Surfing flows

Corey Hoffstein (host): One of the things that really dramatically changed in the last couple of years has been the role of social media in the influence of traders. So we can talk about the Reddit meme mania, but I would even argue that someone like Elon Musk was, in many ways, able to “meme” his stock into the S&P 500^® and meme his way into shoring up his balance sheet by creating people who were just avid fans and would buy the secondary issuance. Our friend [quantitative researcher] Lily Francus has written about the idea of salience and social leverage in many ways. How do those risk factors change the profile of these trades?

Aneet Chachra: That’s become much more important, as you’ve given lots of good examples of that. The way I think about it is like lottery tickets: we all know they have a negative expected return. And I hate to admit this, but sometimes I bought lottery tickets. I’ve been in an office, and there’ll be a big Powerball jackpot and somebody will put together a pool. And I’ll join in because I have this tiny fear that, what if everybody in the office wins the lottery except for me because I wouldn’t chip in $5? So meme stocks can be like that, in that you have lots of people who either know each other or they meet online and they all decide to pile into a particular stock.

But there’s a really big difference between lotteries and memes. So, with lottery tickets, it doesn’t matter how many tickets I buy or my friends buy; we’re not going to change the outcome. But that’s absolutely not true with stocks. If you have a whole bunch of people who are all piling into the same name, especially if they’re using call options, it’s going to cause an impact on price. And this is what I tend to call social leverage. And what you see with that is that people who come early into a trend, they tend to benefit the most and then people tend to come in afterwards.

The other thing is, is that the flow effect is originally when people start buying these shares, the most flexible holders tend to exit out because they’re happy to see this pickup in price, and then the people left are much, much more inflexible. So you end up with, in the example of Tesla, index funds have a huge holding in it. Momentum strategies for sure have gone into it. But you also get these stocks that tend to be “culty,” or at least that there’s a lot of true-blue believers that will not sell no matter how high the price goes. Then what happens is that even the same amount of flow can again start to cause this nonlinear impact where there’s just so much supply that has been sucked out by all these inflexible holders that whatever flow has to jam up the price from a few people that are willing to transact.

Now, the old saying in markets has been, “markets take the escalator up and the elevator down.” And I still think that’s mostly true at the index level, but that’s not true at all at the single stock or crypto level. You definitely see lots of examples of things taking the elevator up and taking the elevator down. And then once that happens to a particular stock, people know that, “Hey, it can happen again.” It’s like the famous for being famous, and that’s what I think Lily Francus, she coined the term “salience.” And once something happens that it becomes a salient, or a meme, then the risk profile of that security totally changes because it now has a completely different holder base and price impact of flows and option markets. Nobody is out comparing AMC’s valuation to other movie theater chains. Nobody’s really looking at AMC’s valuation at all. Same thing is true with GameStop, where you’re not going to try to build a long/short model where you compare it to other mall retailers. And the hedge funds that didn’t take that into their risk management, there’s certainly examples of where they did quite poorly because of that.

But I don’t want to just pick on retail meme stocks. There’s lots and lots of examples of this. There’s thematic ETFs [exchange-traded funds], or you’ll see there’ll be growth hedge funds that all piled into a relatively small number of tech names. And the thing is that, once that happens, then you will see that a whole bunch of businesses and securities that should not necessarily be correlated because their businesses are quite different. Like, if you think of a thematic ETF that owns electric cars and biotech companies and Internet companies, the underlying businesses are very, very different, yet they will often all trade together because they have the same set of holders. [That’s the] same thing we’re seeing across hedge funds, where if you look at the results for a lot of tech names, they range from being very, very good to not so much, but yet they’re all trading together. And so when you start seeing very high correlation across assets that shouldn’t necessarily be correlated, that’s a really good sign to me that it’s flow effects that are dominating.

The full recording of this interview can be found on Apple Podcasts, Spotify, Google Play, YouTube, and other major platforms.

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