The tussle playing out between hedge fund short-sellers and day-traders mobilizing on Reddit to drive up stocks such as GameStop may be entertaining, comparable to watching a bitter argument play out on Twitter between two people you don’t like.
However, the spectacle once again raises the question whether or not broader markets are in bubble territory and, assuming they are, what the impact of the burst will be.
As Paul Donovan, chief economist at UBS Global Wealth Management, points out, the most damaging bubbles are ones that banks get caught up in because their losses impede the flow of credit to the real economy.
Losses taken by latecomers to rallies in obscure single stocks and in crypto may impact consumption patterns and induce some risk aversion, but they should not hurt the banks.
Can the rest of us sit back and enjoy the spectacle, then?
Perhaps it would be better to ponder some lessons from the disaster narrowly avoided in the first and second quarters of 2020.
The coronavirus
Since March, all markets have been supported by trillions of dollars’ worth of liquidity injected at negative real rates by central banks. Free markets in capital no longer function. All valuations have been divorced from fundamentals. The only argument is by how much.
Covid is changing economies profoundly. There will be winners and losers.
Investors want to hear about winners.
Up until now, they have ignored the mutation of more infectious and deadly strains of the virus and problems with vaccine production and delivery. Money has flowed into all risk on trades: not just tech stocks, spacs and cryptos, but also corporate credit; high-yields bonds, now trading at spreads close to all-time lows; and even real-estate funds.
The lesson of the March crash was the same as from every other crash
Regulators tell the managers of such funds not to promise easy daily redemptions when the underlying assets are inherently hard to value in discontinuous and one-way falling markets and difficult to sell without incurring large losses.
The lesson of the March crash was the same as from every other crash. Sell-side dealers would not execute in size at the prices being displayed on screens. They don’t want to warehouse risk.
Any fund demanding liquidity from the banks will be charged heavily for it.
Fund managers don’t like to hold cash as a reserve to meet redemptions, because it drags on their returns as the bubble inflates. Big inflows in the third and fourth quarters of 2020 and during January this year have been fully invested.
Euromoney struggles to see why funds investing in real estate, the lumpiest asset class known to man, are allowed to promise daily redemptions, unless they carry large cash buffers.
Firebreak
When the crash comes and mark-to-market valuations make their funds look bad, managers will first switch to discounted cash-flow analysis and then either close gates to redemptions or seek to pass on the high cost of accessing liquidity through so-called swing pricing.
Swing pricing seeks to transfer the discounts from selling in collapsing markets on to those investors seeking to cash out early from funds, so as not to dilute returns for those that cling on.
That reallocates the price of the trade and disincentivizes a rush to the exit. Will it be enough of a firebreak?
Banks always lend heavily against real-estate collateral. Fire sales by funds invested there will lower the value of their security.
It will be the same with investment-grade corporate credit and high-yield bonds, especially if fund managers trying to sell vertical slices of their portfolios – the low quality and illiquid, along with the better quality and more liquid – should be overwhelmed by redemption requests.
We might all joke that we wish we owned stocks that can rise 900% in a week, too. However, when the crash comes in corporate credit and real estate, and fire sales by funds invested in those markets hit the value of collateral held by banks, that won’t be such fun to watch.
