Former SAC Trader Shares A Short Squeeze Story
When I first got to SAC Capital in 1999, I sat back-to-back with another cyclicals trader. A tall and muscular man, he was one of the room’s best traders and most charismatic personalities. After a few weeks, however, I began to notice a disturbing pattern in his behavior.
About 2pm on most days he would start cursing at some imaginary personal in a low voice, just loud enough for me to hear. This wasn’t garden variety stuff either. It was language more appropriate to, well, the sort of private club that has a dungeon in the basement.
It took me a few weeks – I was new, after all – to ask him,
“hey… what’s with the rough talk every day after lunch?”
“Oh, I get bored a lot of afternoons, so I’ll pick a few names I know other hedge funds are short and buy a few blocks of 10 or 20 (thousand shares) just to see if they’ll panic and cover… Sometimes it works, sometimes it doesn’t…”
A few weeks after that exchange I noticed that it had been several days since the last such episode so I asked him, “everything OK? You haven’t been doing the short squeeze thing…”
His reply, which came with a heavy sigh, was “I think I’ve lost my joie de vivre…” Remembering that phrase come out of this rough and tumble trader’s mouth makes me laugh to this day.
Fast forward to January 2021 and the short squeeze game is wildly different, as we’re seeing with GameStop, AMC and other names. It’s no longer about a single bored trader. The narrative has shifted to a social media-organized group of small-money retail investors. And given what’s been happening, they definitely are not at risk of losing their joie de vivre.
The way I see it, there’s a lot of disruptive innovation in what’s going on just now and that paradigm can tell us something about what might happen next in capital markets. This is the Clayton Christensen model we talk about frequently, and the basics are as follows:
- Disruptive companies start at the low end of a market, focusing on customers underserved by established players. Incumbents ignore this new competition because the customers they’re losing aren’t especially profitable.
- Over time the disruptor climbs the value chain, offering better products and services. They still leverage their original competitive advantage but use it in new ways.
- Eventually the incumbents either fail or adopt the disruptor’s business model, and the whole cycle starts over again.
- Examples: Japanese cars in US/Europe markets from 1960 – 2000, Amazon from the 1990s to the present, exchange traded funds from the 2000s to now. Even the old Sears mail order catalog of the 1910s and 1920 was a classic disruptor of small-town general stores.
Viewed through this lens, retail stock investing is following a pretty classic disruption model and we have to assume it will have further influence on capital markets. The underserved market – retail investors, often younger – now have free stock trading and social media that binds them together. They aren’t usually risking huge sums – stimulus checks have pride of place in terms of explanations for where their capital stock originated – but there’s a lot of them in the system now. As a cohort, they seem well versed in both gambling and gaming. They know how to call a bluff, think about statistical probabilities, and act quickly when they have to. Individually, these factors don’t mean much. Collectively, they multiply on themselves.
The big lesson about disruption we’ve all learned in the last 10 years is that when the ball gets going, it rarely stops. Opining on whether that’s good or bad isn’t especially useful. We see the same trends in many other places, politics being first among equals on this count.
I’ll close out today’s story with three ideas for how to navigate the unusual market we find ourselves in on the assumption it will last for a while.
#1: There’s every possibility that we’ll see more hedge fund de-risking days like yesterday, so remember our 5 percent rule. If the S&P 500 closes down 5 pct or more, history says that is a good entry point. There may be more than just 1 – as many as 5 to 12 if things go really pear shaped – so don’t go all-in on the first big flush. But do buy some…
#2: Be very wary of shorting any name a retail investor likely knows. There’s a certain irony that GameStop, where plenty of the current crop of retail investors likely shopped in their youth, is the eye of the current storm. If I were running a market neutral book, I would pair longs with industry/sector ETF shorts and look for relative outperformance. Single stock shorts can blow out portfolio risk very quickly in the current market.
#3: Stay focused on the big picture. GameStop and its ilk are attention magnets, but all the really important issues to equity values remain. Vaccine rollouts. Earnings leverage. Inflation and interest rates.
Keep your focus on those and try not to lose your joie de vivre.
Sun, 01/31/2021 – 17:00