“I’m not upset that you lied to me, I’m upset that from now on I can’t believe you.”
I hope you enjoy this week’s letter. This one is more investigative than narrative, but it does have a theme to it.
Did you know the US and Soviet Union almost came to full-on nuclear war in 1983?
In November 1983, NATO forces in Europe conducted a military exercise, Able Archer 83, simulating a coordinated nuclear attack by the Soviet Union. The exercise was extensive: a division of American troops flown to Europe under radio silence, changed military commands (simulating a strike on the headquarters) and even attack aircraft taxiing from hangers carrying realistic-looking munitions.
Scarred by the 1941 Nazi invasion, the Soviet goal was to ensure a similar strike never happened again. So, as NATO forces conducted their activities, the Soviets were hyper-vigilant. Their capable intelligence apparatus picked up signals intelligence (ie. radio transmissions) calling planned US bomber sorties “strikes.” The Soviets flew dozens of surveillance flights over Europe, observing increased US naval activity and ground force movement. They freaked and issued alerts to their forces and initiated Operation Ryan, “an intelligence effort to detect and preempt a Western ‘surprise nuclear missile attack.’”
Disaster was averted when Assistant Chief of Staff for Intelligence, US Air Forces Europe, Lt. Gen. Leonard Perroots decided NATO forces would not mirror the escalated Soviet threat level. The Soviets had misunderstood the situation. Able Archer 83 concluded peacefully after 5 days of exercises.
Let’s come back to Able Archer. We recently had some historically significant excitement in the US stock market.
As you’ve undoubtably heard, a bunch of hedge funds bet heavily against GameStop (stock symbol $GME) and have lost billions so far. The narrative has been cast as a David vs. Goliath scenario, or alternatively, the foolish, coordinated actions of a bunch of “unsophisticated investors” (quoting Massachusetts Secretary of State). But what actually happened?
The GameStop saga actually began a while ago. GameStop ($GME) is a company that owns hundreds of brick-n-mortar stores that sell video games and related electronics. In 2019, retail investors (meaning non-professional traders, many of whom are millennials) on a Reddit forum called /r/WallStreetBets noticed it. Though it was struggling, the company had plenty of cash reserves. Betting that $GME would improve, they bought stock. A little while later, a couple noteworthy business guys (Michael Blurry [cf. The Big Short] and Chewy.com founder Ryan Cohen) noted that 90% of the stores were actually still profitable. They then bought positions in the company. The stock rose. As 2020 progressed, the upcoming 2021 releases of new gaming consoles (a typical boon for a video game store) fueled further speculation that $GME stock was a solid buy. In early January of this year, Ryan Cohen took a seat on the board. The stock rose even more.
As all this was happening, several notable hedge funds like Melvin Capital looked at the GameStop data and saw a business death spiral, so to speak. Generally speaking, brick-n-mortar stores like GameStop have struggled to compete with the rising e-commerce trend. Then COVID happened. Many brick-n-mortar stores were horribly impacted, and GameStop was no exception. Its 2020’s revenue was $2.188B less than 2019, a 30% decline. Based on that reasonable analysis, the hedge funds shorted the stock, effectively saying, “we’re betting this business will go bankrupt.”
But who are these hedge funds making such bets? Well, they’re basically the sharks of Wall Street, making billions annually through shorts- basically speculation that a business will fail. But they don’t just bet. They hire private investigators to dig up damaging information, then they launch media blitzes to broadcast their findings. The publish their shorts on their websites. Their executives do interviews on CNBC and CNN Business. They tell their friends about the struggling company at Wall Street invitation-only “idea dinners.” As time goes on, their tactics eat away public confidence and sentiment turns negative. The stock price goes down. [If you’d like to see this in action, review the media from when these hedge funds were shorting Tesla stock in 2019.] Typically, the struggling company eventually lives up to the negativity. It fails, leading to bankruptcy and thousands of jobs lost. The hedge funds then collect huge returns from their speculation. [I don’t even fully understand how.]
These hedge fund shorts touched a nerve with the millennial retail traders. Many of the millennials, like me, purchased videogames or consoles at GameStop years ago. They didn’t want to see it fail. Plus, the hedge funds represented all the evil of the 2008 market collapse… white-collar Wall Street folks that got government bailouts while our hard working, middle-class parents lost everything. Some of the personal stories of the 2008 economic devastation on /r/WallStreetBets are quite moving. Anyway, annoyed at the hedge funds, they bet against them and purchased as much $GME stock as they could. It became quite irrational.
I won’t try to explain shorts and gamma squeezes. I’ve spent all week in this space and still don’t think I understand them enough to write accurately. I’ll withhold a play by play of this week, as well. There are others that have done a better job of that. Suffice to say, these countering moves between WallStreetBets and the hedge funds spiraled up into $GME stock price highs and a full-blown infrastructure crisis. Earlier Saturday (1/30), Goldman Sachs said this activity could take down the entire market.
How did this come about? What’s at the core of this?
It seems that this is a huge misunderstanding. But let’s get into this more…
We chalk conflicts up to “misunderstanding” all the time. Misunderstanding is normal. But that doesn’t mean it’s not significant. If you misunderstand a contract, you can lose enormous sums of money. If a police officer misunderstands someone’s intentions, an innocent person might die. In Able Archer 83, a misunderstanding almost plunged Europe, the USSR and the United States into nuclear war. Though its normal, misunderstanding can have disastrous consequences.
That’s where we’re at today. These are the disastrous consequences of misunderstanding.
Let’s start at high altitude and then dive down into the mess.
First, what’s the market? The stock market was originally set up to “help capitalize businesses and allow people to exit their investment by selling it on to another investor [that also wants to own that business].” That just means companies sell off portions of ownership to raise money, and then the original buy sells it at a later date. It’s akin to me selling off 20% of Kwacha Road in order to fund the website changes, and then the buyer selling it to Mark Cuban next week. The stock price is what, based on their valuation, someone is willing to pay for that portion of the company.
But what it once was isn’t what it is today.
It’s no longer about investing in businesses. Instead, the market has become in the words of investor David Friedberg, “a synthetic casino.” “Every stock trades based on the assumption that someone will pay more for it [in the future] than I am paying for it today… [that’s] not investing in businesses.” To back up that point, last year the total value exchanged on the stock market was $121,000,000,000,000 (that’s what $121 trillion looks like) spread out across 2.7 trillion trades. [To put that in perspective, at the end of 2020, the value of all listed companies was $50.8 trillion. All, literally all, publicly traded US companies could have been sold twice with the amount of notional value that exchanged hands in 2020.] But “do you think that $121 trillion of notional equity value traded provided capital to businesses anywhere close to even 1% of that total?” In other words, how much of that value exchanged actually made it to the businesses being bought and sold? Answer: Virtually none.
We’ve misunderstood the market. It’s not about investing in the underlying businesses anymore. It’s about speculating on what something will be worth tomorrow. Then, other people speculate on that outcome. It’s a casino. The games are shorts, options, and derivatives. The chips and cards are the stocks. Cash in or cash out, the house (almost) always wins.
But let’s dive down to the lowest level first.
The retail investors are in the spotlight of the current show. But how did they get to be there? Well, they leveraged the advantages of the internet- speed, low/no barrier to entry, access to information, connection of large groups of people, and technology.
But these retail investors are misunderstood, for two reasons.
First, this is not a simple David vs. Goliath story. Though the institutional media has depicted it as such, the 2.7 million members of /r/WallStreetBets did not take down Melvin Capital et al. alone. Not even close. I can’t explain a gamma squeeze other than to say that the hedge funds that shorted $GME had to buy $GME to cover themselves, which sent the price higher. So that was part of it. But here’s a huge, less mentioned part. Other hedge funds and big institutional money saw Melvin Capital et al. hemorrhaging cash and bought stocks to participate in the frenzy with the retail investors. The data from the market makers backs this up. It went from the “Little Guy vs. Wall Street” to “Little Guy + Wall Street vs. Wall Street.” Yes, the retail investors kicked the situation off, but then larger players exacerbated it.
The extent of retail investors responsibility is misunderstood.
Second, the retail investors misunderstood the effect their numbers would have on trading infrastructure. To be fair, many experienced professional “stock jockeys” were/are unaware of the exact route and potential impediments to a trade. At any rate, the enormous volume of $GME trades and resulting market volatility led to a clusterf at the clearing house, a company called Depository Trust & Clearing Corporation (DTCC). The purpose of DTCC is to perform the exchange of the actual stock certificates between the buyer and the seller.
From The New York Times: “But DTCC’s role is more than just clerical. Clearinghouses are supposed to help insulate a particular market from extreme risks, by making sure that if a single financial player goes broke, it doesn’t create contagion. To do its job, DTCC requires its members to keep a cushion of cash that can be put toward stabilizing the system if needed. And when stocks are swinging wildly or there’s a flurry of trading, the size of the cushion it demands from each member — known as a margin call — can grow on short notice.”
On Thursday, DTCC hiked up that “margin call” tenfold and left the trading platforms only hours to come up with three billion dollars of additional deposit. The question remains whether that enormous hike was legal and ethical. The (intended?) effect was to shut out retail investors for Thursday and part of Friday which allowed the hedge funds to take less losses. My suspicion is that this is where “the fix” happened.
The effect of the retail investors’ own trade volume is misunderstood. This is already shaping up to be the point of greatest focus.
Let’s swoop up one level to the popular app, Robinhood, that made all this possible.
What is Robinhood? Robinhood is a trading company on a mission, as they describe it, “to democratize finance for all.” Through their well-designed app, Robinhood specializes in opening up the market to retail investors through $0 trades. But while retail investors have swarmed to Robinhood, nothing in life is free.
In order to bring about “democratized access,” Robinhood steers all their users (by default) towards “margin accounts.” In margin accounts, the client doesn’t own any securities. Rather, margin account holders “own” a promise from their broker. The broker has to later fulfill that promise, hence DTCC and the above discussion. However, the $0 trades pose a major problem: how does Robinhood make money? They sell their clients.
Again from The New York Times: “Robinhood’s marketing, meanwhile, papered over the fact that its business model, and the free trading, were paid for by selling customer’s orders to Wall Street firms in a system known as ‘payment for order flow.’ Big trading firms like Citadel Securities and Virtu Financial give Robinhood a small fee each time they buy or sell for its customers, typically a fraction of a penny per share.” Though the NYT doesn’t make it clear, in the “payment for order flow” Robinhood essentially sells an up-to-date customer profile.
Robinhood users have misunderstood the relationship. They’re actually the product.
[I had wanted to go deeper and talk about the hedge funds and the “market makers” like Citadel, but this is already super long. I’m going to jump to the end.]
I think the largest disconnect happened here. Straight from their website: “The mission of the Securities & Exchange Commission is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The SEC strives to promote a market environment that is worthy of the public’s trust.” Basically, you’ve had a bad week at the SEC when millions of Americans are clamoring from you to use your investigative and law enforcement powers, and Wall Street executive are publicly advocating for additional regulations. WFH isn’t their best look.
There is a growing mass of people on both the Left and Right that are disenchanted with the social status quo. After the injustice of the 2008 bailouts, those people took to the streets and literally occupied Wall Street. But they’ve now learned new skills… and for once, the tables turned. They were on top and the hedge funds were losing. But trading was arbitrarily suspended on the legal, free, and fair exchange of stocks. Now we know that was because of a tenfold increase in DTCC margin calls and a corresponding liquidity issue at Robinhood (they didn’t have enough in the bank to cover such an enormous jump in operating costs).
Why did that happen? Why did it take over 30 hours for the margin call and liquidity issue to come out? It looks like it happened because the wrong people were winning. There’s a lot of disappointment, anger, and resentment coming from the same wounded place in our collective soul as books like Hillbilly Elegy, Dignity, Between the World and Me, Dreamland and articles like this and this.
Regulators misunderstand the effect of their silence.
But that’s not all. As I said on social media earlier this week, the United States has always been an economically oriented people. The first act of the American Revolution was to throw tea into Boston Harbor in defiance of a tax. The driving issue behind the American Civil War was the economic importance of slavery. Segregation was about keeping non-whites restricted to subsections of society, and that was particularly seen in various aspects of the economy (different restaurants, movie theatres, hotels, etc. for blacks). The economy and our contribution to it is a leading source of identity.
Regulators misunderstand the role that the economy has in the lives of Americans. Disregarding a rising feeling of economic hopelessness in people that are super sensitive to the judgements of the market is an extraordinarily bad idea.
Let’s wrap this up. I’ll do so by sharing this…
I don’t fit into American culture very well. I love this country and have given years of my life and part of my health to her protection. Still, over the years here I’ve always sensed I’m on the outside looking in. But this week, for the first time, I knew what to do in America (which raises an interesting question about belonging and function for another day). I fit in.
The world of misunderstanding (and, I believe in this case, corruption) has a distinct look. Since the rational is constantly providing contradictory inputs (ie. CNBC & MSNBC interviews this week vs. the populist sentiment on both the political Left and Right), we have no choice but to decrease the attention we give to it. That elevates a new modus operandi- intuition.
The world of intuition has a currency, too. In fact, in it you and I have boundless capital that we can spend as conservatively or liberally as we please. That currency is trust.
In a safe, predictable, fair world, it is wise to spend that trust liberally. I’ve found that the majority of people are well worth some level of trust, though there’s still a minority that aren’t. But in an unsafe, unpredictable, irrational (corrupt?) world, that’s mostly flipped. I approach each almost all interactions with suspicion and drop my guard as soon as my intuition says its ok. You don’t change anything external… but it’s an entirely new mode of attention.
This is a long, long letter so I’ll wrap it up. Here’s a quote from Shakespeare’s play All’s Well That Ends Well: “Love all, trust a few, do wrong to none.”
Thanks for sticking with me.