Welcome back. It has been consoling, after admitting on Thursday that I was stumped by the recent behaviour of the bond market, to hear from various readers that they are, too. Another bit of evidence pertaining to this mystery below. But first, a few reflections on meme stock deflation, which is slightly less confusing.
I always thought the meme stocks would go out with a bang. Instead we’re getting a steady slide. Here is the daily performance of four of the most prominent meme stocks over the past month. All chart data from Bloomberg unless otherwise noted:
What to make of this? At one level, nothing. These stocks’ valuations have nothing to do with fundamentals. They are just games of musical chairs or chicken among speculators. At Unhedged we are Serious People interested in Serious Things, so we shrug. If the armies of retail mopes use meme stocks to make a ton of dough off the hedge fund pros, great; it is also great if the mopes get worked over by the pros. Both make nice morality tales, one about hubris, the other about euphoria. But if the air just hisses out of the whole thing — which looks like it is happening now — it doesn’t even make much of a story.
On another level, though, the meme stocks may be gauges of the extremes of sentiment in an ageing bull market. If they get dumped, the next asset class to go might not be a mere plaything. So what’s going on?
One aspect of this, which I have written about before, is the effect of the options market. I asked volatility maven Benn Eifert, the chief investment officer of QVR Advisors, if the options market explained the sagging stock prices. He texted this:
To translate this a bit: “gamma” refers to gamma hedging, or hedging of options positions by buying the underlying stocks. As a stock price goes up, options market-makers need more shares to hedge any calls they have sold on that stock. The market makers buy, driving the share price up still further. A self-reinforcing cycle begins. The same can happen in reverse when prices fall.
“Decay” refers to the fact that as a call option comes closer to its expiration date, it requires a smaller hedge, because there is less time for the price of the underlying stock to move around a lot. So market markers can sell some of their hedge shares as time passes, creating steady selling pressure.
To generalise, both the gamma and decay effects mean that, for stocks that have attracted a lot of option speculation, a decline in that speculation means downward pressure.
Another, somewhat vaguer point. When you trade options, what you pay for — what gives options their profitmaking power — is the volatility of the underlying security. As the options trader Lily Francus put it to me, options speculators “aren’t concerned if the price is $60 or $600” so long as it moves around a lot. Furthermore, meme stocks are different from most stocks in that their volatility tends to go in the same direction as their stock price (for somewhat technical reasons). So the slow slide of meme stock prices therefore corresponds to a decline in their volatility. Here for example is a chart of 90-day realised volatility for GameStop:
As volatility diminishes, meme stocks should become less attractive to speculators in options. They become boring. This takes away a source of demand for the shares — hedging. So the stock falls more, bringing volatility down further, and the cycle continues.
This may not bode well for meme stocks in the near term, but it doesn’t seem to me to say much about risk appetites in the market in general. Not everything in the market has the special self-reinforcing/self-unwinding characteristics of options speculation.
Meme stocks are not, however, only the playthings of the options market. People buy and sell them the old fashioned way, too. And demand seems to be falling. Here is a chart of retail flows from Vanda Securities (meme stocks are on a different scale than the others, shown at right):
This chart shows that retail meme stock purchases have crashed before and come back. More to the point, though, it shows flows into meme stocks are not particularly well correlated to flows of other wildly risky types of stocks. I am therefore hesitant to conclude that the meme stock sell-off is the first pebble in a larger risk-aversion avalanche. I want confirmation from elsewhere. But casting my eye across markets, evidence of dulled risk appetites is rare. Here is the share price of the ARK innovation ETF, a grab bag of highly speculative tech names:
The winter frenzy may have calmed, but that’s an 87 per cent one-year gain, and a 24 per cent bounce over two months. At the margin, speculative risk remains in demand. Yes, the Spac boom has blown over. But even there, there are recent signs of life:
Valuations are high. The bull run has been long. But meme stocks aside, I don’t see the early signs of a correction. Perhaps you hear tremors my ears are too dull to discern. If you do, email me.
Thursday’s letter, in which I admitted my inability to explain the recent downward shift in Treasury yields, elicited the following comment from a reader:
This strikes a note often played in analysts’ notes recently. The logic goes like this. China supplies a lot of the world’s growth. A lot of Chinese growth is driven by credit. When China tightens credit, the whole world slows. Inflationary pressures in particular abate, because China is the marginal buyer of commodities, and commodities are a key driver of inflation (even if central banks deny it).
Lots of the charts of this phenomenon are fiddly, with time lags and inventions and adjustments, so I tried making a non-fiddly one. This is Bloomberg’s China Credit Impulse (basically, new credit as a percentage of gross domestic product) against the year-over-year change, in percentage points, of both 10-year US Treasury yields and US 10-year break-even inflation expectations:
China credit did seem to lead rates and inflation out of the financial crisis and after 2015. In 2012 and in the past few years the signal is less clear, particularly on inflation. The story about the connection is nice and simple. But the world economy — which is what we are talking about when we talk about the connection between Chinese borrowing and American rates — is not nice and simple. This is a suggestive chart. I am worried it is deceiving me.
If you missed my colleague Anjli Raval’s outstanding piece on asset sales by big oil companies, read it now. The key point (in my view) is the asymmetric financial incentives of public company sellers and private company buyers, driven in part by the carbon-reduction goals of the former. This should make ESG investors think, as Matt Levine emphasises in his discussion of Anjli’s article.