William Hogarth knew a bad investment when he saw one. Photographer: Edward Gooch Collection/Hulton Archive via Getty Images
The mistake of betting that a stock will fall, then getting crushed when it doesn’t, goes back a long way.
In August 1719, as the first stock market bubble in history was gathering steam, the mercurial Scottish financier John Law made a bet with Thomas Pitt, the earl of Londonderry and uncle of the prime minister, William Pitt, that the price of British stocks would fall in the year ahead. Law was at that time the master of the French financial universe, the man in control not only of the Mississippi Company, which held a monopoly on trade with the French territory of Louisiana, but also of the Banque Royale, and hence the French money supply. He was long France, short England.
Law sold 100,000 pounds of British East India Company stock short for 180,000 pounds (that is at a price of 180 pounds per share, or 80% above face value) for delivery on Aug. 25, 1720. The price of the shares at the end of August 1719 was 194 pounds, indicating Law’s expectation of a 14-pound price decline.
At first, Law’s “long France” trade was all that seemed to matter. Shares in his Mississippi Company soared by a factor of 20, from 98% of their face value to 1965% in November 1719. But at that point the Mississippi bubble burst. Within a year, the stocks were down to 200%.
Big Bubbles Abroad
Share price as a percentage of par = 100
Sources: Antoin E. Murphy, "John Law: Economic Theorist and Policy-Maker" (Oxford, 1997); Larry Neal, "The Rise of Financial Capitalism: International Capital Markets in the Age of Reason" (Cambridge, 1990)
To compound Law’s woes, he was also on the wrong side of a short squeeze. Far from declining, by April 1720 the price of East India stock had risen to 235 pounds, and it continued to rise as investors exited the Paris market for what seemed the safer haven of London (then in the grip of its own less spectacular South Sea Bubble). By June the price was at 420 pounds, declining only slightly to 345 pounds in August, when Law’s bet fell due. As much as the bursting of the French bubble, it was his big, bad short that ruined Law.
Contemporaries agreed that Law’s grand financial experiment had been a disaster. From London, Daniel Defoe was scornful: the French had merely “run up a piece of refined air.” So incensed was one Dutch investor that he had a series of satirical plates specially manufactured in China. The inscription on one reads: “By God, all my stock’s worthless!” Another is even more direct: “Shit shares and wind trade.”
As far as investors in Amsterdam were concerned, the Mississippi Company had been trading in nothing more substantial than wind. As the verses on one satirical Dutch cartoon flysheet put it, Law’s scheme had been “wind and smoke and nothing more.”
Fast forward just over three centuries, and wind and smoke are back in financial markets in ways John Law’s critics would immediately recognize. It was already obvious last summer that the Covid-19 pandemic was creating conditions of irrational exuberance in U.S. financial markets. Near-zero interest rates, checks from the government and shelter-in-place orders: these, along with the no-commission trading made possible by online platforms such as Robinhood, had opened the gates of the stock market to a new generation of financial barbarians.
The rise to fame last year of Dave Portnoy was just one symptom. Portnoy boasted of his two rules for making money in stock markets. Rule one is that “stocks only go up.” Rule two: “When in doubt whether to buy or sell see Rule One.”
Coarse, sunburned and perpetually dressed for a sophomoric spring break, Portnoy brought to investing what Donald Trump brought to politics: the sweaty smell of populist excess. On the other side of the big, bad short were “the suits” — professional hedge fund traders such as Andrew Left of Citron Research and Gabe Plotkin of Melvin Capital Management LP. Like a lot of smart guys last year, Left and Plotkin were betting that the stocks of traditional bricks-and-mortar retailers like GameStop Corp. or Bed Bath & Beyond Inc. would fall. After all, weren’t they on the wrong side of both technological change and coronavirus lockdowns? Quarterly disclosures made those short positions public.
It wasn’t Portnoy but “u/Jeffamazon” who four months ago proposed “The REAL Greatest Short Burn of the Century” in a Reddit post to the r/wallstreetbets group. The argument was simple: The scale of the short positions against GameStop was much too large in relation to the amount of stock available to be traded. “GME’S ACTUAL SHORT INTEREST IS OVER 110%,” wrote u/Jeffamazon. “Shorts are beyond trapped in their position. … GME’s balance sheet is healthy with $100M in net cash … so they aren’t going bankrupt anytime soon.”
“Thanks to MMs [money managers] literally not using their brain and relying on ze maths to configure their entire business, we can take advantage of them sleeping at the wheel for a few seconds.” But the stated rationale for this classic short squeeze was not purely financial. As befits a populist insurgency, it was to deliver “a kick in the shorts’ teeth” because “the only way to beat a rigged game is to rig it even harder.”
For journalists and politicians also spending way too much time indoors (just spending it less lucratively), this was an irresistible story. While they had been appalled by a mob of several thousand MAGA and QAnon types storming the Capitol, the political class was enchanted by the spectacle of two million subscribers to wallstreetbets storming Wall Street itself.
The story found its shaman in the person of Keith Gill, a dude in a red headband who goes by the name “Roaring Kitty” on Twitter and something unprintable on Reddit. The foot soldiers of this insurrection were exemplified by the Reddit subscriber who commented on Jeffamazon’s post: “I don’t understand any of it, f*** it im in.”
This was a movement, gushed the Wall Street Journal, of “ordinary investors, stuck at home in the pandemic, swapping tips and hatching trading strategies on online forums … often buying things Wall Street has bet against. Many tout their long-shot wagers with the expression ‘YOLO,’ or, ‘You only live once.’”
Politico couldn’t resist: “The Internet-driven populist sentiment that helped propel politicians to national office is now coursing through global markets … Some segments of the younger generation, flush with extra cash in part due to stimulus payments and weighed down by boredom during the Covid-19 pandemic, are looking to exact a measure of vengeance on big Wall Street hedge funds.”
Any journalist who ventured to question this narrative — for example, my Bloomberg Opinion colleague John Authers — was soon sifting gingerly through an inbox full of invective: “How much did Melvin pay you to write this garbage? shill. Literally trying to protect an industry trying to fleece jobs from low income workers. Sleep well chump.” And: “Plus 1 for the little guys.” And: “The American dream and being able to make your own way. This isn't a casino. This is a riot.” And: “Bloomberg defending the suits. Not surprised. They’re just mad the rubes are in on the joke now.”
As the mania grew in magnitude and spread to other uncool stocks — notably AMC Entertainment Holdings Inc. (the cinema chain) and BlackBerry Ltd. — and from there to silver and even to the joke cryptocurrency Dogecoin, the plot thickened. First, the short burn caught fire, as planned: From below $20 on Jan. 12, GameStop stock soared to above $347. AMC leapt from $2.29 to $19.90. But then Robinhood began to restrict trading in GameStop. “I’ve never been more convinced about market manipulation and hedge funds controlling the game than today,” complained Portnoy to Fox News’s Tucker Carlson. Ted Cruz chimed in.
The Reddit Effect?
GameStop and AMC share prices index, Jan. 12 =100
Yet this was the kind of populism that appeals to the left as well as the right. On CNN last Sunday, Elizabeth Warren called for a Securities and Exchange Commission investigation into the role of “big money.” The Progressive Pasionaria Alexandria Ocasio-Cortez exulted at this “populist rally.” “People were really feeling like everyday people were finally able to collectively organize and get back at the folks who have historically had all the marbles on Wall Street,” she told the streaming platform Twitch. She demanded a congressional hearing and an investigation into Robinhood’s “unacceptable” restrictions on GameStop trading.
To anyone who bought this tale of populists v. suits, I recommend Charles Kindleberger’s classic “Manias, Panics and Crashes,” first published in 1978. Among the book’s many insights, you will find Kindleberger’s five-stage life-cycle of a bubble:
1. Displacement: Some change in economic circumstances creates new and profitable opportunities for certain companies.
2. Euphoria or overtrading: A feedback process sets in whereby rising expected profits lead to rapid growth in stock prices.
3. Mania or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money.
4. Distress: The insiders discern that expected profits cannot possibly justify the now exorbitant price of the shares and begin to take profits by selling.
5. Revulsion or discredit: As share prices fall, the outsiders all stampede for the exits, causing the bubble to burst altogether.
The key to this framework is the different roles played by insiders and outsiders.
Ever since the creation of the first joint-stock companies in the early 17th century — the Dutch and English East India Companies — and the first exchanges, such as the Amsterdam Beurs, where shares could be traded, stock market bubbles have had three recurrent features.
The first is the role of what is sometimes referred to as asymmetric information. Insiders — those familiar with the management of bubble companies — know much more than the outsiders. Such asymmetries always exist in business, of course, but in a bubble the insiders can fully exploit them.
The seasoned speculator, based in a major financial center, may lack the inside knowledge of the true insider. But he is much more likely to get his timing right — buying early and selling before the bubble bursts — than the novice investor. He is also likely to have much more money than the newbie and therefore to be able to speculate in size without risking an excessive proportion of his capital. In a bubble, in other words, not everyone is irrational; or, at least, some of the exuberant are less irrational than others.
Secondly, each group of insiders and outsiders will tend to move together. The difference is that the insiders will operate like a wolf pack, the outsiders like a flock of sheep — if not lemmings.
My favorite illustration of this is the way George Soros successfully speculated against the British pound in September 1992, one of the biggest shorts of my lifetime. Older readers will remember Soros’s thesis that the rising costs of German reunification would drive up interest rates and hence the deutschmark, and that this would make the UK government’s peg to the German currency — formalized when Britain had joined the European Exchange Rate Mechanism in 1990 — untenable.
As interest rates rose, the British economy would tank. Sooner or later, the government would be forced to withdraw from the ERM and devalue the pound. So sure was Soros that the pound would drop that he ultimately bet $10 billion, more than the entire capital of his Quantum fund, on a series of transactions whereby he effectively borrowed sterling in the UK and invested in German currency at the price of around 2.95 deutschmarks.
His Quantum fund made around one billion dollars as sterling slumped — ultimately by as much as 20% — allowing Soros to repay the sterling he had borrowed, but at the new lower exchange rate, and to pocket the difference.
The popular version of events was that Soros single-handedly “broke the Bank of England.” This was naïve. Quantum’s assets under management were around $5 billion in 1992. The international reserves of the Bank of England were $44 billion — nearly nine times greater. If Soros had taken on the Bank of England on his own, he would have lost.
On the other hand, the Federal Reserve estimated that daily turnover on the world’s foreign exchange markets had increased from $58 billion in 1986 to $167 billion in 1992. In the words of the Economist, “The British Treasury’s seemingly comfortable reserves were as nothing compared with the speculators’ firepower.” The key to the Soros trade was thus to get a critical mass of investors to put on the same trade that he had in mind. That was not hard because Soros was already part of a network of like-minded investors.
As Robert Johnson of Bankers Trust recalled: “I walked out of [a meeting with Soros] with absolutely no question that we were going to go after this thing [and] I knew other people in the banks and counterparties would imitate us.” Soros’s partner Stan Druckenmiller recalled: “We really went after this thing and kept going and going and going like the Energizer bunny … So anybody with a brain is going to ask his dealer, ‘What the hell is going on?’ And I know people talk. It’s Quantum.”
In some cases — notably with Louis Bacon — Soros and Druckenmiller shared information over the phone. Other hedge fund managers who were in the trade included Bruce Kovner of Caxton Associates LP and Paul Tudor Jones. Magnifying the scale of the short selling were the efforts of the banks who were lending the hedge funds money.
Finally, as the role of the banks in Soros’s big short illustrates, a crucial difference between insiders and outsiders is that the insiders usually have better access to credit than the outsiders.
Knowing these things would have helped many people better understand the events of recent months.
Let’s begin by disposing of the populist insurgency hypothesis. According to Federal Reserve data, the top 10% of Americans in terms of wealth own 88% of corporate equities and mutual fund shares (up from 80% 30 years ago) while the bottom 50% own just 0.6% (down from 1.4%). More than half is now owned by the top 1%. Not surprisingly, therefore, some of the leading YOLO investors are current or former financial services professionals. Not surprisingly, the largest holders of GameStop stock during its dizzying rally were institutions, notably BlackRock Inc., as well as hedge funds such as Senvest Capital Inc.
The Rich Get Richer
Distribution of U.S. household wealth
Source: Federal Reserve
Now, let’s look at how the smart and the dumb money worked. Robinhood itself is one of a new generation of online brokers, catering to smaller “retail” investors — the outsiders. Robinhood’s service is free to the outsiders. It gets paid by the insiders: among others, the market maker Citadel Securities LLC, part of Ken Griffin’s Chicago-based hedge fund and financial services group, for funneling transactions its way. When Robinhood had to post additional billions to the National Securities Clearing Corporation in response to the volatility of stocks such as GameStop, the money — a cool $3.4 billion — was provided by some of the biggest names in venture capital, including Sequoia Fund Inc. and Andreessen Horowitz, as Gillian Tett pointed out last week, as well as the hedge fund Tiger Global. The key point about Robinhood is that if they really were outsiders, they would have blown up because they would have lacked that kind of support.
The conspiracy theory that Robinhood froze new purchases of GameStop shares in response to pressure from the hedge funds makes no sense, however. Citadel and Point72 Asset Management LP injected $2.75 billion into Melvin Capital on Jan. 25. Two days later, Melvin announced that it had closed out its short position in GameStop. It was only after that, on the 28th, that Robinhood froze new purchases of GameStop shares — not to help Melvin, which had already exited the trade and realized its losses, but to help itself.
Notice, too, who has been cheering on the “Gamestonk” — none other than the richest man in the world, Elon Musk, who has an ax of his own to grind when it comes to short selling. “Here come the shorty apologists,” Musk tweeted on Jan. 28. “Give them no respect Get Shorty.” One of the worst trades of 2020 was shorting Musk’s electronic car company, Tesla Inc., a trade that has burned some famous fingers, notably those of Jim Chanos and — surprise! — Gabe Plotkin of Melvin Capital. The Tesla shorties lost more than $39 billion last year.
But if the biggest beneficiary of the Tesla short squeeze was the richest man in the world, this sure ain’t the sequel to Occupy Wall Street. As for who the biggest losers of this episode were, that’s easy: the outsider retail investors who bought GameStop or AMC at or near the top of the bubble.
Finally, remember the crucial role of access to credit. The Fed has created the conditions for multiple bubbles by promising zero rates and quantitative easing as far as the eye can see, and never mind if inflation goes above 2%. “Frankly we welcome slightly higher … inflation,” Fed Chair Jay Powell said last month. “The kind of troubling inflation people like me grew up with seems unlikely in the domestic and global context we’ve been in for some time.”
Maybe. But general asset price inflation and a rash of bubbles are pretty much guaranteed. Margin debt is currently growing at its fastest rate in 30 years — faster than in the dot.com bubble, faster than on the eve of the global financial crisis. When the first margin calls go out, needless to say, they will be to the little guys.
Of course, if Powell is wrong — if the combination of mass vaccination, post-pandemic euphoria, yet more fiscal stimulus and an overflowing monetary punchbowl does reignite inflation expectations, as Larry Summers warned last week — then all stock market investors, insiders and outsiders alike, may be in for a rude awakening. According to a recent and exhaustive analysis of long-term equity returns in 39 developed countries over the period from 1841 to 2019, there is “a 12% chance that a diversified investor with a 30-year investment horizon will lose relative to inflation.”
That might not have surprised John Law. But in times like these, financial history offers the kind of perspective that all market participants — yes, even Dave Portnoy and Keith Gill — badly need and are mostly short of.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.