Those stocks have, as a group, more than doubled in value, with Tesla rising a mind-boggling 590 per cent and Apple a still eye-watering 139 per cent before the selling that started on Thursday (US time). Tesla was still up 480 per cent on Friday’s close and Apple about 115 per cent.
There’s an obvious explanation for why stocks generally, and tech stocks in particular, have risen strongly since March.
That was when the Fed threw the kitchen sink at the financial system, the economy and the markets by injecting trillions of dollars of liquidity and credit into the US system. The overall stockmarket has risen 60 per cent since that moment in late March.
The Fed’s more recent decision to effectively abandon inflation-targeting has added to investors’ conviction that negligible interest rates – in real terms, negative rates – will be the norm for the foreseeable future, providing both a safety net and an incentive for risk-taking.
The tech stocks, unlike their more conventional industrial peers, have actually benefited from the pandemic and the demand for digital products and services but also offer greater – and indeterminate – long term growth prospects.
They represent a disproportionate share of revenue and profits and, because they are less capital intensive than more traditional companies, far higher returns on equity.
The ceilings on their potential are unknowable, which gives investors a green light to pay whatever prices it takes to get a piece of the action, however unlikely the future growth rates required to validate those valuations might be.
That’s the broad backdrop to what has happened in the market for those technology stocks in the lead-up to last Thursday.
The detail of the tech stock boom is, however, interesting and disquieting.
In the aftermath of the sharp sell-off late last week it has emerged that a “whale” – Japan’s SoftBank – has been a heavy buyer of both the physical stock and, more particularly, call options over the shares in the big tech companies.
The giant technology conglomerate founded by Masayoshi Son is best known for its investments in start-ups. It runs the world’s largest venture capital fund and more recently has started up a new fund to invest in listed tech companies.
It is said to hold about $US10 billion ($13.7 billion) of physical shares and a massive hoard of options – the Wall Street Journal has said it has call options over $US50 billion of listed tech stocks — to buy more shares.
Call options give the holder the right to buy shares in future at a pre-determined price. They are a bet on the shares rising.
At the same time as SoftBank has been accumulating its position in the mega techs, so have retail investors.
The rise of commission-free brokers like Robinhood and the addition of options trading to their platforms have provided retail investors the ability to take what are effectively leveraged bets on the companies’ share prices continuing to rise.
What the episode demonstrates is the extent to which the extraordinary valuations of the tech stocks and the increased activity of unsophisticated investors during the pandemic can, in combination with the high levels of automated algorithmic trading, combine to produce exaggerated market movements.
“Out of the money” options – call options with a strike price above the current share price – are a cheap way to gain a leveraged exposure to a stock.
They give the buyer the opportunity, without the obligation, to exercise the option and acquire the stock. If they choose not to exercise (because the exercise price is above the share price at the option’s expiry date) they lose their “premium,” or the investment they made to buy the option.
The recent share splits by Apple (4 for one) and Tesla (five for one) have made those stocks – and options over those stocks – particularly attractive to small investors because the lower denominations provide more leverage to their share prices.
Call options are provided by investments banks and other institutions as a way of generating incremental revenue on their holdings. To the extent that they don’t actually hold the underlying shares they hedge their option exposures in a rising market by buying the physical shares.
As Softbank and others plunged into the market for call options over the tech stocks – volumes in the last couple of weeks were running at levels about three times their average levels last year – those on the other side of the options were forced to buy stock to cover their exposures, adding to the buying pressure and the upwards spiral in tech shares.
In turn, that would have forced “momentum” traders – hedge funds and algorithmic traders – to buy the stocks, adding to the price pressure.
Depending on your perspective, that’s either a virtuous circle of activity or a vicious cycle. Last week, perhaps because the rise in tech shares was too sharp even for the true believers, it became a vicious cycle in reverse, with investors scrambling to take profits before they evaporated.
What the episode demonstrates is the extent to which the extraordinary valuations of the tech stocks (Nasdaq’s stocks trade on an average price-earnings multiple of about 64 even after the sell-off) and the increased activity of unsophisticated investors during the pandemic (attributed, at least partly, to bored housebound millennials) can, in combination with the high levels of automated algorithmic trading, combine to produce exaggerated market movements.
What happened last week may be, and probably is, just a correction to the value of stocks that had run far too far, too fast. It may be, however a foretaste of what’s to come in a market where the valuations ought to, given the economic backdrop, make investors nervous and poised to cash out their gains the moment they think there’s any semblance of a threat to the outsized paper profits the bull run since March has delivered.
Leverage and momentum work in both directions and the nature of the current market, peopled by algorithmic traders, hedge funds and an increasing level of retail investor participation, makes for exaggerated outcomes.
Stephen is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.