☀️☕ Squeeze those shorts! Strategists and The Wall of Worry

6 February 2023

It’s Monday. Be Happy 😄

US large-cap S&P 500 closed 1.04% DOWN 🔻 Tech-heavy Nasdaq Composite closed 1.59% DOWN 🔻 Pan European STOXX Europe 600 closed 0.34% UP ▲ HK’s Hang Seng Index closed 1.36% DOWN 🔻 Japan’s Nikkei 225 closed 0.39% UP ▲ 

📝 Focus

Squeeze those shorts! Strategists and The Wall of Worry

📊 In the Markets

Amamiya, there we go again (BOJ to stay “Doveish”?)Unemployment down, stock markets downMusk a winner on fraud, Tesla a winner on EV taxes

📖   MoneyFitt Explains

🎓 Covered Shorts and Short Squeezes 

📝 Focus

Squeeze those shorts! Strategists and The Wall of Worry

Short covering 🎓 by hedge funds has added a lot of fuel to the market rally since the start of the year. The prevailing wisdom from almost all market strategists at the start of the year was that for the first half of 2023, you could hide in bonds or, better, in cash while the recession wreaks havoc on earnings and asset prices, particularly those of shares (especially in Europe and the UK.) You could then look to buy shares in the second half of the year. Sensible calls from Wall Street’s Finest, given what was known then.

The trouble is that those turned out to be pretty much consensus calls, and many experienced, professional investors had already reached the same conclusions (which were, to be fair, well thought out and quite likely) and were largely already positioned IN those trades. Those scenarios were, therefore, largely priced into markets, and any deviation from them would result in outsize moves in the other direction.

Welcome to 2023! The FT reports that, according to a Goldman Sachs report, professional investors such as hedge funds, who placed their bets on falling markets (as expected above) all rushed to exit those losing positions all at the same time… and did so at the fastest pace since November 2015.

Exiting short positions basically means buying back shares which you’ve borrowed and then sold in the hopes of repurchasing them at a lower price. If prices move up instead of down and traders start repurchasing them anyway, this adds fuel to the fire and punishes those too slow (or too stubbornly committed to their perfectly logical strategies) to do the same. (This also applies to investors who do not explicitly “go short” but express the same negative views by being “underweight” relative to an index.) If markets keep grinding up, remaining investors often reluctantly cave in one by one (or are told to do so by their risk managers), leading to the old market adage:

“Bull markets climb a wall of worry”

Prepare to see many more market experts appearing on CNBC explaining why the current market rally won’t last. (They may be right!)

And this is why you need to know what the best and brightest market experts are saying. Not to blindly follow them, but to consider what might already be IN the price, so you don’t get surprised again this year!

📊 In the Markets

Amamiya, there we go again (BOJ to stay “Doveish”?)

The Nikkei newspaper reports that Japan’s government is considering Bank of Japan (BOJ) Deputy Governor Masayoshi Amamiya to succeed incumbent Haruhiko Kuroda as the central bank governor upon the end of his second 5-year term in April.

Amamiya has consistently been in the “dove” camp and called for keeping ultra-low interest rates (central bank “doves” prefer to stoke growth rather than to keep a lid on inflation.)

He drafted many of the BOJ’s monetary easing tools over the years, including the massive asset-buying programme in 2013 in which the BOJ committed to radically overhaul its monetary policy and inject about US$1.4 trillion into the economy by buying Japanese Government Bonds “across the yield curve” (meaning JGBs of all maturities.)

Though he did also say last July that the BOJ must “always” think about how to exit ultra-loose monetary policy, currency markets have traded the Yen lower against the US Dollar, taking it as a possible sign that the exit from policies such as 2016’s Yield Curve Control will be slower than hoped for.

Higher global rates in the current inflationary world (even if both face peaking) are fodder for the so-called “carry trade” in which investors borrow a low-yielding currency and sell it to buy a higher-yielding one. Keeping the BOJ relatively doveish would feed the revival of this trade (which had been “wiped out” during the period of globally low-interest rates after the global financial crisis of 2008), which in the past saw holdings in those higher-yielding currencies make their way into financial assets such as stocks and bonds.

Unemployment down, stock markets down

As if we didn’t already know, Wall Street showed off its true colours by reacting negatively to what normal, decent people would think is a good thing: Many more Americans managed to find jobs in January than expected, driving unemployment down to just 3.4%, the lowest since 1969… and major indexes sold off aggressively.

The Labor Department’s closely watched nonfarm payrolls data (i.e. the number of workers employed in the US excluding farm workers) showed 517k jobs added in January, more than two-and-a-half times greater than the 185k average estimated in a Reuters poll of Wall Street’s Finest, double December’s 260k and a quarter more than the 400k monthly average in 2022.

The labour market remains red-hot. This raises the risk of the dreaded wage-cost inflationary cycle, in which high prices force workers to demand higher wages, which employers (because of a shortage of workers) have to accept, and who (to remain profitable) then have to raise prices, and on and on. (January’s average hourly earnings did drop slightly to 4.6% compared to a year earlier, but remains well above the Fed’s 2% consumer price inflation target.)

So, stocks fell as investors fretted that the Fed would keep hiking interest rates and keep them higher and for longer than they’d been expecting. “Higher and longer than investors had been expecting” would bring them basically in line with what almost all Fed officials have been publicly saying for many months now anyway, so the casual observer may wonder, “why the surprise?”

US government bonds also fell on Friday, meaning that (because bond prices and yields, the interest rate you’d get at those prices move in opposite directions) the yield on the benchmark 10-year Treasury bonds rose 0.14% to 3.53%.

Musk a winner on fraud, Tesla a winner on EV taxes

After a 3-week trial, Elon Musk defeated a class action shareholder lawsuit that had said his August 2018 tweet saying that he had “funding secured” to take Tesla private had cost investors billions of dollars in losses.

“Thank goodness, the wisdom of the people has prevailed!”

Thank goodness, the wisdom of the people has prevailed!

I am deeply appreciative of the jury’s unanimous finding of innocence in the Tesla 420 take-private case.

— Elon Musk (@elonmusk)
Feb 3, 2023

His legal defence strategy seems to have been “I was saying dumb stuff for fun, but if I really wanted to do it I could do it” and, anyway, he had believed what he wrote in that “split-second decision” tweet.

His lawyer added that the “funding secured” tweet was only technically inaccurate, adding, “Who cares about bad word choice?” Apparently, nobody, as this argument seems to have worked well enough on the jury to return a unanimous decision to acquit.

It helps that, as reported in the FT, a member of the nine-person jury said it’s “hard to sometimes understand in layman’s terms. I don’t understand stocks. I don’t invest in options.” (Everyone needs to get more financially literate!)

No juries of ordinary people yanked off the street to serve indefinitely are involved in SEC Fraud charges: It took Musk a week to settle the securities fraud charge brought by the SEC in late 2018 for the same offence. Both Musk and Tesla each paid US$20 million in penalties (without admitting or denying the allegations.) 

Meanwhile, Tesla and other electric vehicle (EV) makers got a boost after the US Treasury Department expanded the kind of EVs eligible for federal tax credits. EVs like Tesla’s Model Y, GM’s Cadillac Lyriq and the Ford’s Mustang Mach-E are now eligible under the higher SUV / van / pickup truck price limit of US$80k from the previous US$55k (which Musk had tweeted recently as “Messed up!”)

📖 MoneyFitt Explains

🎓 Covered Shorts and Short Squeezes

If you believe that a stock will go down for whatever reason (perhaps it is expensive relative to its prospects or perhaps if you suspect fraud), you can sell the shares you have. But if you don’t own any of its shares, you can still sell them by first borrowing shares for a fee from an existing shareholder via your broker and then selling them on the market. 

If you’re right, you can repurchase them (known as covering your shorts) at a lower price and pocket the difference, less the fee you paid to borrow the shares. Easy!

But if the shares go up a bit, you can just wait for the shares to come down, while calmly re-examining your investment thesis.

But if the shares start shooting up, you are in a bind and have to decide very quickly if you want to buy back the shares you sold and take the loss or watch the loss potentially widen dramatically. 

If you have a lot of shares, your buying will push the share price even higher, and the losses will be even bigger. But if you don’t repurchase them, your losses could be even bigger than that, potentially much bigger, especially if everyone knows that you are short.

The nightmare scenario is if other traders force the shares higher and higher, knowing you have no choice but to repurchase them at some point. If your losses on paper look too huge, the broker you borrowed from can force you to buy back those shares. 

Welcome to the wonderful and terrifying world of “squeezed shorts!”

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