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Passives, pensions and populists: stock market warnings from Carson Block

It’s not the Reddit-crowd that is destined to break the stock markets, according to the famed activist short-seller
Passives, pensions and populists: stock market warnings from Carson Block
  • Carson Block is worried that the ‘stock market powder keg’ might soon explode
  • Avoiding the carnage is a tough task for retail investors

Five minutes in discussion with Carson Block is a wonderfully cathartic experience. “I was recently struggling to assemble a step and repeat to do some filming,” he recalls “and I took the metal frame and smashed it into the tiled floor. I destroyed that thing and I have no regrets, it felt good.”

It’s that feeling of pent up anger which the Muddy Waters’ founder thinks is responsible for the recent rampage on Wall Street, facilitated by commenters in Reddit channel r/wallstreetbets. “Everybody in societies that have been hit by Covid is angry, we are all just struggling to keep ourselves together”. 

While Mr Block likes “the occasional outlet of physical violence against an inanimate object”, others have turned their anger into an investing mob. “I don’t believe the narrative that this is anger at the establishment,” he says, “it’s that latent anger which has come to the surface. Everybody wants to break something.” 

It’s tough to deny that the Reddit crew whose organised trading caused a surge in the share price of bricks and mortar video game company GameStop (US: GME) inflicted pain on several Wall Street hedge funds. Melvin Capital, for example, reportedly lost 53 per cent in value in January after being forced to cover its short position in GameStop, while Muddy Waters itself reduced its own short positions to avoid being burned. But that pain is only likely to be temporary. What’s more permanent is the fact that the stock markets are not functioning as they should. The Redditors’ stampede is clear evidence that company valuations have become completely dissociated from reality. Bubble territory.  

Mr Block has spoken before about the stock market powder keg. “Since the 1980s we’ve had too much leverage in the system,” he explains. When LTCM blew up, the banks bailed it out. Then came the internet stock bubble which, once again, led to the creation of more credit. The same was true when the housing market collapsed and in 2020 when demand and supply were both crushed by Covid-19, the central bank’s cure was more credit. “When you get to a point where money is so cheap, investors end up chasing too much risk for too little reward.” 

But how to deal with this as a retail investor? “It’s really difficult for me to give this advice,” says Mr Block. That’s hardly surprising. Markets have been malfunctioning for years if not decades, but investors who have remained on the periphery have missed out on major returns. 

But while Mr Block doesn’t think that eshewing stocks is the right course of action, he says it is vital that retail investors understand what passive investing is doing to the market. “A friend of mine has done some research,” he says, and has found that active investment can increase a $1 stake in a company to $2.5 – this multiplier is restricted by the fact that active investors have to find someone willing to sell their shares. But the passive investment multiplier effect is unrestricted, meaning a $1 passive investment can increase the market capitalisation of a company by 17 times. “On 99 out of 100 days, this is a positive system for retail investors, but it has made equity markets very fragile and when it breaks it’s going to break hard.”

In March last year, Mr Block was convinced that the Covid-19 stock market sell-off had sparked the unravelling of this system, but he admits he hadn’t considered that “the Fed was going to be able to put the toothpaste back in the tube,” with another generous credit splurge. “But,” he warns, “at some point it doesn’t work.”

Looking ahead to what might cause the break, Mr Block is concerned about the impact of unemployment. Many 401k (pension) plans keep buying passives, but unemployment could at some point force the 401k passive demand to taper off, while the impact of people pulling their pensions out of the stock market could spark some active selling. “I don’t know when things break down, but I think they could break down at any time,” says Mr Block, “we’re not talking about the economic fundamentals. We’re basically talking about flow dynamics.”

The overriding message from the famed short activist is caution. The retail traders who attempted to get one-up on Wall Street with their surge into GameStop have already been burned by the inevitable fall – reckless behaviour at a time when the markets are already incredibly fragile is not going to help anyone. Nor is the excessive use of free trade platforms which – like all ‘free’ digital products – make money from the data they gather on their customers. When picking their stocks, retail investors seeking to survive the circulating carnage should perhaps ask the question that, according to Mr Block, is at the heart of healthy markets: “which companies are the best users of my capital?”