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Melvin Capital, GameStop and the road to disaster

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It was a routine regulatory filing, the kind hedge funds must make every three months, where Melvin Capital first showed its hand.

The “Form 13F” filing that landed on August 14 last year listed 91 positions it held at the end of the second quarter, including shareholdings in household names from Microsoft and Amazon to Crocs and Domino’s Pizza. Halfway down the list: an apparently innocuous bet against GameStop, a struggling video game retailer.

That the New York hedge fund should think GameStop’s shares were going lower was hardly remarkable — many others were betting the same way. Wall Street analysts had sell ratings on the stock and the retailer’s prospects looked grim as gamers switched to downloads. But by using the options market for the bet, which forced it to disclose the position, Melvin had put a target on itself.

An eagled-eyed Reddit user called Stonksflyingup was not the only one to spot Melvin’s position, but they might have been the most prescient. In an October 27 video posted on the WallStreetBets message board — titled “GME Squeeze and the Demise of Melvin Capital”, using GameStop’s three-letter stock market ticker — the Redditor used a scene from TV show Chernobyl to portray Melvin as a nuclear reactor that would blow up when its bet against GameStop went wrong.

Within six months, half of Melvin’s $13bn fund had been wiped out.

The David-and-Goliath narrative of the events, in which retail investors organised on Reddit overwhelmed the short-sellers who had bet against GameStop, has captured the imagination far beyond Wall Street. To many in the hedge fund industry, however, the tale has raised the more prosaic question of why Melvin left itself so exposed and why it didn’t reverse out of the trade earlier — questions it will ultimately have to answer to its clients. 

“I don’t get why Melvin were there, I just don’t get it,” said one prominent short seller who had looked at GameStop but decided not to bet against the company.

Line chart of Borrowed GameStop shares as % of outstanding showing Short sellers squeezed in crowded GameStop bet

GameStop had been a favourite target of short-sellers for some time. The proportion of shares borrowed to back those short positions had been between 50 and 100 per cent of the company’s total stock over the first half of last year, according to IHS Markit. The shares traded between $3 and $6.

“We get really uncomfortable if one of our shorts has a 10 per cent short interest ratio,” the short-seller said. The higher the short interest, the higher the risk, since if everyone rushed to exit their positions at once, a sudden surge in demand to buy back stock would push the price up further — a classic short squeeze. “That’s the part where the retail people got it right, to their credit.”

Melvin declined to comment.

That Melvin was caught in such a squeeze is particularly surprising given the reputation of Gabe Plotkin, who founded the fund in 2014 after years working for Steve Cohen at SAC Capital Management. Cohen viewed him as one of the best traders he had ever worked with, and put money into Melvin early on. Plotkin was able to be picky about which investors’ cash he took, and would lock up money for longer than most other equity hedge funds.

At SAC and at Melvin, Plotkin was known as a low-profile but aggressive trader. He did not focus solely on short selling, and often ran bigger bets on rising share prices. Nevertheless, he had a reputation for punchy short positions. Melvin was running two of the five biggest short positions in Europe last month, for example, as measured by short interest in a company’s stock, according to data group Breakout Point.

Melvin’s August filing showed it owned put options for 3.4m GameStop shares, instruments that rise in value as the stock goes down. Buying puts is typically seen as lower risk than traditional shorting. Puts give you the right to sell shares at what you hope is an advantageous price, but do not commit you to doing so, capping losses at the cost of the option, whereas losses from shorting can be unlimited. But a 13F provides only partial details from which it is not possible to calculate a fund’s total short exposure, and Wall Street continues to speculate about the full extent of Melvin’s position. It was enough to tip its hand.

The next quarterly filing revealed something else: Plotkin was doubling down. Melvin’s options position had grown to 5.4m shares over the third quarter, according to the 13F published on November 16, even as the share price had risen by 135 per cent, to $10.20.

GameStop shares became detached from the reality of its business prospects © AP

The posts about Melvin on Reddit became more frequent as traders on the forum declared war on the hedge fund by promising to drive the shares “to the moon”. GME next to rocket emojis became a frequent sight on WallStreetBets and users referred to GameStop as “the real greatest short burn of the century”.

The growing riskiness of the short positions had also not gone unnoticed among professional traders.

Fund managers who specialise in investing in undervalued stocks often look at the most heavily shorted companies to identify potential candidates, since if they are right and the stock eventually goes up, a rush to the exits by the short-sellers can help drive the price up further and faster.


53%


Melvin Capital’s losses in January

Senvest, another New York hedge fund, noted the short interest when it bought into GameStop in September, for example, according to an interview its founders gave to The Wall Street Journal, which revealed their $700m gain on the stock.

An important aspect of short selling involves closely monitoring trading volume in targeted stocks, said Brad Lamensdorf, a long-short hedge fund trader who runs Active Alts. 

“All investors need to create some kind of process to monitor the market. Volume precedes price action,” he said, and the trading history of GameStop contained signs of heavy buying back in November and December.

“When you see that kind of heavy sponsorship and accumulation of a stock, it represents a dangerous signal for short sellers,” said Lamensdorf.

Line chart of Share price at market close ($) showing GameStop shares did indeed go 'to the moon'. And back.

As Reddit day traders and others piled in, longtime short sellers like Melvin had to decide which way to jump. Those who got out their positions before the end of the year, as the stock soared towards $20, suffered heavy losses — but not as heavy as those who waited until the middle of January, when the founder of Chewy.com joined GameStop’s board promising to bring it into the digital era, after which the share price went parabolic. 

The temptation to stay the course was obvious, since GameStop shares had become detached from the reality of its business prospects and would one day tumble. But with the level of short interest going up, not down, the risks were mounting. Meanwhile, investors started trying to squeeze short sellers out of other popular positions, too, such as the cinema chain AMC, the tech group BlackBerry and more. Many of Melvin’s shorts sustained losses in the melee.

“The stocks in question are, from a market cap perspective, little guys,” said Brian Barish, president of Cambiar Investors. “What the Reddit crowd have gotten right is that this ecology was ripe for being upset by a sudden surge in trading. Even if GameStop has very poor long-term viability, shorting it this much to express this opinion is just too damn dangerous.”

When Plotkin was forced to exit his bet against GameStop last week and crystallise its losses, the shares peaked at $483 on the day, a rise of 11,000 per cent since the second quarter of last year. Melvin took an emergency cash injection of $2.75bn from two other hedge funds — $750m from Cohen’s Point72 Asset Management and $2bn from Ken Griffin’s Citadel — to deal with the losses and top up the fund. It had lost 53 per cent of the $13bn it was managing at the start of January over the course of just one month.

Melvin is now faced with the task of picking itself up from the debacle, with the eyes of the industry upon it but at least with two powerful endorsements. “I’ve known Gabe Plotkin since 2006 and he is an exceptional investor and leader,” Cohen said last week as he doubled down on his protégé. Griffin, too, was public in his praise. “We have great confidence in Gabe and his team.”



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Copper hits record high with demand expected to rise sharply

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Copper prices hit a record high on Friday in the latest leg of a broad rally across commodity markets sparked by the reopening of major economies and booming demand for minerals needed for the green energy transition.

Copper, used in everything from electric vehicles to washing machines, rose as much as 1.2 per cent to $10,232 a tonne, surpassing its previous peak set in 2011 at the height of a previous commodities boom.

The price has more than doubled from its pandemic lows in March last year due to voracious demand from China, the biggest consumer of the metal, and also investors looking to bet on a big uptick in the global economy and protect their portfolios against potential for rising inflation.

Government stimulus packages and the shift towards electrification to meet the goals of the Paris agreement on climate change are expected to fuel further demand for the metal, which analysts and industry executives believe could hit $15,000 a tonne by 2025.

“Capacity utilisation rates of our customers are the highest in a decade and that’s before stimulus money both in Europe and the US has started to flow,” said Kostas Bintas, head of copper trading at Trafigura, one of the world’s biggest independent commodity traders. “That will be significant.”

The US and Europe were becoming significant factors in the consumption of copper for the first time in decades, he added. “Before, it’s effectively been a China-only story. That is changing fast.”

Concerns about the long-term supply of copper due to lack of investment by large miners has also pushed up prices. There are only a few large projects in a development, while most of the world’s easily produced copper has already been mined.

“The current pipeline of projects likely to start producing in the next few years represents only 2.3 per cent of forecast mine supply,” said Daniel Haynes, analyst at banking group ANZ. “This is well down on previous cycles, including 2010-13 when it reached 12 per cent.”

The upward march of other raw materials is showing no signs of abating. Steelmaking ingredient iron ore traded above $200 a tonne for the first time as China returned to work after the Labour Day holidays in early May. 

In spite of production cuts in Tangshan and Handan, two key steelmaking cities in China, analysts expect output to remain solid over the next couple of quarters. 

“Recent production cuts in Tangshan have boosted demand for higher-quality ore and prompted mills to build iron ore inventories as their margins are on the rise with steel supply being restricted,” said Erik Hedborg, a principal analyst at CRU Group.

“Iron ore producers are enjoying exceptionally high margins as around two-thirds of seaborne supply only require prices of $50 a tonne to break even.”

Elsewhere, tin on Thursday rose above $30,000 a tonne for the first time in a decade before easing. Tin is used to make solder — the substance that binds circuit boards and wiring — and is benefiting from strong demand from the electronics industry, which has been lifted by growing numbers of stay-at-home workers.

US wood prices continued to race higher ahead of the peak in the US homebuilding season in the summer with lumber futures rising to a record high above $1,600 per 1,000 board feet length, up from $330 this time last year.

Agricultural commodities also continued to rally as a result of a particularly dry season in Brazil, concerns about drought in the US and Chinese demand. Strong increases in food prices have started to affect global consumers. Corn rose to a more than eight-year high of $7.68 this week, while coffee has risen almost 10 per cent since the start of month, hitting a four-year high of $1.54 a pound this week.



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Wall Street stocks waver as investors await US jobs data

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Wall Street stock markets wavered, with tech losses dragging down some indices, but remained close to record highs ahead of US jobs data on Friday that could pile pressure on the Federal Reserve to rethink its ultra-supportive monetary policies.

The S&P 500 was up 0.2 per cent in the afternoon in New York, hovering slightly below its all-time high achieved late last month. The peak was reached following a long rally supported by the Fed and other central banks unleashing trillions of dollars into financial markets in pandemic emergency spending programmes.

The technology-heavy Nasdaq Composite, however, which is stacked with growth companies sensitive to changing interest rate expectations, was down 0.5 per cent by the afternoon in New York, the fifth straight losing session for the index.

The divergence of the two indices followed patterns from earlier this year, when investors sold out of growth companies over fears of rising rates and poured into more cyclical plays. That trade has been more muted recently but could be coming back, said Nick Frelinghuysen, a portfolio manager at Chilton Trust.

“It’s been a bit more ambiguous . . . in terms of what regime is leading this market higher, is it quality and growth or is it value and cyclicals?” Frelinghuysen said. “We’re in a little bit of a wait-and-see mode right now.”

The 10-year Treasury yield, which rose rapidly earlier this year amid inflation fears, declined 0.05 percentage points to 1.56 per cent on Thursday.

In Europe, the Stoxx 600 closed down 0.2 per cent, hovering just below its record high reached in mid-April.

With the US economy close to recovering losses incurred during coronavirus shutdowns, economists expect the US government to report on Friday that the nation’s employers created 1m new jobs in April. Investors will scrutinise the non-farm payrolls report for clues about possible next moves by the Fed, which has said it will continue with its $120bn a month of bond purchases until the labour market recovers.

Up to 1.5m jobs would “not be enough for the Fed to shift”, analysts at Standard Chartered said. “Between 1.5m and 2m, there is likely to be uncertainty on Fed perceptions.”

Central bankers worldwide had a strong “communications challenge” around the eventual withdrawal of emergency monetary support measures, said Roger Lee, head of UK equity strategy at Investec.

“If it is orderly, then you can expect a gentle continuation of this year’s stock market rotation” from lockdown beneficiaries such as technology shares into economically sensitive businesses such as oil producers and banks, Lee said. “If it is disorderly, it will be a case of ‘sell what you can’.”

On Thursday the Bank of England upgraded its growth forecasts for the UK economy but stopped short of following Canada in scaling back its asset purchases.

The BoE maintained the size of its quantitative easing programme at £895bn, while also keeping its main interest rate on hold at a record low of 0.1 per cent. The British central bank added that while its asset purchases “could now be slowed somewhat” after it became the dominant buyer of UK government debt last year, “this operational decision should not be interpreted as a change in the stance of monetary policy”.

Sterling slipped 0.1 per cent against the dollar to $1.389.

The dollar, as measured against a basket of trading partners’ currencies, weakened 0.4 per cent. The euro gained 0.4 per cent to $1.206.

Brent crude fell 1.1 per cent to $68.17 a barrel.



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Gensler raises concern about market influence of Citadel Securities

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Gary Gensler, new chair of the Securities and Exchange Commission, has expressed concern about the prominent role Citadel Securities and other big trading firms are playing in US equity markets, warning that “healthy competition” could be at risk.

In testimony released ahead of his appearance before the House financial services committee on Thursday, Gensler said he had directed his staff to look into whether policies were needed to deal with the small number of market makers that are taking a growing share of retail trading volume.

“One firm, Citadel Securities, has publicly stated that it executes about 47 per cent of all retail volume. In January, two firms executed more volume than all but one exchange, Nasdaq,” Gensler said.

“History and economics tell us that when markets are concentrated, those firms with the greatest market share tend to have the ability to profit from that concentration,” he said. “Market concentration can also lead to fragility, deter healthy competition, and limit innovation.”

Gensler is scheduled to appear at the third hearing into the explosive trading in GameStop and other so-called meme stocks in January.

Trading volumes in the US surged that month as retail investors flocked into markets, prompting brokers such as Robinhood to introduce trading restrictions that angered investors and drew the attention of lawmakers.

The market activity galvanised policymakers in Washington and investors. Lawmakers have focused much of their attention on “payment for order flow”, in which brokers such as Robinhood are paid to route orders to market makers like Citadel Securities and Virtu.

That practice has been a boon for brokers. It generated nearly $1bn for Robinhood, Charles Schwab and ETrade in the first quarter, according to Piper Sandler.

Gensler noted that other countries, including the UK and Canada, do not allow payment for order flow.

“Higher volumes of trades generate more payments for order flow,” he said. “This brings to mind a number of questions: do broker-dealers have inherent conflicts of interest? If so, are customers getting best execution in the context of that conflict?”

Gensler also said he had directed his staff to consider recommendations for greater disclosure on total return swaps, the derivatives used by the family office Archegos. The vehicle, run by the trader Bill Hwang, collapsed in March after several concentrated bets moved against the group, and banks have sustained more than $10bn of losses as a result.

Market watchdogs have expressed concerns that regulators had little or no view of the huge trades being made by Archegos.

“Whenever there are major market events, it’s a good idea to consider what risks they might have placed on the entire financial system, even when the system holds,” Gensler said.

“Issues of concentration, whether among market makers or brokers at the clearinghouse, may increase potential system-wide risks, should any single incumbent with significant size or market share fail.”



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