As we moved through the day yesterday, we couldn’t help asking ourselves whether Melvin Capital...the hedge fund that received a $3bn bailout this week...will end up being like the Bear Sterns hedge funds of 2007? Long before Bear Sterns (the investment bank) went belly-up over a decade ago, two of their hedge funds were bailed out (in the summer of 2007). That took place when the stock market was at/near all-time highs...and shortly before it rolled over. Several months later a zillion other hedge funds went belly up. (Of course, they were not bailed-out).
Our point is that when a hedge fund needs to get bailed-out when the stock market is at/near all-time highs, it highlights that there are HUGE levels of leverage in the system...and thus the markets become much more vulnerable to a surprise. No, this does not mean that we’re going to see the same kind of collapse in the stock market that began back in 2007. We’re merely reiterating what we’ve been saying for a few weeks now: The risk/reward equation has shifted significantly to the risk side of that equation...and thus the record levels of leverage in the market place could/should lead to an outsized decline in the stock market before too long. Of course, a one day move like we saw yesterday does not make a change in trend, but a lot of warning signs have been slapping us in the face in recent weeks...and thus it’s time for more people to start paying attention to them.
The decline we saw yesterday came on a huge jump in volume. The composite volume was 7.3bn share...which is the highest reading since 2011. Of course, a lot of that huge increase was due to the “upside volume” that developed from the buying that took place while investors were covering their shorts in a small number of highly shorted names. Therefore, just because a lot of yesterday’s volume was upside volume, it’s still a warning signal...due to the fact that this upside volume still involved the unwinding of leverage.
We’d also note that the breadth for the S&P 500 and Nasdaq Composite was more than 5 to 1 negative (9 to 1 negative on the NDX Nasdaq 100)...and all eleven S&P groups finished in negative territory. In fact, those groups all fell anywhere from 1.39% and 3.82%...so it was an ugly day for all of them. So there’s no question that it was rough day for the stock market.
Moving back to the comparison we highlighted in the first paragraph, Wall Street still doesn’t “get” what’s going on with these massive short squeezes. Earlier in the week, they were saying that the situation involved the “willingness” of certain investors to pay such high prices for the stocks of companies whose prospects stink (like GME & AMC). This buying has NOTHING to do with a “willingness” to buy...it has to do with “forced buying”...it has to do with the unwinding of leverage!!!!.....NOW, the narrative has become that what is going on has to do with the “little guy” sticking it to the big (arrogant) hedge fund players. Ok, we realize that this is a great narrative for financial journalist...because it sells. However, it still takes away the REAL situation that is developing right now...and that situation is a further move towards the unwinding of leverage!!!
(We’re going to highlight the phrase, “the unwinding of leverage” over and over again today AND in the days ahead, so get use to it...because THIS is the REAL issue that we all should be talking about!!!!!!!)
The reason why this WILL become a serious problem for the markets if it continues much longer is that there is a lot more leverage on the long side of the market (repeat, A LOT MORE)...than there is on the short side. Therefore, if the “unwinding of leverage” continues...instead of the situation involving a wild rally in a small number of stocks...it’s going to involve a powerful sell-off in hundreds of stocks.
It is becoming more obvious to us that most of Wall Street (and especially many of the millions of new individual investors) don’t realize that the serious level of “forced buying” that is taking place right now in those heavily shorted stocks...has the ability to CAUSE a decent amount of “forced selling” in many other securities...and that this situation can snowball out of control if it continues in an unbridled fashion.
When these hedge funds are “squeezed” on the short side, they frequently have no choice but to sell some of the long positions to meet those margin calls...because the liquidity in the stocks they are short becomes very limited. In other words, they cannot raise the money they need by buying-back the security involved in the “squeeze”...so they HAVE to sell some of their long positions to meet their obligations (because they are the only assets they own where they can raise the needed money). The problem is that those long positions are ALSO leveraged. In fact, they’re even more leveraged than their short positions.
Therefore, the “unwinding of leverage” that is taking place right now on the buy side (the short covering side) can quickly spill-over and become a situation where the “unwinding of leverage” takes place in forceful fashion on the sell-side. In other words, after these players are “forced” to buy stocks in an asset that is rising in a parabolic way in a short squeeze...they ALSO end up selling so much on the long side that they then get hit by margin calls...and are “forced” to sell into a falling market.
THIS IS HOW THE “UNWINDING OF LEVERAGE” IN SMALL NUMBER OF NAMES ON THE BUYSIDE (SHORT SQUEEZE) CAN QUICKLY TURN INTO THE “UNWINDING OF LEVERAGE” IN A LARGE NUMBER OF NAMES TO THE DOWNWIDE (MARGIN CALLS).
We don’t know if this is the beginning of the 15%-20% deep correction we’ve been saying for several weeks could/should start in late January or in February or not. However, there are just TOO MANY warning signs to ignore...and therefore we continue to say that raising more cash over the coming days and weeks should be something that ALL investors should consider. Those who are leveraged now will be “forced” to sell at EXACTLY the wrong time...while those who have some cash on the sidelines will be able to buy, buy, buy when there’s “blood in the streets.”
Matthew J. Maley
Chief Market Strategist
Miller Tabak + Co., LLC
Founder, The Maley Report
275 Grove St. Suite 2-400
Newton, MA 02466
Although the information contained in this report (not including disclosures contained herein) has been obtained from sources we believe to be reliable, the accuracy and completeness of such information and the opinions expressed herein cannot be guaranteed. This report is for informational purposes only and under no circumstances is it to be construed as an offer to sell, or a solicitation to buy, any security. Any recommendation contained in this report may not be appropriate for all investors. Trading options is not suitable for all investors and may involve risk of loss. Additional information is available upon request or by contacting us at Miller Tabak + Co., LLC, 200 Park Ave. Suite 1700, New York, NY 10166.