By Quincy Krosby, Ph.D.

Every so often, the famous warning from former Chairman of the Federal Reserve Alan Greenspan on Dec. 5, 1996 — “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?” — resurfaces in a much simpler form: The market is forming a bubble similar to 1999.

Back then, it was a period of intense optimism, in which profits didn’t matter; it was a dot-com boom regardless of what came before the dot. It was the “New Paradigm” — until it wasn’t. As the Greenspan Fed began raising rates in 1999 and 2000 — Jan. 1, 1999, the 10-year Treasury was 4.72%; Jan. 1, 2000, the 10-year Treasury was 6.66% — in order to ward off potential inflationary pressures stemming from the strong economy, market strategists continued to stress that the technology sector, for the most part, was immune to higher rates.

In February 2000, with Y2K concerns forgotten, Greenspan’s semiannual testimony to Congress prompted markets to pull back when he suggested that further interest rate hikes would be necessary. NASDAQ, home to the booming technology sector, would peak on March 10, 2000.
Of course, each market chapter is unique, with distinct contributing characteristics and events, but there’s typically a recurring theme of a shift in Federal Reserve monetary policy that telegraphs tightening on the horizon. Federal Reserve Chairman Jerome Powell has said numerous times that the Fed is prepared to allow rates to run above its long-standing 2% inflation target before raising interest rates, as it seeks to ensure maximum employment.

Powell outlined what constitutes a strong labor market from the Fed’s perspective, including wage growth and full workforce participation that incorporates minorities, before declaring that maximum employment has been achieved. With the prospect of another fiscal relief/stimulus package, coupled with low interest rates, and a Fed committed to keeping rates low for longer, concerns are growing louder and louder that the so-called “Reddit day traders” are being fueled by central bank easy money and fiscal largesse.

In 1999, comments compared the “irrational” surge in technology names to the lead-up to 1929, while today the comparisons allude to both 1999 and 1929. In an oft-cited 2001 study, Purdue University research revealed that 95 companies that attached a “.com” (or “.net”) to their core names witnessed a nearly 74% rise in their stock price within 10 days of the initial announcement. Today, strong share price rises have been associated with many initial public offerings including QuantumScape, DoorDash and Airbnb, only to see the exuberance ease if not fade completely.

The Fed's Response

A further question referred specifically to GameStop, and the mounting criticism that “super easy monetary policy, asset purchases and zero interest rates are potentially fueling a bubble that could cause economic fallout should it burst.” The chairman’s response was that the Fed did what was necessary to help the economy pull out of an “unprecedented” shock, and that there’s “nothing close to it in our modern economic history.” In addition, Powell stressed that the relationship between low interest rates and asset valuations is not as “tight as people think because a lot of different factors are driving asset prices at any given time.” Moreover, he characterized financial stability vulnerabilities as “moderate.”

The International Monetary Fund (IMF) warned about “excessive risk-taking” in a blog posted on Jan. 27, as investors continue to bet on “persistent policy backstop.” The message cautioned that along with market exuberance a “sense of complacency appears to be permeating markets.”

Bubble Watch

Headlines across the financial press have so overused “bubble” in describing the market’s performance, that at the end of January, “mania” was adopted to chronicle the daily moves by the retail traders pouring into silver, GameStop, AMC, Hostess Brands and even Nokia. Does anyone even remember when the Blackberry was considered the must-have smartphone? But it’s a heavily shorted and thinly traded name, and that’s what makes it attractive to the retail traders. The moves, amplified by seemingly thousands if not millions of retail traders who simultaneously are buying call options on their target companies, are forcing the market makers who sold them the call options to buy the underlying stocks in order to hedge their risk.

This is the classic “gamma squeeze.” And hedge funds that have shorted (betting that the share price will go down) the same stocks that the retail pack is buying, are forced to “cover their shorts” by purchasing the stock at a higher price. If stopped right there in the process, it would be limited to a corner of the overall market, keeping the broader market generally immune from the battle between the Main Street trader and the Wall Street pro. The concern stems from the sales made by hedge funds to cover their losses when covering their shorts and forced to buy them at a higher price. Looking at the market at the end of January, there are interesting “oversold” stocks across sectors, suggesting that forced selling by hedge funds was necessitated by the need to shore up hedge fund books” following the short squeeze attacks.

 

It is becoming clear that professional investors have been involved and, to some extent, are leading the frenzy as they post commentary on the blogs followed by the larger retail trading community. And most likely, high-frequency trading that relies on algorithms is adding to the speed at which short stock targets are moving. But the most intriguing question is whether we see a similar move on targets of vital national interest, including the U.S. dollar and Treasuries, commodities, etc.

Senator Elizabeth Warren, interviewed on CNBC, said, “We need an SEC that has clear rules about market manipulation and then has the backbone to get in and enforce those rules.” She was adamant that to have a “healthy stock market, you’ve got to have a cop on the beat.”

The debate now is focused on who the “cop on the beat” is supposed to patrol. Senator Ted Cruz and Congresswoman Alexandria Ocasio-Cortez have managed to agree on a central point that has garnered widespread agreement, as well as controversy, that the restrictions put in place by the trading platforms used by the traders hurt the legitimate rights of the traders versus the interests of the hedge funds. This is at the core of the questions surrounding the democratization of the markets: Should complaints made by the hedge funds take precedence over the rights of the retail trader?

On the last trading day of January, in response to the continued mayhem in the markets, the SEC said that it is “closely monitoring the extreme price volatility of certain trading prices.” Further, the statement sends the message that “aggressive enforcement” will be taken if market manipulation is discovered.

At the end of January, “put” buying (betting that the share price goes down) has picked up in heavily shorted names, and prices for downside protection are rising steadily as traders appear concerned that the frenzy could see a swift end.

Riding Out the Frenzy

As we enter February, a statistically difficult month for the market, concerns are growing about how long the trading “mania” can last. Do hedge funds exit the “short” business completely, or do they wait it out and see if threats of potential lawsuits or government regulation thwart the continued siege? Or does it just fizzle out and die a natural death?

While each side of the debate throws stones at the other, neither side can be defined that easily. Hedge funds, for example, do intensive fundamental research on companies and usually take their short positioning following a period of deep review. The waiting period to see if they made the right choice can be excruciatingly long. Hedge fund managers and investors aren’t just slick Wall Street types as portrayed on film. Many pension funds, particularly during periods of low interest rates, will allocate funds to hedge funds in order to increase returns.

Conversely, day traders aren’t all just angry 25-year-olds. Experienced professionals have joined the fray, as money goes to where it’s best treated — until it isn’t.

This will sort itself out, and as the market was already poised for a deeper pullback, this will allow the market to burn off froth and bring valuations back to a more reasonable level. Apprehension about the ongoing monetary and fiscal stimulus fueling excessive risk-taking has been tempered by the sell-off itself. The market is recalibrating and beginning February with an economy that is demonstrably healing.

COVID-19 cases are leveling off, vaccine-related logistics are beginning to show a higher rate of daily inoculations, and, according to the most recent Kaiser Family Foundation’s survey, more Americans want the COVID-19 vaccine “as soon as possible” rather than on a “wait and see how it’s working” basis.

Headlines about “variants” are worrisome, but pharmaceutical companies are already preparing to introduce booster shots to neutralize them. Until COVID-19 is completely eradicated we will need booster shots, but we will also have reopened the economy. The high-frequency data releases coupled with fourth-quarter earnings reports indicate that we are looking at a more normal second half of 2021.

Investors will have to absorb the consequences of too much liquidity and leverage in all pockets of the market, and the debate will surely continue. We need to keep in mind that when Alan Greenspan issued his “irrational exuberance” warning it was 1996, and it took four years for the bubble to pop. Granted, markets run far more quickly with today’s high-frequency trading, but market downdrafts help ground market expectations and exuberance, and keep them rational.

Dr. Quincy Krosby is chief market strategist at Prudential. She will present a market update for WIFS members on Wednesday, February 17 at 3 pm ET. Register.

References include the following: Associated Press, Barron’s, Bespoke Investment Group, Bloomberg, CNBC, Cornerstone Macro Research, The Economist, Evercore ISI, Federal Reserve, The Financial Times, Fox Business, Goldman Sachs, International Monetary Fund, Morgan Stanley, The New York Times, Real Money – TheStreet, Renaissance Macro, Reuters and The Wall Street Journal.

The views and opinions are those of the author at the time of publication and are subject to change at any time due to market or economic conditions. This document has been prepared solely for informational purposes. This is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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