearly half the level of the Big 5 stocks of 2000.
  • Sentiment indicators indicate extreme optimism, which is bearish for the market.  Net foreign purchases of US stocks are at record levels.
  • Their concluding line: “Investors should remain disciplined, diversified and opportunistic with regard to rebalancing.”  I agree.

If you would like to read the full article, click on the following link:  2021 U.S. Market Outlook: Better Days? | Schwab Funds

The Recent Merger

As most of you know by now, Charles Schwab recently completed their acquisition of TD Ameritrade, which I have used as custodian (including the predecessor organizations) for client accounts for more than twenty years.  For now, TD Ameritrade operations will continue as though it is a separate entity, but eventually their operations will be merged.  Charles Schwab has an excellent reputation and I expect a good working relationship with them in the future.

If you have any questions, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA

Posted on

Political Dysfunction Reaches New Heights

Regardless of the election outcome, the prognosis for political cooperation is poor.  In the past, many of us recall political debates that that had a sense of decorum.  It also seemed as though the distinctions between political parties were more subtle.

This year, the first Presidential debate reminded us of a high school cafeteria food fight.  It appears that the two major political parties are incapable of agreeing on much of anything.  As a result, much of the activity in Washington, DC seems counterproductive and theatrical in nature.

Jeff Gundlach, CEO of Doubleline Capital, has a reputation for being outspoken and having a better batting average than many when making predictions.  At the start of 2016, he predicted that Donald J. Trump would become the next President when he had not yet emerged as the winner from the Republican primary fracas.  Gundlach has never endorsed Trump and in fact has criticized him for relying too much on hyperbole such as “the best economy ever.” Gundlach took issue with the description because economic growth has relied to a large degree on government deficit spending.

On a Schwab webcast last week, Gundlach once again predicted that President Trump would be re-elected.  Gundlach said, “The polls right now say he isn’t going to win, but they said that four years ago.”  He referred to a chart from Predictit that showed the betting odds of a Trump win at about 42% now versus 13% in 2016.  In contrast to the flip in the betting odds from four years ago, Gundlach qualified his prediction by saying “my conviction is way lower than it was four years ago.”

Gundlach attributes much of Trump’s advantage to avoidance of uncertainty.  “You might dislike Trump or some of his policies, but risk is not what you’re getting with him, particularly compared to turning the presidency over to another party, and particularly when that party’s candidate isn’t saying what some of his policy positions are.”

Living up to his reputation for being outspoken (especially for a bond manager), Gundlach predicted that by 2027, economic inequality, strained by fiscal and monetary policy, would come to the point of some sort of revolution.  As for the 2024 election, he had this to say, “Well, if you think 2020 is weird, just wait for 2024.  You ain’t seen nothing yet.”

Another round of corona virus aid and economic stimulus was postponed until after the election.  A wide gap exists between the two parties regarding the total size of the aid/stimulus package, how much aid should be given to state and local governments, enhanced unemployment benefits, special liability protection for businesses, and other issues.

The Congressional Budget Office projects the budget deficit to decline from a record level of 16.0% of GDP ($3.3 trillion) in fiscal year 2020 to 8.6% of GDP for the fiscal year ending September 30, 2021.  Of course, the projection includes a variety of assumptions that are subject to change.  Regardless of the election outcome, we can expect the continuation of large budget deficits and dysfunction in the political arena.

If you have any questions, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA

Posted on

The Fed’s New Rationale

The Fed’s New Rationale

Federal Reserve Chairman Jerome Powell gave a speech at Jackson Hole, Wyoming to outline the Fed’s new rationale for monetary policy.  The purpose of the speech was to outline a new framework for the Fed’s monetary policy.

Chairman Powell said the review of monetary policy was motivated by “our evolving understanding of four key economic developments.”  The four economic developments that he listed are:

  1. Assessments of the potential, or longer-run, growth rate of the economy have declined. For example, since January 2012, the median estimate of potential growth from FOMC participants has fallen from 2.5 percent to 1.8 percent.
  2. The general level of interest rates has fallen both here in the United States and around the world. Estimates of the neutral federal funds rate, which is the rate consistent with the economy operating at full strength and with stable inflation, have fallen substantially, in large part reflecting a fall in the equilibrium real interest rate.
  3. The record-long expansion that ended earlier this year led to the best labor market we had seen in some time. The unemployment rate hovered near 50-year lows for roughly 2 years, well below most estimates of its sustainable level.
  4. The historically strong labor market did not trigger a significant rise in inflation. Over the years, forecasts from FOMC participants and private-sector analysts routinely showed a return to 2 percent inflation, but these forecasts were never realized on a sustainable basis.

The revised statement of longer-run goals and monetary policy was approved unanimously by the Federal Reserve Open Market Committee.  While some aspects of the Fed’s policy remain in place, Chairman Powell highlighted some changes.

  1. The Fed expressly acknowledges that interest rates at the “lower bound” of its policy range reduces their scope to support the economy in the future by cutting interest rates.
  2. Maximum employment is a broad-based and inclusive goal. They appreciate the benefits of a strong labor market, particularly for many in low- and moderate-income communities.
  3. Going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks.
  4. Their actions to achieve both sides of their dual mandate (stable prices and maximum sustainable employment) will be most effective if longer-term inflation expectations remain well-anchored at 2 percent.

In a curious comment that seems designed to give the Fed more leeway, Chairman Powell said that they would not be tying themselves to a “particular mathematical formula” that defines average inflation.  Their approach “could be viewed as a flexible form of average inflation targeting.”

While the economic developments that Chairman Powell listed are accurate, some commentators believe the Fed needed a new rationale to justify the huge volume of purchases of US Treasury securities and, to a lesser extent, mortgage-backed securities.  Since September 4, 2019 (one year ago), the Fed has added $2,276 billion of US Treasury securities and $460 billion of mortgage-backed securities to their balance sheet.

The Congressional Budget Office is now projecting a federal budget deficit of $3.3 trillion for the fiscal year ending September 30, 2020.  This requires US Treasury debt issuance that far exceeds demand from the private sector, so the Fed buys much of the new debt.  The increase in the monetary base to accommodate federal deficit spending and US Treasury debt issuance is likely to lead to inflation that exceeds 2%, along with further declines in the US currency.

Note to Clients

Earlier this year, I asked clients for approval via e-mail or phone conversation to temporarily increase the maximum limit on the precious metals allocation from 15% to 30%.   I now expect the reasons for having a significant precious metals allocation to remain in place for some time.

During the next two weeks, I will be sending out revised investment guidelines to show a potential allocation range of 0 – 30% for precious metals.  In the past, I committed the maximum of 30% of portfolios to precious metals bullion.  This proved to be timely and the precious metals allocation in most accounts now exceeds the initial allocation of 30% because gold and silver have increased in price more than most securities.  I would also like some provision in the investment guidelines to acknowledge that the upper limit on the allocation may be exceeded due to better relative performance.  I am not necessarily a perma-bull on precious metals, but I believe it will continue to be an attractive asset class until the US and other governments take a rigorous stance against deficit spending and the creation of more fiat currencies.

If you have any questions, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA