Crowding the Market in Large Cap Tech

Photo credit: Dickson Phua || A heavy use of derivatives is like being stuck in traffic… in the short run, you are going where everyone else is going…

I’ve written about this topic a few times before:

What happens when a party or parties take on an investment position that is large relative to the amount they can afford to lose? The above articles handled questions on that for the following crises and mini-crises:

  • The London Whale
  • Was PIMCO getting too large for the derivatives market?
  • The 1993 blowup of the floating rate guaranteed investment contract market
  • The demise of The Equitable in 1991.
  • Long-term Capital Management
  • The Correlation Crisis in 2005 in the CDO market
  • AIG and subprime mortgages

But today, the furor is here:

Whether it is Softbank taking undue risks to play catch-up in a bad year, or many individuals, hedge funds, etc. jumping on a large cap tech momentum trade using stocks and call options (and total return swaps, etc.), there has been a lot of hot money chasing the trade that has dominated 2020.

In the short-run momentum often persists, until it becomes too expensive to hold the momentum asset. Call prices get too high for new entrants, and real money investors start concluding that it is time to take some profits.

Now, if a market is cheap, the purchase of out-of-the-money options can give the market a kick as the option purchases force those that sold the options to hedge them. Though it makes sense to hedge options with options, eventually someone has to either go naked and not hedge, or hedge using common stock.

But, when the market is expensive, and volatility gets higher, the economics of the trade gets harder until the trade reverses, and the momentum effect goes the other way. Softbank may have been foolhardy or desperate, but if they completed their trade last week, that may have been the end to the non-economic buying that started in early August. They may have put in the top for large cap tech.

The same thing happened to tech in 2000, and financials in 2007-8. Or, in the opposite way, European financials were forced by their regulators to sell US stocks at the bottom in 2002. Forced sellers often create market bottoms. Greedy buyers often create market tops.

And why is that? The last one to respond to momentum looks like a fool. But it seems rational at the time, as he does not want to take more losses, or is sick and tired of missing out on the gains.

The main problem is a crowded trade in large cap tech. The current articles focus on derivative trades around that crowded trade, but that is not the issue. By themselves, the creation of derivative positions does nothing. It’s who holds the derivative positions that matters.

  • How well are they capitalized?
  • Do they have the capability of holding?
  • Do they know what to do in a crisis?

If they are thinly capitalized, or have a short time horizon for other reasons, they will follow the momentum closely. As such, the risk of derivatives is akin to credit risk at worst, and crowding at best. When investors act to prevent a worst case scenario, the selling pressure can be severe.

And so, to that end, I say to you “lighten up on your large cap tech positions.” Those who own those positions have short time horizons, and may bolt. There is no way these companies grow into their valuations, so don’t think you can hold on for years. This is just a mania, and as such, it will meet its end.

One thought on “Crowding the Market in Large Cap Tech

  1. I am surprised you don’t mention the biggest bubble, the most crowded position in decades (centuries?)… bloated government financed by debt.

    Throughout the G7, baby boomers have answered every question with “we need to create a commission to study this” and invariably said commission recommended creating yet another permanent agency. In most cases, bigger government was the answer before anyone knew the question.

    So now Japan, Europe, Canada and the USA have bloated governments (crowded position) financed with giant “debt” bubbles — they have zero chance of repaying this debt, so it isn’t really debt at all (weak balance sheets behind the crowded position).

    Without central banks and central economic planners and central “health” dictators, what does the G7 have? Unfunded old age transfer systems (eg social security) that will be paid by quarantined youngsters who don’t know how to operate a manual can opener.

    In the USA we have a dementia patient and a violent Marxist running against a giant tupee, both of them pushing 75-80 years of age, neither needs to worry about the debt levels they leave behind for others to pay.

    Public employees enjoy pensions and post employment benefits that no tax payer gets, even though the public sector gets paid more on average and works far fewer hours.

    That is the crowded trade. We can limit our exposure to FAANGS and worthless Tesla shares. How do we trim exposure to failed government that gets bigger and bigger the worse it performs?

    Please don’t reply with some nonsense that some new candidate is going to do the same stupid things but not get the same stupid results. That is a lie and we all know it

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