"The Falcon Cannot Hear the Falconer"

"The French revolution in finance" is underway, or is it just a moment in time?

This famous quote from Yeats’ ‘The Second Coming’ poem has been interpreted many ways.  Literally, in the sport of falconry, the falcon obeys every command of their master, the falconer, and eventually comes back to land on the falconer’s glove.  Yeats suggests the falcon cannot hear the falconer, thus not responding to their commands.  It has deep metaphorical meaning that is debated.    I think he is trying to suggest the human (falcon) is not obeying the expectations of their creator/God (falconer).  Many interpret the poem to be discussing something deeply spiritual, inciting some kind of anarchistic war against their God. 

I had no intention of writing something again so soon about stock markets, but the recent behavior the last couple of days inspired me to share my perspectives on what you’ll hear about ad nauseam if you’re watching BNN/Bloomberg or CNBC et al. 

Rather than quoting Yeats, I’ll crib Gordon Gecko, who was quoting Yeats loosely when he suggested to Bud Fox in the famous movie “Wall Street”…… “….so the falcon heard the falconer”.   Essentially, Gecko was praising the work of Bud Fox, suggesting that the student (Fox) had bested the teacher (Gecko). 

The relevance of all this to the market humbly in my opinion is what you’re seeing the last few days with weak, life support companies surging hundreds and some thousands of percent in the market the last few days.   I’ll explain what I see happening, but essentially the “amateurs” are besting the “professionals”, and it is leading to an epic meltdown for some institutional investors.  Here is what is technically happening as I understand it.  You’ve got a lot of companies in financial distress, many for reasons due to the pandemic and the subsequent impact to their business.  A couple to highlight that have seen their share prices skyrocket (charts below) would be GameStop, and AMC.   Gamestop is a video game and gaming merchandise retailer, largely suffering to online retail competition like so many other traditional retailers.  GameStop has never traded above $30 per share in the last five years, today it’s trading at $320 per share.  AMC is the massive movie theatre and entertainment complex, and with movie theaters essentially closed all throughout the US, their fortunes have been sadly COVID impaired, maybe permanently. 

Now what is going on here?  Well, without getting into the weeds too much, these stocks are seeing their share prices rise due to what’s commonly referred to as a “short squeeze”.  Selling a stock short is is a trading strategy to try to capitalize on further declines in corporate health and ultimately further decline in a companies share price.  You’re betting against the company.   How it works is pretty simple, although it is a very sharp instrument that has bled out many investors over time.  What you do is sell stock in the company that you think will decline, without owning the stock.  You borrow shares from your broker, and sell them at the current market price.  You still owe the borrowed shares to whoever lent them to you, and at some point in the future, you will buy the shares in the open market at market price, to repay the lender with the original amount of shares you borrowed.  Let’s put some numbers to it to crystallize things.   You think shares in ABC are going to decline.  They currently trade at $50/share.  You borrow shares in ABC from your broker and sell them in the market for $50.  You receive $50 into your account for shares that you borrowed, and still have to repay the physical shares.  You’re hoping the shares will decline to say $25/share, and you’ll go to the market, buy new shares for $25, and then give those back to the lender and close out your transaction.  If this works properly, you’ve made $25 profit.  The danger in short selling is that the downside is infinite.  If you are wrong, and the shares go up in value, you have to go into the market and buy shares that are worth more than you borrowed them at…….just do the simple math and you’ll quickly see if it goes the wrong way on you, your losses are infinite, or rather your losses are as high as the stock will go.   If you just conventionally buy and sell stocks in the market, your losses are essentially limited to your original investment.  You buy a stock at $50, if it is shitty it could ultimately go to $0 and you lose your investment, the original $50.  If you short a stock at $50 and it goes to $300, you’ve lost $250 on an original $50 bet.  We can make it more complicated than that if we want to, but essentially that’s what’s going on.   You can short stocks in your brokerage account if you want, but it is as I describe it a very sharp instrument that can inflict a lot of damage if you are wrong.  For that reason, most of the short selling in the market is occurring by large institutional traders, hedge funds, etc, the so-called “smart money”, a phrase I despise due to its deeply offensive insinuations. 

There are many different opinions on the ability to sell short.  Some think regulators shouldn’t allow it because you’re betting on something negative happening.  They might also argue that if enough investors choose to “gang up” on an Company, even one that isn’t in distress, you could kill it for profit among a few smart traders.  Back in the crisis in 2008, when the banks were teetering, the regulators banned short selling in the US and UK (Canada too I think I remember) so that vulture investors couldn’t come in a pick at the carcass via short positions, and essentially destroy them.  Some of this happened to Lehman and Merrill Lynch before one went bankrupt and the other was bought by Bank of America for pennies on the dollar. 

Those in favour of short selling see it as a valuable tool to enhance market efficiency and ultimately enhance price discovery, leading to overall better, more honest reflected outcomes of ALL buyers and sellers in the market.  Either way, it is allowed, and typically it is the domain of large institutional investors and hedge funds.  I certainly don’t want to suggest those large institutional investors who short are doing something untoward, because that isn’t the case……sometime maybe, but certainly not commonly. 

So here we are, GameStop and AMC (to just show a couple of examples) are skyrocketing in price, even though the fundamentals of the underlying business are suffering, and frankly not really improving.  What is going on?

Well, it appears that this is the falcons hearing the falconer.  You have seen a massive increase in DIY stock trading over the last year that makes the “Day trading” phenomenon of the late 90’s look like child’s play.  Online retail trading platforms like Robinhood (irony in name is intended) explode with millions of new retail investors, trading at fractions of what it used to cost.  These platforms have democratized trading, which once was the monopoly domain of brokerages and big banks, and whereby they charged huge commissions to simply buy or sell stock, has now been democratized to the extent many platforms don’t charge commission for trades.  Indeed a good thing for investors.  OK, back to what I understand it going on.  On chat platforms like Redditt and others, there exists chat boards where these armies of retail investors go to talk about ideas.  Apparently, one of the ideas that has been discussed on these forums is buying huge swaths of stocks that have been heavily shorted by some hedge funds.  All these small, retail investors discover that XYZ Hedge Fund (I won’t name them) has a massive short position in GameStop, betting that they’ll fail.  All these small retail investors go in and start buying massive amounts of the stock, making the stock go up, inflicting losses on the hedge fund who is short the stock.  The more the idea gains traction in the chat rooms, the more momentum the buying creates, even more buyers show up, bidding the stock even higher.  The cycle is further exacerbated in that the higher the stock goes, the steeper the losses the hedge fund who is short suffers.  At some point, the hedge fund has to determine whether to cut their losses, and buy the stock at the higher price, and close out the squeeze.  The mere act of them cutting their losses and buying the stock sends the stock even higher, hence the cycle continues.  Rarely would the short seller close out everything at once, so this doesn’t play out in a matter of seconds, it plays out in this instance over days.  But the end result is real, someone who was short GameStop at $5, now has to buy it at $320 to repay the borrowed stock.  This has resulted in quite literally several large hedge funds going into distress, they might not recover, who knows.  But very, very steep losses for the institutional trade, and huge wins for the little guy. 

If you watch the business channels, the amount of navel gazing going on, and the amount of alarm sounding is quite something.  “This can’t be allowed to happen”, “this is bad for the market”, “investors are going to get hurt” are just a smattering of the cries being heard. 

To be clear, spreading false information about a company to see its shares go up, only to capitalize on the higher price and sell it, is not legal.  It is a pretty old trick known as the “pump and dump” and you can and people have gone to jail for this.  However, it appears that there is nothing untoward happening here, just a small army of small investors convincing the hoard to buy a specific stock that they believe has a massive amount of short interest on it.  There are lots of ways to trade stocks and invest.  The two simplest ways to think about investing would be fundamental or technical.  Fundamental is the type of investor I am.  I was trained to think about the underlying business and what it is worth, and then acquire positions in good companies whose future prospects look good, based on the merit of the business.  This is how someone like Buffet would think, or Prem Watsa here in Canada (Fairfax Financial), or the granddaddy of fundamental investing Ben Graham.  The other side would be technical trading, looking at trends, momentum, moving averages, etc.  They spend a lot more time looking at charts than they do learning about the actual business fundamentals.  I’m not hear suggesting one is better than another, and we can further expand both those strategies into multiple more tangents, but those are two broadly accepted strategies.   These individual investors who have discussed apparently squeezing the short sellers in an attempt to make the stock rise appear to have been momentum trading quite well, both to their benefit and the massive detriment of the “smart money”. 

What is further interesting is that these tactics have been going on for a long time institutionally.  The concept of an “idea dinner” is hardly a new thought.  Get together with a bunch of large investors and decide where the low hanging fruit is in the market, where is the wounded gazelle we can take down…..and you go and do it.  It’s a little disingenuous for some market participants to be crying foul at this. 

As one investor Tweeted today “this is the French revolution of finance”.   Accurate maybe, perhaps premature, maybe regulators will decide for some reasons this isn’t a good thing.  Some were trying to cite the need for hazard signs and warnings how dangerous this is for retail investors.  Indeed, Gamestop isn’t going to stay at $320 for long.  It will be back to $10 per share in no time.  And whoever puts that last trade on at $320 thinking $400 is the next stop is going to get smoked for sure.  But the rich have been doing this to the poor for a long time.  To now feign the need to put up a hazard sign so that the unsuspecting small investor in his basement might get hurt is pretty comical.   If you scour the chat boards, there are lots of comments from these folks about how they’ve paid of their student loan, or how they’ve paid off their mortgage.  That idea does scare me, as it turns the market into an actual casino, where everyone thinks they can do this.  This is a moment in time, and it will end, and it will end badly for many as well.  However, in this moment in time, it is pretty entertaining to see the falcon indeed hear the falconer. 

For full disclosure, this is not endorsing any trading strategy.  Frankly, I think this is insane, and you shouldn’t be selling short unless you really know what you’re doing, and I also believe that trying to do this yourself through online trading is hazardous.  But I thought it was a really interesting lesson for everyone involved.   Buy and hold great companies, and good funds, and broad markets is my best thought as to how to confidently make returns long term.  Boring yes, but boring works.