The rally of the past few weeks has been sudden, strange, unprecedented and now is showing its weird side. I continue to be fascinated by the intersection of social media and investing. It’s literally the new Wild West of group think. We saw that on display in the past few days with some of the oddest rallies the market have ever seen.
Despite the fact that it declared bankruptcy on May 22, Hertz (HTZ) has rallied 7 fold in 3 days for an 888% return. This, despite the fact that the shares are essentially worthless. Then the traders turned their eyes on soon to be bankrupt Chesapeake Energy (CHK), which shot up 5 fold in 2 days. Most recently, an electric truck company Nikola (NKLA) with no revenue and none to speak of until 2023, surged 107% 3 days after its IPO. For anyone with a semblance of how the bankruptcy process works, this is baffling. Equity owners are at the bottom of the ownership waterfall and only can reap any benefits once every creditor, starting with employee pensions, secured debt holders, senior debt holders , subordinated debt holders and not to mention the lawyers and accountants who help manage the bankruptcy, all get paid. During the bankruptcy process, a company can be either completely liquidated and all its assets sold off, or it can be restructured to eventually come out of bankruptcy to become a viable company again.
In the latter situation though, the old shares are canceled and new ones would be likely issued to creditors who can try to make themselves whole again when the company goes through a new IPO and they can then sell their shares.
The fact that companies that are either on the brink of, or currently in, bankruptcy are rallying speaks of the type of market participants out there. Bloomberg did a piece in February about the then 900,000 strong Wallstreetbets Reddit forum and how the forum was so large and influential that it was able to move markets in certain stocks. There is speculation that the forum was behind the rally in Virgin Galactic (SPCE) earlier in the year and I wouldn’t be surprised if group of retail traders is behind a rally like this in bankrupt shares and companies without revenue as well.
This type of rally may eventually haunt some participants though, as it has the hallmarks of an SEC case all over it. If a forum or online community was indeed behind much of these rallies, there is a good chance that it was being stirred up by people that knew the shares were worthless but was able to gather a team of “greater fools” to bid up the prices of these stocks and profit from it.
I didn’t start to realize the term knowledge is power until I started to work at some of the large financial firms. Understanding the “plumbing” of the financial system can allow you to take advantage of it. For example, in the Bloomberg article on Wallstreetbets, they detailed how traders had figured out how brokerage firms cover the calls they write for hedging purposes. The traders flood the market with call options in the morning which forces firms to buy more stock to cover their call writing, thus pushing the value of the quoted shares up. I immediately thought of sneaky strategies like this when I saw the rally in these shares. Bankrupt firms shares trade like penny stocks and have a very small market cap, the type of situation that makes them rife for market manipulation from either big investors like hedge funds or an army of small retail traders. If there are enough traders that can “paint the tape” i.e. trade shares amongst themselves at higher and higher prices to bid up the shares until even more clueless investors pile in, then they can effectively hold a stock hostage in terms of price with nothing to do with the underlying fundamentals.
The S&P Also Defies Gravity
If these were isolated cases it would be strange enough in itself but despite the fact that the NBER announced that in February the US entered a recession, the S&P 500 has regained all that the index lost during this year. The S&P is just playing catch up though, the Nasdaq 100 is already above it’s pre Covid high.
All the more reason why these “dumb” rallies don’t make any sense. If the narrative has now shifted from fear of an “L” shaped recovery to one of a “V” shape, then there is an easy play which I detailed in my last post. In that post, I detailed a few sectors which are likely to see an uptick if we are indeed early in the recovery phase of the economic cycle. Depending on your time horizon though, it may make sense to just snap up all the risky assets you can right now, just look at how tightly correlated markets were before the shutdown and how this relationship has broken down since.
Source: Zero Hedge
This would mean mid-cap and small cap stocks are an easy call to profit from the bounce they would see post opening up were they to follow the same momentum path as the large caps.
That may be too logical and too timid for the army of impatient retail traders though. They are looking for those 800% returns that they see in the headlines within a few days. Eye popping returns like these lure in more speculators and the cycle continues until some poor souls are left holding the bag.
What is frustrating from a small responsible investor’s point of view, is that episodes like these always preceded tighter restrictions by the SEC. In the 90’s When day traders were piling into the dot com bubble, buying and selling during working hours by market participants with small sums of money (a few thousand bucks) was endemic. This went on for years in the late 90’s with no one stopping it as people kept on making money and the bubble fed itself. However as the bubble later imploded, the SEC clamped down and imposed rules that froze buying and selling if it was done too often within a 5 day period on an account with less than $25,000.
It’s for these same reasons that the SEC creates the class of “qualified” investors. To attain this mark, you must have $1 million of investable assets or make over $200,000 a year. Without this, it closes off the door to less liquid and more sophisticated investments in hedge funds and private equity. Basically it means that those with more money get access to better investments, propelling the type of income inequality that the “dumb money” is trying to catch up to.
A Fruitless Endeavor
For all the chats and the posturing and the FOMO (fear of missing out), the fact remains that over the long term, most market participants, traders, professionals etc, don’t beat the market. Wall St. will even try to fool you into thinking there is even a debate. There’s almost no debate. When it comes to large cap and even mid to small cap developed market stocks, almost no one beats the market over the long term.
The problem with boasting about all those ” “triple baggers” and whatever great speculations people brag about, the bad investments die out with a whimper and are usually never discussed. When taking people’s entire portfolio into account, and looking over a term of 15 years or longer, the story becomes much more mundane. The media does a good job of stoking our envy muscles by showcasing those that have made extreme bets and trounced the markets, but these are showcased because they are so exceedingly rare. If you were to just keep to the popular financial media though, you may think it’s a somewhat commonplace occurrence.
In fact, there is evidence that more retail investors in the market are a harbinger of lower returns in the short to medium term just because of the way in which they bid up stocks without any fundamentals. According to a recent research note by Sundial, retail traders made up over 50% of open calls last week. When retail traders have made up over 45% of open calls on the market, it precedes losses of 3% in 2 months time and 15% in a year in the large indexes. This could mean trouble for the current rally we are in and could mean stocks middle around for the next year as the economy and businesses slowly lurch back to their potential and try to make up ground from the shock of Covid.
Source: Bloomberg
The other point to take away from this rally is that it offers some opportunities to short the market for those brave enough to do so. If the ability to short is even an option for beaten down shares in or about to enter bankruptcy, then it presents a great opportunity for short sellers. Shares of NKLA don’t have this issue and could be a strong candidate given there is no revenue even expected until 2023.
With such wild swings, you could still trade on the fundamentals and lose your shirt, it’s a dangerous game people are playing out there. This is the reason that for most active traders or active market watchers, I suggest the core satellite approach to investing. This entails keeping 90% to 95% of your entire portfolio in more conservative, diversified, indexes investments and go crazy with the 5% to 10% of your portfolio. If you win, it’s great but if you don’t, you will live to survive another day. Stay safe out there and be careful of the trading company you keep.
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