From bubble busting to short squeezes and back again - Business displacement meets speculative finance

The world turns differently in a risk-on displacement market. The pandemic has been disruptive to many businesses which creates huge displacements in valuation. Some firms may never return to their old profitability and market positioning. Others will rebound or may reinvent themselves. Given the economic spike down, revised economic growth can turn losers into winners. There will be new winners and losers, and many of  the old ways of extrapolating sales and earnings just will not work. 

Disruption and displacement lead to valuation uncertainty and one man's value play is another man's possible speculative bubble. Greater return dispersion will occur across and within industries. Hence, there can be extreme short interest in some names viewed as having excessive prices and huge flows into names that are expected to be set for a new lift-off. There can be inflows and short interest growing at the same time. This is a condition that cannot last. There will be a winner and loser as valuation is revealed. 

Yet, when short interest gets too large, the bubble hunter becomes the hunted, and we move to a short squeeze. What make sense for one short trader becomes irrational in the aggregate; a sign of crowded herd behavior. The excessive bubble crowd switches to the negativity crowd, and it becomes a race to see who has the deeper pockets and exposure staying power. Reality will be somewhere in the middle but overshoots will occur as excessive feedback loops continue to be the norm. 

For those on the sidelines, these localized extremes should be viewed as important warning signals. Little bubbles and extreme behavior at the individual market level may just tell us that the bigger asset class bubbles may quickly move to the forefront, albeit this talk has been going on for some time. With a speculative mindset, excessive and cheap capital, and the inexpensive marketability of financial products and brokerage, the potential for upside and downside overshoots is more likely. We now live in a fat-tail world. 

Nevertheless, there are ways to play the game better.

1. Know the rules of the game. At extremes, the rules will change or the obscure (fine print) rules will be invoked. See the margin changes brokerage restrictions of January.

2. Think through extreme scenarios. Extremes will occur so be ready through anticipating low probability events. Can bad stock move higher? Can markets overshoot fundamentals? Can expected risks be breached?

3. Be ready for both left and right tail events. Everyone has been talking about meltdowns, but in January we saw the opposite melt-ups. Can you live in a fat-tail world? How will you adjust to fat-tails?