Not Quite That Correction

2021 started off in the strangest possible way. There was a violent protest in the capital of a large country, as people stormed into the legislative assembly, threatening to physically harm elected representatives. This would not be surprising in some sub-saharan countries, perhaps. But it was the USA.

And then later in the month, a financial crisis came to light as some investors on a Reddit forum decided that they would take on the entire financial system, and managed to do so for nearly two weeks. Again, this was in the USA.

To find out what happened, read our post on the topic.

What we’ve got is a system that’s not exactly stable. Both politically and financially. What happened really in the financial system was a little disconcerting. To understand this, we need to step back a little.

A few months back, Softbank reported some big gains in their Vision fund. $20 billion in tech stocks, and of that around $4 billion was in an interesting instrument: options. Stock options have got immensely popular because they allow crazy amounts of leverage - and participation is very high by retail investors. The market makers in the US, who have to provide liquidity to the markets (they always must have a buy and a sell rate) must also hedge their exposure regularly. When they sell call options, they have to also buy some of the underlying stock. If $AMZN is at $3300 then a $3500 call option may cost only $10 - which, for 100 shares is a $1000 payout. The market maker, though, may end up buying say 20 shares of $AMZN to hedge - which costs them $66,000.

This is a complex procedure called delta hedging where the trader will estimate the amount of money he will lose on his call option if $AMZN goes up $1, based on a bunch of parameters like time left to expiry and expected volatility in the stock price. He might decide that he will lose $0.20 if Amazon moves up a dollar. That means for an exposure of 100 shares, he’ll offset it by buying 20 shares.

The option buyer bought options worth $1000. The option seller now has bought shares, to hedge, which are worth $66,000.

Simply put, if you want some stocks to go up, you just buy enough options, and the market makers' purchases will make the stock fly. Softbank saw this and booked a big profit in the last year.

And then, people at Reddit saw this. Individual investors, in a stock called Gamestop. They bought options, which pushed up the value of Gamestop from about $18 at the end of December 2020, to $400 just last week. This isn’t because it’s a fantastic company - it’s because of the frenzied buying due to the options market makers and retail investors.

Now this has exposed a peculiar situation : the uncontrolled leverage in stocks in the US. There are 300,000 open call option contracts in the US. That translates to 30 million shares of Gamestop. However, there are only 70 million shares of Gamestop.

If those 300,000 options are “exercised” - a concept where you can say, look, here’s the money, give me my 100 shares per contract - then I ask you this: where are the shares going to come from? Can someone go and buy more than 50% of Gamestop shares from the market? What would that do to the price?

And then, there’s the short interest. You can borrow shares and short them. As an owner, you can lend shares to, say a hedge fund named Melvin, who wants to short them. Let’s say you do this with 1 million shares, and I buy those 1 million shares. Since you have only “temporarily” lent them, you think you own a million shares. I know I own a million shares. No one has even heard of Melvin.

So, effectively the same set of shares has two owners. This is leverage. And this is exactly how the Harshad Mehta scam erupted. Which is why in India, we are careful to allow this only to the extent of about 20% of the “free float” (non promoter holding) of a stock.

How much leverage is allowed in the US? There’s no limit. Gamestop has 70 million shares issued. However, if you add up all the “owners” you will find 140 million shares. That’s because 70 million shares - 100% of the overall issued shares - are short.

This is insane, but legal. And because it’s legal, we see a problem in the market - a tinycap like Gamestop caused a near 8% correction in stocks. Because when the prices went up,  everyone that was short, including the otherwise silent Melvin, lost money. And when they lost money they tried to sell everything else in order to make their margins. Melvin Capital, a hedge fund that was short Gamestop, lost 53% of its portfolio in Jan 2021. It had to receive a bailout of $2.75 billion in order to survive. In that fear, a large number of hedge funds exited from their larger positions, which brought the entire stock market down.

This tiny, $1 billion company called Gamestop, bringing down a multi-trillion dollar market?

It’s only possible when you have excessive leverage.

And this might only be the beginning. The market has realized that some players are over-leveraged. And eventually, they will all join ranks to take advantage of this situation. It may seem like it’s all Reddit, but it’s also a large number of other hedge funds looking at each other and thinking: if they can do it, ….

When you have very hot markets, it’s impossible to predict where damage can come from. But it’s also true that weaknesses are exposed slowly. In 2007, the first sign that there was a problem appeared in June 2007, when two funds from Bear Stearns “broke the buck” - the US equivalent of liquid funds losing money. That caused a bit of damage, but quickly those funds were rescued. Everyone said the funds were too small to matter, but it was a sign of things to come. What did the funds invest in? Subprime mortgage finance.

We don’t know the options market + the short interest in the US drives us into another set of problems down the road. But we do know this is a situation of excess leverage. One we must watch, even in India, because when the US sneezes the world catches a cold.

In more happy news, our budget didn’t do anything wrong. Which is a good thing, as budgets go. They didn’t add more taxes, or increase the rates of long term capital gains taxes. They decided to spend some money - even if it was money that was otherwise being spent anyhow, but now accounted for properly. We decided to be less “afraid” of the fiscal deficit - and it’s perhaps one of the few years we will have the luxury of doing so. The world will also do this, as we all slowly get back to life.

What the budget did was to hurt fixed income yields, but we believe that will be sorted as the market will keep prices high. We’ve seen our fixed income portfolio a little hurt there, but we’ll take action on it only if we see more likelihood of serious damage.

Other than that, the budget did not amount to much. The point is that rebuilding India will be done mostly by the private sector, and increasingly by the larger companies. The smaller ones struggle to a very large extent for lack of funds, lack of attention, higher compliance requirements (GST, TDS etc.) and high interest rates. This has resulted, at least right now, in a big move to the larger corporates. We’re seeing some really profitable growth in many of our companies, even the ones in telecom. Over time, some of this will moderate but we do think the next big winners are getting shaped through disruption.

Restaurants, for instance, have changed to allow for a much higher “delivery” rate, than for actually seating people. Conversations have moved to the web, and if you aren’t terrified of hearing the word “webinar”, you’re a lucky person. Because everywhere, people are taking on zoom links, on twitter, on whatsapp and what not. They’re sometimes too busy to meet because there’s a bunch of webinars to attend and podcasts to listen.

It’s in this chaos that we will discover the next set of heroes. Those that can shape the chaos to make successful businesses. For example, doctors that will be able to advise remotely, to the makers of devices that can connect them with their patients remotely, it’s the new that will change the world. If a sick person needn’t actually visit a hospital, she will avoid infections that would invariably occur when you go to a place that has, surprise, other sick people. The productivity benefits are enormous - but the winners are those that adapt or make the leap possible, not the ones that insist that you must visit them in person.

I remember speaking with a retired banker who refused to use “net banking” because he was philosophically against the concept of a bank coming to a customer - customers must visit the bank, not the other way around, he said. This was 15 years ago. And today, more money is transferred through UPI than even at an ATM. The bank has come to you, and it no longer matters which bank - all of them are the same.

We’re betting on a few in the long term multicap portfolio, of course, but we can see them pop up often in momentum as well. There will be more, when the likes of Zomato, Swiggy and even Paytm list. The new Nifty will contain less Aluminium and Steel, and more Silicon and Lithium.

We had an incredible PMS town-hall in January, and I do encourage you to visit :

To view the recording.

The rest of this year is likely to be quite volatile in the markets, but this will throw us a lot of opportunities. Even now, we haven’t seen even a 10% correction since May 2020. Even when the overall economy hasn’t yet roared back to life. We’re dancing, but we’re aren’t sure if it’s us or the floor that’s shaking. It’s possible to still dance, while we’re aware it could be either. Letting your hair down doesn’t have to always mean letting your guard down. On that note, let’s still hope the party continues.

Cheeringly,

Deepak