When Does the Game Stop?

This piece is written by a third party because we think highly of the author and their perspective. It may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

Pete published this yesterday (Feb. 1) on his website.


The current state of equity markets is part of a broader progression over many years, as was the South Sea bubble, which has many lessons applicable to current circumstances.

How Did We Get Here? What’s happening now in equity markets isn’t the product of some paradigmatic democratization of finance. It’s likely just another bubble that will end badly. In my view, the behavior fueling the bubble is the culmination of many factors as follows:

  • Monetary Policy. Monetary policy action has given retail and professional investors alike comfort that the Fed has their backs at all times. Despite the fact that policy space is non-existent, the chant ‘don’t fight the Fed’ is burned into peoples’ minds. Pavlovian responses are hard to break. Low rates have also enabled companies to issue inexpensive debt (as Apple just did) to buy back shares and increase share scarcity. Notwithstanding this scarcity, low rates do not lead to ever-higher valuation multiples. It takes lower-and-lower rates to do that. At zero, they can go no lower.
  • Fiscal Policy. Fiscal policy choices are almost always made to pander to political bases, but the extremely polarized environment has made decisions even less objective. Politicians should stop trying to get ‘likes’ and start leading by making adult choices. The fiscal policy driven explosion in money supply (M2) has helped fuel the manic demand for equities. The pandemic has made for hard choices, and the next phase of relief is a make or break decision for the economy… and not in the way most may think.
  • Technology. Social media has generally brought extreme behaviors to normalcy – whether its pornography, racism, gambling, or otherwise. Markets simply reflect the broader societal trend and have become more like casinos. That doesn’t mean the behavior or opinions should be censored, unless there is an overwhelming public purpose. For every retail investor who says F&*K IT I’M IN, there will be others – some professionals – who say F&*K IT, I’M OUT. That’s the mechanism that will correct for the current misbehavior. When markets lose credibility and rationality, investors tend to opt out.
  • Might the Game Continue? Surely, it could for some time. In particular, new stimulus (supplementary direct deposits) could continue to fuel the speculative bubble in equities despite the substantial economic tradeoffs in the form of higher taxes and rising yields.[7] Clearly, those in love with equities now aren’t considering much beyond the next time they see a confetti bomb. Even this only delays the inevitable.
  • May I Make a Suggestion? I implore legislators to consider revising the income limits for the stimulus checks. Give more to the lower income families who need it most. The $150,000 joint AGI limit on stimulus checks is absurd (at more than twice the median household income)! It may make you popular, but it’s profligate and irresponsible. At least some portion of it is being used to speculate in equity markets, and it risks overheating not only equity markets but the economy. If the latter happens, the Fed will need to raise rates sooner than it has guided (i.e. – it’s almost never guidance), and that will be a cataclysmic occurrence for markets and the real economy. Target the measures to necessities: rent forbearance, food, healthcare, unemployment assistance, small business loans, etc.


Recent price action in OTC equity markets and in roughly a dozen names with high short interest is the culmination of a broader progression. It amplifies the observation that many markets – equity markets in particular – now have little to do with the fundamentals of underlying assets.[1] What Bitcoin has in common with GameStop is the idea of asset scarcity paired with a vague narrative that ‘something big’ is happening. Shorts squeezes occur on limited supply. As the argument goes, Bitcoin is in limited supply.[2] Its success, and the reason for it, has emboldened speculation in equities. Some market participants have discovered that the value of the chairs go up the fewer chairs there are. Here’s the problem: eventually there’s just one person in a chair. The rest have nada. This kind of speculation based on scarcity isn’t new. It happened in Holland in 1636 in tulips. It happened again in 1719 with the South Sea Company… and again and again.

This is more than just a sexy story about everyman beating the big dogs.[3] It has real and broad implications. Importantly, overvaluation and mispricings in equity markets have impacted pricing in corporate credit markets. In a number of cases, companies have smartly used irrationally overpriced equities to refinance debt and maintain unprofitable operations.[4] Reflexively, this delays the repricing in equities as bankruptcy risk is diminished. A new generation of arrogant, day traders is only partly responsible. They will eventually learn – just as we all have at some point – the hard way. We’ve seen it before, and it should come as little surprise. Whether you trade out of Mom’s basement, from a nice living room with a couple of kids running around, or in a suit on Park Avenue, markets don’t discriminate. As far as they’re concerned, stupid is as stupid does – eventually, at least. Just wait … the game will stop. It’s a matter of when not if.[5]

Has the market’s malfunction finally become so obvious that the credibility of equity markets is at risk? Targeted short squeezes are not a new phenomenon nor is gamma (or leverage) in options markets. Their most recent manifestation is new. The recent squeeze serves as a convenient and plausible explanation for recent hedge fund de-grossing and last week’s market selloff, but it’s far from the only cause. Credibility in markets is essential and fragile. Paired with extremely bullish sentiment, an already extant valuation bubble, high corporate leverage, extremely high retail margin levels and institutional gross exposures, uncertainly around new virus strains, and little visibility around earnings, the end of the recent squeeze (when it finally happens) could serve as a catalyst for a broader de-risking.[6] Bubbles can pop at any time and for any reason with post facto attributions typically pointing to the most recent and obvious event.


There’s an expression popular in Brazil: “Estou rindo para nao chorar.” It translates: “I’m laughing, so I don’t cry.” It’s laughable that the same politicians that want more regulation are now complaining about Robinhood curtailing activity when it was regulatory capital requirements that necessitated it. Those requirements serve an important public purpose; they assure the stability of the financial system. Moreover, politicians are complaining about payment for order flow, but that’s precisely what allows for commission free trading. In other words, without institutions paying for Robinhood’s flow, because Robinhood has no significant revenue directly from its online clients, it could not exist. While not surprising, it’s somehow still frustrating to hear visceral responses from the likes of AOC and others designed exclusively to pander to their bases without having even a remote understanding of market structure.

The fact that Citron’s Andrew Left and other media named short players have ‘capitulated’ may be a signal that the game is about to stop. Short interest will fall just as the pool of greater fools buying those same overvalued stocks begins to dwindle. As fewer short players participate, ‘borrow’ will loosen and diminish the scarcity. When the pool of speculators is finally exhausted – and it will be – it will be a lesson hard learned for those still in the trade. That’s what markets always do eventually; they humble all of us over time. It’s simply part of the learning curve over a long enough period of time. (Day trading for a few years does not qualify). Ultimately, markets punish those who make overly emotional or uninformed decisions. In this case, it’s taking more time than usual because of the sheer number of social media participants, most of whom haven’t seen a real selloff. The South Sea Bubble, too, was a populist event based on the public being ‘given access’ to an asset previously reserved for the elite; it took nine years to build and popped in a year.

What we’ve been witnessing is not some democratization of investing, it’s the kind of mob behavior that is almost always associated with bubbles and the catastrophe that follows. A Bloomberg story articulated it well: “The absurdist morality tale over the unalienable right of Redditors to pump up meme stocks and punish Wall Street has obscured a more reckless impulse.”[8] In order for a company like GameStop to experience a continued rush in its stock price, a few things would need to happen over time. First, it would need to generate far more revenue and quickly perform unlikely operational miracles. Revenue has fallen almost 50% from 2012 to 2021 and even optimistic projections have it rising only modestly for 2022 and 2023. Because of irrational equity markets, it could certainly do at-the-money (ATM) equity offerings as AMC has done to take advantage of its current equity valuation. That could buy it more time to fight the secular decline in its business and help it to reinvent, but no matter who joins the Board, the Chew-ification of the company has massive risk. It will take time. I participated I the restructuring of Atkin Nutritionals long before Rob Lowe became spokesman. It’s slog.

I had no idea that this was ‘a thing,’ but according to the above referenced story, Robinhood sends confetti to users when they trade: “Whenever Robinhood sends confetti to app users who place a trade, for example, it’s ‘kind of like with slot machines, they’re so colorful and loud and noisy,’ Mothner said. ‘Those little jolts feed the desire to keep going.’” Like just about everything on social media, the rush is fueled by bravado and ‘likes,’ which are pretty ephemeral. Retail may be ‘winning’ against the ‘elite’ now, but that doesn’t frame the conflict properly. We are all losers against the rest of the world if our free market system for pricing risk loses credibility. Ever hear of JT Marlin? The new Boiler Rooms are simply the online stock forums. Pump and dump is alive and well; it’s just been reinvented in a more insidious form. Eventually, thoughtful investing will return, but only after those who can least afford to lose money, lose it.

Gamma Hammer

There’s been some suggestion that the short squeeze impacting mostly hedge fund short positions is causing a broader hedge fund de-risking. It’s certainly a sexy narrative to suggest that retail traders are forcing a broad deleveraging amongst hedge funds, but is it true? Well, it’s almost impossible to know. However, market sentiment can be fragile, as Lu Wang and Melissa Karsch wrote: “Wednesday’s plunge widened to encompass stocks in the broader category of ‘recent winners.’ First among those was the ARK Innovation ETF (ticker ARKK), which surged about 150% last year with wagers on momentum-driven tech stocks.”[9] I’d written about how ARKK was a posterchild for the foolishness afoot in my last piece Fantasy World. Also according to the same authors in a different story, Goldman clients experienced the biggest one-day decrease in gross leverage on Thursday. Still, at 237%, leverage sat in the 96th percentile of a one-year range.[10] There could be more de-risking to come especially because margin leverage at retail accounts is also at all-time highs.

Leverage has proliferated in other ways. Options are, indeed, one of them. When a customer (retail or otherwise) comes in to place an order to buy an out-of-the-money option, a market maker (as opposed to an agency participant) will sell that customer the call option. That short call may sit on the market makers balance sheet; if so, the market maker is at risk. A short call is synthetically equivalent to short stock. The farther out of the money the option’s strike price, the lower the delta to that option (i.e. – its share equivalent). Nonetheless, in order to offset its short exposure, the market maker will usually buy the share equivalent of that option in underlying shares – creating a bid for the shares and potentially driving up the price. If the underlying price moves closer to the strike price for that option, the customer  may begin making money while the market maker may begin losing money (all else equal) – unless it buys more shares. In fact, gamma is the leverage on an option that makes the owner synthetically longer (and the market maker synthetically shorter) as the underlying stock price approaches the strike price. The market maker must buy more shares in response to this change.

As a squeeze occurs, this impact is exacerbated because it happens quickly – forcing the market maker to aggressively buy shares. This is how the power of the retail crowd was amplified – through leverage. It’s a temporary impact and not a paradigm shift. Now that this dynamic is well-known, the game is likely to stop as market makers aren’t dummies (just the opposite). They will take steps to hedge or modify their participation in irrationally priced securities. Some brokerages have already done so. They must protect their own capital positions in a highly regulated environment. As for some hedge funds, the squeeze in their short share positions may have prompted a temporary de-leveraging as prime brokers required more capital and eliminated margin on impacted names and potentially impacted ones, but this specific effect won’t be the singular reason for a broader selloff. This is not to say a broader selloff won’t occur, as the equity markets find themselves precariously positioned. Sometimes it doesn’t take much to break the back of sentiment.

Going South

Remembering a bit of history might help us learn from its mistakes. In the 18th Century, England was a class-based society (some might say it still is). The lower classes did not have access to markets unless permitted to do so by the elites. Such opportunities were scarce. Until 1711, when the South Sea Company formed, England had been engaged in the War of Spanish Succession. Spain and Portugal were in control of most of South American trade. Parliament looked for ways to fund its war efforts. They included two lotteries – yes, lotteries. The lotteries lost credibility when it became clear the government was providing a deferred annuity instead of a lump sum prize that it had funds to pay. The government also owed a significant sum to various private creditors, including debt owed to the public through those lotteries. The company was endowed with the exclusive right to trade with South America, under the assumption it would be able to do so after a treaty was signed.

In return for this, The South Sea Company underwrote the English National Debt. In other words, the existing national debt was cancelled and restructured as equity in the new Company, which issued shares to the former creditors with the promise of about a 6% dividend. The purpose of a series of conversions between the company’s formation and into 1719 intended for debt holders and annuitants to receive a haircut to their principal in exchange for shares. They converted an illiquid investment into shares that could be readily traded. Unsurprisingly, shares backed by the implicit government guarantee were considered safe – despite the lack of cash flow. The paper form also provided for a convenient way to hold and move money – far easier than coinage. A final conversion occurred in early 1720 alongside a delay in the dividend.

To increase confidence after the dividend deferral, the company talked up its stock based on the value of its potential trade in the New World. The share price rose from £128 in January 1720, to £175 in February, to £330 in March and to £550 at the end of May. A credit backstop of £70 million made available by the Parliament and King may have made this investment seem all the more bullet proof – despite the fact the company was not generating significant revenue and the validity of trade routes remained in international dispute. According to Historic UK, the frenzy spread to other companies:

“One company floated was to buy the Irish Bogs, another to manufacture a gun to fire square cannon balls and the most ludicrous of all ‘for carrying-on an undertaking of great advantage’ but no-one to know what it is! The country went wild, stocks increased and huge fortunes were made.”

We all know how it ended; fortunes were lost and then some. There was no one specific catalyst for the collapse except that reality eventually collided with the hype. There were no greater fools left to buy the shares of a company that could not deliver on its promises, and scarcity alone was not enough to maintain its value.

Aside from the scarcity effect, there are a plethora of other similarities between the speculation of today and during the South Sea bubble. One of the most obvious similarities would seem to be the involvement of the government, which throughout history has had a penchant for distorting incentives and giving people a sense of empowerment only to make to leave them in the cold. A second would be the involvement of a public that bought the bogus narrative late in the game. As Bloomberg reporters Greifeld and Ballentine wrote about GameStop’s impacts:

“The mania quickly spread to other meme stocks like BlackBerry, AMC Entertainment and Express, which each soared to highs unseen in years. The surge in trading activity, and the tremendous volatility it caused, prompted Robinhood and other online brokerages to restrict purchases of some of the Reddit-fueled names, sparking outrage on both sides of the aisle in Congress, and sowing darker, conspiratorial motives among WSB users.”

This sounds eerily familiar to what happened 300 years ago. There is also no coincidence that government sanctioned gambling made the populace then comfortable with this kind of risk taking.

There are also some important differences. One of them is that the retail investors on Reddit and elsewhere may be bag men and not even know it. Levels of sophistication on these forums vary widely. Anybody can start a meme that gores viral. Nobody knows their intention.[11] Unlike 300 years ago, there is no fraud being perpetrated by the companies or the hedge funds that are at the center of the anger. In contrast, the South Sea Company did perpetrate such frauds by over brokering its prospects. This is what the plethora of SEC and FINRA regulations to protect retail investors is designed to do. It was never contemplated to protect retail investors from themselves unless there’s fraud. This problem is far thornier as it involves First Amendment rights. The forum users are likely misleading each other – I’m guessing in most cases innocently and unwittingly. While the collapse of the South Sea bubble led to systemic issues and suicides, standing alone, the current mania would be unlikely to result in a market de-grossing. However, this was already likely to happen given the fantasy world in which equities currently exist. The condition has simply been laid bare in a unique way this time around.


Unfortunately, nobody likes it when their parents tell them they are being reckless, but wrapping the car around a tree and barely getting out alive often does the trick. It’s part of growing up and part of learning to invest. I was 18 once, and it happened to me. I learned to pay attention while driving. Many of my peers who are far more bullish than I – that’s pretty much all of them – are relying on a burst in GDP and earnings to support higher index price forecasts. Let’s get real. It’s the stimulus you’re relying on. That’s it. GDP will likely spike because of it. The extent of the spike is an exercise in finger wetting. SA strong GDP print won’t be the driver for equities. GDP hasn’t mattered for a long time, and I doubt it will change risk appetites much in 2021.

Earnings on the other hand are where I believe the disappointment will come. While for years they haven’t mattered much either, the stark reality now is that the Fed can’t act within its non-emergency framework to help support risk assets. All else equal, only lower rates boost asset values; rates are zero and bond yields are close. I also believe an extraordinary risk exists in too much fiscal stimulus to the wrong recipients. This could lead to a further overheat in the equity markets and in the real economy. The latter could necessitate a hike long before the Fed is ready. That is one sure fire way to prick this bubble and to hurt Main Street in the process. Sometimes less is more, Nancy, Chuck and Mitch. Be macro-prudential and not grandiose. I know it’s hard.


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[1] Newbies Discover Penny Stocks and 1 Trillion Shares Get Traded. https://www.bloomberg.com/news/articles/2021-01-14/one-trillion-off-exchange-shares-traded-is-latest-froth-marker

[2] This part of the narrative around Bitcoin makes little sense as it can be readily substituted for by other forms of crypto. At some point, the manufactured scarcity narrative will likely fall apart.

[3] Many Reddit forum users and others are far more sophisticated than often characterized with some encouraging groups to ask their brokers not to lend out shares – increasing scarcity and exacerbating the squeeze.

[4] AMC, in particular, provides a spectacular example of how a company uses the equity markets to continue to fund itself and maintain ultimately unsustainable levels of leverage. The company has done what any smart operator might. When equity markets are open, it issues shares. It has been doing so using the ATM (at-the-market) process, which makes dilution to existing shareholders less obvious. It has raised over $800 million in proceeds, which has provided it with ample liquidity for at least this year. Thus, despite a business in secular decline and a pandemic, it now has about $1.4 billion in cash.

[5] I wrote my first piece entitled Robinhood Rally in September of 2019. It pointed out the importance of retail investing in boosting equity valuations. Also see: https://www.businessinsider.com/stock-market-crash-3-pieces-investing-advice-stock-market-bubble-2021-1.

[6] Interestingly, most bubbles pop when leverage forces losses. ‘Gamma’ is just a fancy way to talk about the leverage an options creates for its holder or a counter-party to that holder.

[7] What drives rising long-dated yields is a more complex discussion, which most mischaracterize. However, when speculation is in force, market participants tend to eschew long-duration risk free assets for equities. This leads to a rise in risk-free long-dated yields – just as the converse occurs on risk-off. This is not in fact driven directly by inflation, which has no direct way to impact long yields. Counteracting this effect is the Fed’s messaging about inflation and rate policy staying low for longer (i.e. – the Fed reaction function). Because long yields are the geometric average of short yields over time, this keeps long yields low. Carry trade arbitrage is the mechanism for it (buy long fund short). Uncertainty around future policy is the most important reason for term-premia to exist. Should the economy overheat because of excess stimulus, the expectation could change relative to the trajectory of rates, and yields could rise.

[8] GameStop Mania Is Delivering a Dangerous Rush to the Reddit Mob, by Katie Greifeld and Claire Ballentine. “But what’s been obscured of late by the morality tale over the unalienable right of Redditors to pump up meme stocks as a way to redistribute wealth is this: that many of these mostly young men, cooped up with little else to do during the pandemic, have banded together for the pure, unadulterated rush of gambling and hitting it big, again and again.”

[9] https://www.bloomberg.com/news/articles/2021-01-27/hedge-fund-favorites-are-telltale-leaders-in-broad-stock-selloff

[10] https://www.bloomberg.com/news/articles/2021-01-29/hedge-fund-pressure-lingers-with-short-sellers-targets-rallying

[11] Meet the GameStop investor upending the stock market with cat memes, reaction GIFs, and fundamental analysis. https://markets.businessinsider.com/news/stocks/gamestop-investor-deepfuckingvalue-roaring-kitty-reddit-stocks-wall-street-2021-1-1030022004. Perhaps at $4 it made sense!

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  1. Avatar for glarri glarri says:

    The $150,000 joint AGI limit on stimulus checks is absurd”

    It could be the other way around, that it is best to send stimulus checks to everyone, even Jeff Bezos. Why do such a seemingly mad thing? If the people who are wealthy enough not to need a stimulus check are a small enough percentage of the population (say 2% of the population), the administrative cost and delay of figuring our who is and is not to receive stimulus checks might be more than the cost of including the wealthy and the rich people stimulus checks. After all it only costs 2% more to include the most wealthy 2%.

    Also it won’t change their spending by much, if at all, so it’s not going to increase inflation.

    And if you really care, claw it back under the tax code. The wealthy and the rich will be filing tax returns anyway.

  2. It should be indexed to the filing status (including children) and local poverty level or median income. 100k for a family in a major city isn’t rich. 100k for a family in a rural area most likely is. I agree your approach is also viable, not that we will likely get tax code reform soon.

  3. I think derivatives are going to be the next MBS / CDO. It’s not that they’re inherently bad, but they obscure and multiply effects to an extreme level. If all transactions cleared instantly, perhaps not, but at high volumes we’ve shown they don’t.

    Look at the GME / SPX movements during the heights of the squeeze. They invert themselves to a fair degree. This is a recently 2B company (< 30B at peak insanity) which seemed to have a measurable effect of a diverse set of industries with total market cap over 1,000 times the size (at 31T). That is not good.

  4. The $150,000 joint AGI limit on stimulus checks is absurd (at more than twice the median household income)!”

    This is unbelievably cringeworthy. Imagine being so out-of-touch that you think a global pandemic isn’t brutal and decimating for an individual who makes $100,00+. As if making barely six figures somehow insulates your business, your profession, or your family from what happened.

  5. It makes rational sense to either have a steep reduction to qualify for stimulus checks or pay everyone to save admin costs. After all $1000 is 10% of a McDonald employee income and .00000000% of Elon’s pile of equity.

    However in the real world, sending checks to billionaires would not sell on the left and paying $1000 to “illegals” will get the right riled up.

    Paying higher middle class earners stinky is a dog bone to preempt disgust from all those that think the Poors are nothing but lecherous minority welfare queens lazily feeding off the sweat of white suburban work ethic and enterpreneural sweat.

    Often, the mathematically rational choice is politically harder than it looks.

  6. An upfront apology for responding to a single issue rather than the article as a whole, but I think it is worthwhile in this instance.

    The statement “The $150,000 joint AGI limit on stimulus checks is absurd” comes across as an opinion dressed up as fact in this article. Considering what is on the line, we should all ask for supportive facts before letting this assertion be upgraded to fact. Calling it profligate and irresponsible does not make it so.

    I understand from this article that the author feels strongly that fiscal stimulus of this kind will lead to overheating of equity markets and the economy in general, but I am not clear on his evidence for thinking that it will. His further speculation that this will lead to higher interest rates sooner, is also speculation considering the new “average inflation” approach and requires further supportive facts in order to be taken seriously. It is not that I completely disagree, far from it. But the “fix” presented i.e means testing of some sort, is a cost and consequence-free alternative, and this is far from true.

    The author clearly feels that government stimulus should have a strong element of “means testing” in order to be palatable to him. Considering that means testing has many, well-documented, real-world costs and disadvantages, we should make good use of our clear eyes and full hearts before allowing arguments based on a strong preference for means testing to be dressed up as fact-based fear of inflation.

    Means tested government support is not just more expensive to run, it also encourages very expensive “gaming” of the system which leads to economically relevant decisions such as number of children, and absences from the work force (i.e. tax generation for the country). The fact that many of these “choices” are hard to track economically, is not an argument against them - but rather an argument for digging deeper than GDP when conducting research.

    Perhaps more importantly, I think so certainly, means tested programs also become difficult to maintain politically, as those people with resources and motivation to involve themselves politically are excluded. The proverbial skin-in-the-game is removed, and hence the overall likelihood of success for any program. Surely we are past the point of thinking that different socio-economic classes are not inter-dependent…a certain virus comes to mind.

    Considering where we are at this particular moment, where inequality of just about anything you can think of (opportunity, outcome etc. etc.) it seems like an odd time to be irrationally concerned with higher inflation and interest rates.

    It may not be irrational at all, but if so, the assertion should at the very least be supported by facts. Without these facts, it looks a lot like a political conviction about the role of government and lack of empathy for existential-level issues (unrelated to interest rates) on both an individual and population level.

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