A couple of weeks ago I wrote to you about my pipes bursting and the investing lesson we could take from it – to buy protection when you can, not when you have to.
Well in the last week, we’ve seen another important plumbing lesson play out.
Somewhere in the financial system, a pipe burst on Friday.
The back-end of last week saw some large block trades for individual stocks get dropped on the market. Large cap Chinese tech companies were among those hit, alongside American counterparts.
Viacom was down 27% on Friday, when a multi-billion-dollar sell order hit the market.
But… Viacom is a large US stock, the kind which should be able to take such trades in its stride.
I mean sure, dip or drop a few per cent, maybe seven or eight, but 27%?
Liquidity is a concern, and Viacom is a canary in the coal mine for people who don’t think about liquidity risk.
That, sadly, is most people.
So who was behind all this forced selling?
Bill Hwang, convicted fraudster and insider trader hedge fund manager of Archegos Capital Management. Never heard of him, obviously.
The big banks were fighting over one another to provide him with leverage. Why, you ask? Because lending equals fees, and because risk management is for losers.
It’s not so much let the people trade, as let really rich people have loads of leverage.
The prime brokerage departments at all the big banks – Goldman Sachs, Morgan Stanley, Nomura, Credit Suisse – offer leverage to hedge funds and help manage their positions and relationships with other parts of the bank. It was these prime brokers who were dealing with the fire sale of assets.
The current failure offers some support that big investment banks are basically in the business of “providing too much leverage to just about anything that moves”.
Again, why? Because if they don’t, someone else will.
Goldman had actually blacklisted Hwang for his previous misdemeanours, but in 2018 grew so jealous of the fees their rivals were generating from his extreme borrowing that Goldman allowed him to become a major client again.
Hedge funds that lever up to bet on Viacom to generate excess returns, well… is that investing? Literally anyone can improve returns by adding leverage in a bull market.
And hedge funds are as leveraged as they’ve ever been – over 200% leveraged in fact (three to one).
That’s the sector by the way – not just Hwang and his Archegos fund.
So Viacom may have fallen 27% on Friday – which is far more than it should have given the size of the market and the size of the trades.
But a three-to-one leveraged hedge fund would have lost 81% of its value that day.
On a blue-chip stock.
Two and twenty, for that? No thank you, sir.
So what next?
From the Financial Times:
Bankers in Tokyo familiar with the circumstances surrounding the heavy sell-off of Archegos assets described the event as a possible “Lehman moment” that would force multiple lenders to recognise that leverage extended to the fund had created excessive risk.
Basically, crucially, Archegos was not the only hedge fund which had leveraged a long position on Viacom and these other stocks.
Other funds may be seeing huge losses. They may be seeing margin calls. They may be about to try and dump stock on to an already illiquid market.
Nomura has already warned that this might have wiped out a full half-year of profits.
Credit Suisse opened on Monday almost 15% down.
Like my plumbing issues, liquidity is a risk no one thinks about until a pipe has burst.
The turmoil at the big banks shows that the same is true for even the biggest stocks and oldest banks.
It really makes you question the logic of ARK Invest’s strategy.
Cathie Wood of ARK Invest is one of the most successful investors of the last few years, having called numerous investing and tech trends well before anyone else. But her success in not yet secured.
Her risk management strategy involves, she recently outlined, using large cap tech stocks as an equivalent to cash (something I would disagree with vehemently).
Then, if there is turmoil in the sectors her innovation funds invest in, they move out of the liquid large cap tech stocks into the illiquid small cap disrupters.
Hoooooly moly, what is going on there!
This is buy the dip on steroids, this is stocks only go up, this is madness, surely?!
It is a strategy that only works (and works brilliantly I admit) on the way up, if every dip does get bought and surge higher.
But doubling down and simultaneously worsening the liquidity risk of your portfolio during a collapse in the sectors you invest in… it’s a deal with the devil, it’s selling all your jumpers on the first sunny day in March, it’s betting that the coin will land heads for the eleventh time in a row.
Let me put it this way.
You can make 500% a year for five years and I don’t care because if you lose 100% even just once, all my money is gone.
That is a strategy which adds a good amount of upside on the way up, but which invites the risk of total loss of capital into the mix on the way down. It’s pro-cyclical, when as investors we might fight hard to be counter cyclical, if we want to make it to the next round.
Swimming pools and coin toss competitions
Imagine a deep swimming pool. It has 100 people floating in it. If that number grows to 200 people, you have to take some water out or it’ll overflow. Everyone’s still floating.
Now try 400. Not much water left now, just people. The pool seems full – but the water level is artificially high, because there are so many people in it.
One sunny weekend, 800 people turn up.
When evening comes and the first people start to leave… suddenly 700 people find out that they’re all swimming in an inch of water.
That’s when the panic takes hold, and everyone rushes for the exit at once…
And that is the moment when Cathie Wood wants to buy illiquid small caps.
This is leveraged pro-cyclical investing, and it’s how to look like a genius on the way up.
That’s what Bill Hwang has been doing – I saw a stat that he was generating 40% annual returns at one point.
If you get 100 people to toss a coin ten times, one of them will come up with ten tails in a row.
(Everyone will immediately pursue him for tips on how he did it, what techniques and strategies he used, and while they’re at it – what he thinks of UK politics at the moment and what his views on bitcoin are…)
Wood is going for a record 100 tails in a row.
And she’s all in.
While it’s great to see a woman – and a champion of the energy transition, electrification and disruption no less – dominating the investment scene, and while we should applaud rather than enviously criticise her past success…
… I do feel that the liquidity lessons from my plumbing, and from the plumbing issues in financial markets in the last week, should weigh on her mind a little more than they seem to.
The signs of jitters and fragility in equity markets seem to be growing, and in the shadow of inflation and the bond market finally falling into bear market territory no less.
We cannot know the future or say much for certain in this crazy world of investment, but it does seem, boring though it might be, that now is a time for caution, not for doubling down.
My only exception to that remains the energy transition.
A multi-decade trend with unprecedented social, political and financial support.
Whatever you think of the current bull market – it’s going to be a crucial sector for the long term.
But, I don’t deny, with so much hype, it’s getting harder and harder to find value and to pick the best companies at good prices.
That’s why you need to see what James Allen is working on, and the company I’m currently looking at.
It’s in a sector one commentator has said “if you solve [this] then you solve energy.”
Its share price hasn’t gone crazy. Its potential hasn’t been recognised by the market. And interest in this sub-sector of the energy transition is just starting to gain momentum.
Very best wishes,
Editor, UK Uncensored