The irony of all of this is that while many hedge funds are losing out the smart operators on Wall Street, the market makers, will reap a huge payday from all this activity. What has enabled this behaviour in markets and the tsunami of new investors is the free commission in the US for trading stocks and stock options which ultimately is a function of the ‘payment for order flow’ which is legal in the US but not allowed in Europe. This means that brokerage firms such as Robinhood and ETrade can offer “free” trading but is selling the order flow to US market makers which can then internalize this flow against their institutional flow, but the retail flow also contains valuable information that can be used in setting bid-ask prices etc. If this short squeeze activity continues and it causes financial instability or liquidity drainage then US regulators might increase margin requirement on stock options to curb speculation and ultimately the payment for order flow rule may be changed longer term.
The calm land of the quants sits in a raging storm
The current short squeeze explained above is interestingly enough a derivative of the gigantic market shift that happened in late 2019 when large traditional US brokers followed the footsteps of Robinhood and offered commission free trading in US stocks and stock options. A structural shift happened with a new group of investors accelerating fast, but then came the pandemic and turbocharged the ongoing trend and supersized the group of new investors trading for free. This group of investors seeks information from many different sources and do not necessarily trust established brokers and hence the popularity of Reddit’s WallStreetBets rose dramatically.
This new group of investors are viewing the world of investing in a very different way causing traditional patterns over many decades to break across medium-term frequencies (monthly observation typically used by traditional quant equity strategies). The result has been soaring non-profitable companies and the value factor to underperform to such a degree that large amount of capital is fleeting the value behemoth AQR. The co-founder and CEO of AQR, Cliff Asness, went on Bloomberg TV recently in a great interview and talked about the status about quant investing and you can really feel his pain and the low probability event that things may have changed for good, with old patterns never coming back. Other quant firms such as Two Sigma and Renaissance Technologies have experienced a terrible 2020 across their medium-term frequency quant funds highlighting that we have experienced a statistically significant break in the market structure. At least for now, and it seems the recent short squeeze is adding to the pain with these funds continuing to lose money in first month of 2021.
Tesla expects to growth 50% annually for many years
There are fortunately other things going on than short squeezes with the Q4 earnings season in full swing. Yesterday, we got very strong earnings from Apple beating estimates on both revenue and earnings, but the world’s most valuable company did not deliver an outlook and that spooked investors. When the dust has settled we guess the market will embrace Apple’s result as being phenomenal and management provided clarity of the supply situation of semiconductors saying the demand and supply would be balanced in the current quarter which means that Apple will be able to deliver another strong quarter as the iPhone 12 upgrade cycle continues. Facebook also delivered a beat on both revenue and earnings although highlighting increased headwinds and uncertainty as the lockdowns are eased as they have added tailwind to online advertising and engagement on Facebook’s social media platforms.
The most anticipated earnings release came from Tesla which beat expectations on revenue and missed a bit on earnings, but then positively surprised on free cash flow. Management said that is sufficient funding to fund the current production roadmap and that production capacity will be expanded as fast as possible. Tesla also put out a strong outlook saying that it expects to grow around 50% annually in coming years on deliveries and revenue. The company also had its best quarter ever in the Energy Generation & Storage segment, but this business line is still operating at negative gross margin. The biggest positive thing about Tesla is the free cash flow generation reaching $2.8bn in the last 12 months translating into a company with a free cash flow yield of 3.4% which is on par with other technology companies such as Microsoft, Facebook etc. and means that given the growth profile that the stock is not overvalued. The market was efficient after all in the sense that is correctly discounted the jump in cash flows. There is on key risk to Tesla though and that is the losing market share in Europe which Bloomberg wrote about yesterday. Volkswagen is accelerating its push into EV and that will make it more difficult for Tesla but it will not change the fact that Tesla will likely be in the top 3 on EV production and volume in the decades to come.