Re: Investing-Meme Stocks & The Importance of Shorting.

For those cheering the WSB “short assault” mob, be careful what you wish for.

When short- selling was banned in 2008, bona fide hedgers could no longer short equity against their portfolios.

These portfolios could be comprised of distressed bonds, convertibles, options, or other equities. Inability to hedge then forces long liquidation of LESS LIQUID assets, like credit.

When folks rush for the exits in leas liquid credit markets, prices GAP down, and this can quickly metastasize into a full-blown credit crisis that endangers the plumbing of the financial system.

This WSB/Reddit is tantamount to a full-blown assault on shorts, and those folks supporting it as some kind of “Rebellion of Retail” have no idea how dangerous the ramifications are.

The reason why hedge funds are blowing up left and right is because they are the last bastions of “alpha hunters” in a sea of value agnostic passive money. They actually seek to profit from relative value.

Relative value portfolios by definition REQUIRE the ability to hedge and therefore short. When this ability is taken away or this case scared away, the only alternative is to reduce long exposure in less liquid longs.

If you’re looking for a potential catalyst for the unraveling of this bull market, look no further than here. You may have just found it.

So all the talking heads cheering on this short assault as if it’s some kind of leveling of the playing field have NO IDEA just how dangerous this situation is and just bad the ramifications could be if left unchecked.

This is not some “bleeding heart” defense of “big bad hedge funds” or “evil short sellers.” A well-functioning market requires the ability to short from both a liquidity and risk management standpoint.

Take away (or scare away) the ability to hedge, and you have a MUCH more brittle market structure.

Couple last thoughts before my beauty rest: market crashes usually happen when extreme supply inelasticity meets a drastic drop in demand. Think Econ 101.

In the 1999-2000 crash you had artificially inelasticity via tiny stock floats (3-5%) being driven by seductive demand narratives (“s-curves, metcalfe’s law” — any of this

sounding familiar?)

Musing of the Day: WSB/Reddit Pain Train for HFs continues. I never finished my thoughts last night before being unceremoniously shepherd-crooked to bed by the Mrs. Cogitations continue here.

Seeds of extreme market fragility are sown when: 1) there is artificial supply inelasticity of stocks given limited floats, 2) there are catalysts for a downward demand shock.

Supply inelasticity is rampant across asset classes from stocks (due to passive money as @profplum99 can attest to) to crypto. This is all great when the demand curve keeps shifting up due to QE, seductive narratives, etc.

But supply inelasticity is a very sharp sword that cuts both ways. When demand curves gap down, parabolic upward price moves become parabolic down moves. How is this irrelevant to what we’re seeing with the Short Scare?

The Short Scare is effectively neutralizing a key safety valve for the rare breed of VALUE-SENSITIVE asset manager who relies on this key market mechanism for hedging and risk management.

Pretty much any active strategy that isn’t a long only strategy relies upon shorting to express relative bets and to hedge out less liquid, correlated securities which often include other parts of the cap structure.

When you cut off the ability to hedge whether through fiat (2008) or through lynch mob (2021), you are critically hampering a key ingredient of smoothly functioning markets.

The second and third order ramifications can be extremely serious to our financial system. Why do you think the Fed/Tsy are watching with trepidation?

When a distressed credit trader/convertible arbitrageur/merger arbitrageur/derivatives trader/long-short manager can no longer short without fear of being carried out, what is the alternative?

The ONLY de-risking alternative becomes: reduce long exposures in the less liquid long portions of these relative value pairs: bonds, convertibles, options, etc.

This then is the linkage between what seems to be a market curiosity and what could be something much more serious if not contained.

I could not care less about a couple hedge funds blowing up. I have no skin in that game anymore. But I do know how this contagion can have a negative demand shock on less liquid assets across the board.

It’s the sudden inability to hedge less liquid assets that scares me. It would be like the supply inelasticity of 1999-2000 meeting the seizing up of credit in 2008.

The “Rebellion of Retail/Stick It To The Rich” lynch mob on Reddit/WSB is missing the big picture here. When risk managers can’t risk manage, they are forced to puke their longs. Who will be the bagholders then? ALL of us, if it becomes the next Crash.

Think back to Econ 101 and supply/demand curves. When you have nearly vertical (totally inelastic) supply curves, even slight shifts in demand create price gaps. If those price gaps start happening in less liquid assets that are less hedgeable now, look out below.

The other crazy distortion this Short Scare is creating is the illusion of NEGATIVE DISCOUNT RATES — the junkier the company, the more negative or further out the cash flows, the more NPV ascribed to your stock. Think about how dangerous that is.

Idk if this is the Minsky Moment for this current bubble, but the VIX making new highs concurrent with this Dash-To-Trash is not giving me a warm fuzzy feeling.

When the Dash-To-Trash ironically forces de-risking via long liquidation across tightly coupled asset classes due to artificial supply inelasticities, who do you think the ultimate bagholders will be?

To think that this is just about stocks with “150% short interest is missing the forest from the trees. My entire premise is to show how suppression of the ability to hedge/short fundamentally weak businesses is spilling over into long liquidation. This is happening NOW.

Ahem.

As I was saying, this is NOT about a couple isolated short-squeeze stocks.

https://www.zerohedge.com/markets/its-not-just-robinhood-reddit-rebellion-has-clogged-entire-financial-systems-plumbing