Dear Investors,
In a dramatic twist worthy of the best market dramas, the GameStop saga has seen a resurgence with a return of the Roaring Kitty, the internet persona of Keith Gill. Over the past few weeks, the once quieted meme stock frenzy reignited as retail investors rallied around GameStop, driven by Gill’s latest antics and insights. His recent return to social media platforms and live streams have breathed new life into the fervor, prompting a new wave of short squeezes that have left Wall Street traders scrambling. With humorous memes and relentless optimism, the retail investor community has again challenged traditional market norms, proving that the power of collective action and internet culture remains formidable in the financial world.
“The market can stay irrational longer than you can stay solvent.”
-John Maynard Keynes
GameStop Corp (NYSE: GME) is up over 182% from its low in April of earlier this year, and Gill’s personal portfolio exceeded $500M in company stock and derivative equivalents late last week. Say what you want about meme stocks and Reddit, but this man is redefining the words hold the line.
The Anatomy of a Short Squeeze
Short selling is a way for traders to bet against a stock by selling shares they don’t own with the intention of buying them back later and “covering” their position. You’ve heard the saying “buy low, sell high”, short selling is the same, just in the reverse order.
There is nothing inherently wrong or unethical about short selling and is actually an essential component of the derivatives market – when it comes to futures and options, there must be a short for every long. For equities, however, the short seller must borrow the shares from another shareholder first and then initiate the sell order. The short seller then pays interest to the lender for borrowing their shares, thus compensating them for their willingness to lend them out, just as a customer would to a bank for a cash loan.
The margin requirements also differ slightly between long and short positions. When an investor buys stock, going long, the broker cannot impose a margin requirement greater than 100%, because that is the maximum amount at risk (stocks cannot go below zero). If you wanted to buy $10,000 worth of stock, you will only have to pay the $10,000 initially. For a short, however, the broker may require you to keep additional cash on deposit, to cover the risk of the stock increasing massively because short positions carry theoretically unlimited risk.
When a short starts moving against the holder, the broker may require them to deposit more cash to maintain the position, this is known as a margin call. If the trader cannot deposit additional funds or sell other securities to maintain the margin requirement, the broker may, without notice, close out the position to limit their risk and bring the client’s probability of loss down to a more reasonable threshold. This is what causes short squeezes – brokers automatically closing out short positions (buying to cover), pushing prices higher, causing other brokers and traders to close out their positions. This domino effect is, in essence, a short squeeze.
Trading Meme Stocks: Dumb Money or True Potential?
Interestingly, Gill’s original thesis on GameStop went beyond the massive short interest and was actually driven by underlying fundamentals, including their relatively strong balance sheet, the potential to pivot into a more digital gaming realm, and new leadership within the company, specifically Ryan Cohen’s involvement as Executive Chairman.
Despite the stock’s recent performance though, it’s difficult to believe that the company should carry a fair value in excess of $8 Billion. Still, it’s hard to argue with someone who turned a $50k account into over half a billion in just a few years. Additionally, management has taken advantage of the recent price surge and its shelf registration with the SEC to sell additional shares of treasury stock in the market from time to time, thus further enhancing the company’s balance sheet at prices most analysts would consider artificially high.
It’s not Sonic Capital’s intention to pass judgement upon any particular investment or trading strategy. If a trader is able to consistently profit from a given asset’s price action, why would it be considered dumb money just because of the assets that they choose to speculate in? During the original GME fiasco, it wasn’t Roaring Kitty’s portfolio that went up in flames, it was Melvin Capital’s, the institutions, the so-called smart money, at least until their failure. Even in the case of GameStop, many people forget that the company is actually quite profitable – they generated $1.25B in profit over the last year and a company trading at under 7x their trailing twelve-month profit is far from an insane valuation, at least by Wall Street standards. As Gill pointed out a few years ago as well, their balance sheet is not in bad shape, with positive book value of equity representing a P/B multiple of just 6.35x – high relative to its own history, but hardly excessive compared to many other investments. As of last quarter, GME also had working capital of over $1B and a current ratio of 2.2x, indicating their liquidity is also quite strong and should have no problem meeting any obligations over the next year. We are not going outright long GME by any means, but it’s important to recognize the argument of the retail community.
There are also more dimensions to the market than most casual participants realize, going beyond the outright longs and shorts. Many traders utilize options to take on bullish or bearish positions while limiting their maximum loss, but those too come with their own unique risks. Instead of short selling for example, a trader with a bearish outlook could purchase put options on the stock, reserving their right to sell shares while limiting their risk only to the premium paid for the options. In this case though, the trader can still lose money even if the stock moves in the anticipated direction if it does not move enough. This brings up the topic of implied volatility. Is it really smart to be buying overpriced implied volatility and dumb to be selling it?
As the name suggests, implied volatility is the annualized volatility of a given asset implied by that asset’s option prices. The higher the price of the options, the higher the implied volatility of that asset. Many sophisticated traders, retail and institutions alike, can treat implied volatility as an asset class by itself and profit from expansions and contractions in it, selling implied vol at high levels, and buying implied vol at relatively low levels in the form of long call and put positions.
In fact, some separately managed accounts within Sonic’s purview have attempted to take advantage of such volatility trades, mostly in the form of diagonal call spreads, which involve the purchase of a long-term, deep in-the-money call option, and the sale of a short-term, at or out-of-the-money call. This way, maximum risk is limited to the net debit paid for the position, while collecting theta and benefiting from overpriced implied volatility. The way the trade is structured still involves delta risk (directional risk, if the underlying were to substantially move in an unfavorable direction), but, a creation of time value will simultaneously help the long-leg of the spread, thus providing what appears to be a favorable trade for some of our more aggressive, volatility tolerant accounts.
The Market at Large
Outside of the resurgence in meme stocks, there has been a lot of positive momentum holding pace in the larger market. NVIDIA Corp (NASDAQ: NVDA) pushed new highs last week, reaching a peak market cap of over $3 Trillion, briefly surpassing Apple and on track to de-thrown Microsoft with one more push to the upside. This is fascinating – it took the company approximately thirty years to reach a market capitalization of $1 Trillion, then nine more months to reach a market capitalization of $2 Trillion, and then only three and half months to reach $3 Trillion.
The company’s stock price has continued to be driven by its consistent ability to surpass analysts’ sales and earnings estimates, and now, with a stock price over $1,200, is scheduled for a 10 for 1 split effective today. However, some analysts seem to be becoming more realistic about their outlook on the stock, with the average estimate now at just 1.41% above the current market, and with some estimates as low as 46% below the market.
We’ve covered NVDA in the past, trying to be mindful of both its growth potential as well as their current valuation multiples. However, there are financial indicators that go beyond the traditional. Just last week, the company’s CEO Jensen Huang was photographed signing the chest of a female fan (at her request) while attending the Computex trade show in Taipei.
Although the risk/reward characteristics still make us wary about placing any bets against NVDA or Mr. Huang, we have not seen signs of this level of frothiness in a long time.
The current valuation multiples say it all, with all major ratios trading in excess of their 80th percentile vs. their own 20-year history, and with some as high as their 100th percentile. However, we must also give credit to their incredible (and consistent) profitability. Many of these metrics are as great as they’ve ever been and must also be considered when evaluating the stock as an investment opportunity. Still, given the incredible performance over the last several years, it is at least worth approaching this stock with a healthy dose of caution.
The performance of NVDA, along with the continued resilience in the other “Magnificent 7” stocks, have driven the major indexes higher over the last several months, with both the Nasdaq and the S&P 500 closing at all-time-highs last week. This, of course, begs the question of where markets stand in terms of their own overall valuation.
As a reminder, the Buffett Indicator is a measure of the stock market’s relative value based on the total market capitalization of U.S. Stocks divided by current (estimated) Gross Domestic Product. As of the end of April, this indicator is 53% (approximately two standard deviations) above its long-term trend line, indicating the growth of the equity market is outpacing that of the economy to a potentially unsustainable extent.
While this is just one metric to evaluate the health of the financial markets in general, it does put our long-biased approach to investing on guard given the real possibility of a major correction in traditional assets. This has led to our rotation into even more overlooked areas in the massive market of global equities.
A New Era for Recreational Cannabis
As of April 1st, Germany officially legalized the possession of small amounts of cannabis for adult recreational use. Germany is now the third country in the European Union to legalize the substance for personal use, following in the footsteps of Malta and Luxembourg.
This comes in addition to the growing market in both Canada and the United States. Although not legal at the federal level in the U.S, there are now 24 states that allow the recreational use of Cannabis, having started with Colorado’s movement in 2012.
Over-the-Counter (OTC) traded stocks often have a negative connotation associated with them because they typically do not meet the listing requirements to be offered on a trusted stock exchange like the NYSE or Nasdaq, indicating they are generally lacking in the way of fundamentals. However, it is surprising to see how many companies within the OTC Cannabis Index are not just profitable, but also have healthy balance sheets. Of the 26 companies that make up the index, 81% are profitable – with a median profit margin of 34% and over a quarter trading with a Price-to-Book ratio of less than 1. A majority also have positive working capital and current ratios in excess of 1.0x, indicating their liquidity is relatively strong and they should have no problem meeting any short-term obligations. Interestingly, the OTC Cannabis Index has also been flirting with its 200-day moving average recently and has been trading above it for most of the year. While not definitive by any means, this is often a signal of a major change in trend in the overall industry. And, even though the data on these stocks is limited to just a few years, the last time this index held its ground above its 200-day, investors witnessed a return of not percentages, but multiples.
Still, both Cannabis stocks and OTC stocks as a whole must be approached cautiously, as these truly do represent the Wild West of equity speculation, offering the potential for massive returns but also catastrophic losses if risk is not carefully monitored. Most of Sonic’s Separately Managed Accounts have exposure to this new theme in some form, just with differences in allocation size depending on clients’ individual risk tolerances and long-term financial objectives.
The true commitment to this theme, however, comes not from fundamentals, technical, or macro-economic analysis, but rather from a more quantitative perspective. Any other form of analysis can be misinterpreted and is often subjective, but it is hard to argue with raw math.
Some companies in the industry that are Nasdaq listed also offer surprisingly liquid options, available to any retail trader. What has caught the attention of Sonic Capital Analysts recently is what appears to be the unusually cheap price of implied volatility in some of these names. LEAPS that are just slightly in-the-money have been found to be trading at price levels at or near parity, a phenomenon that should not occur in efficient markets (at least with American-Style options) because it grants an individual the ability to keep the entire upside of a given investment, while limiting the maximum loss to just a fraction of what it otherwise would be. This is the quant element.
On top of being able to take advantage of what seems to be a major inefficiency, the leverage available through options provides the chance to add asymmetry on top of a trade that already appears to have massively skewed risk/reward characteristics. This is what we have started to call “skew on skew”, or “skew-squared”.
Many investors want to know the simple answers, do they buy or sell? Trade or hold? If so, what? It would be nice if the markets were that simple, but in the dynamic world of trading and investing, it’s never that easy. The points that we have outlined here make us cautious as we approach the ever-growing equity market, but as any investor should, we expect to be constantly changing our minds and adjusting our allocations as new data comes to light.
In the meantime, hold the line and look out for those short squeezes!
Sincerely,
Maxwell Fischer
Investment and Trading Analyst
No responses yet