Over the past few days, the level of hedge fund short interest in GameStop fell sharply. Or did it?

On the evening of Monday, Feb. 1, Bloomberg reported that “GameStop Short Interest Plunges in Sign Traders Are Covering.”

Two separate research firms, IHS Markit and S3 Partners, reported the drop:

“Short interest in the video-game retailer plummeted to 39% of free-floating shares, from 114% in mid-January, according to IHS Markit Ltd. data. Data from S3 Partners, another market intelligence firm, showed a similar pattern, with GameStop’s short sales having fallen to about 50% of its total stock available to trade, down from a high of roughly 140% reached earlier this year.”

The reporting coincided with a big drop in the value of GME shares. This is clear evidence that the hedge funds are winning, and that the Reddit army is losing.

Unless the short interest data is being manipulated, which is also a real possibility.

If the U.S. Congress does any real digging when it holds hearings on the GameStop situation, it will uncover some very interesting quirks of the market, many of them revolving around shorting practices.

Most people understand “naked shorting” to be an illegal thing, and it is — sort of.

On the other hand, there are plenty of instances where naked shorting is more of a gray area — not so much a violation of the law as a minor infraction worthy of a parking ticket — and other instances where certain players can short a stock beyond 100% of the float, or short nakedly, in a wholly legal way.

This is where the reported sharp decline in GameStop (GME) short interest gets intriguing.

There are at least two plausible explanations for GME short interest declining — giving the appearance of hedge funds covering more than half their shorts — even as the GME share price fell sharply alongside.

The first explanation is that GME squeezers lost their discipline and broke ranks.

If a critical mass of holders on the long side of GME started selling to realize profit in GME, that would have given the hedge funds an opportunity to cover their shorts — via buying back their shares — at progressively lower levels as the share price fell.

Plummeting short interest along with a plummeting GME share price, in other words, could indicate that the Reddit army is headed for the hills, and the longs were selling early, giving the shorts a means to cover, as the longs got out.

The notion that the squeezers broke ranks, and that the hedge funds are winning, is certainly the perception that was created. The Bloomberg article strongly suggested that the Reddit army has lost.

“Short squeezes can only last as long as there is a large short position in a stock,” the chief market strategist at Miller Tabak & Co. told Bloomberg. “Once that dissipates, the situation changes completely.”

But there is another possibility, which is that the hedge fund short interest in GME didn’t really dissipate.

If the long holders of GME shares did not break ranks and sell en masse, it would have been impossible for the share price to fall and hedge fund short interest to fall at the same time.

That is because, without a critical mass of long-side holders selling into the market, the hedge funds covering their shorts would have nobody to buy from as they covered (bought back) their short positions. 

In this second scenario, though, the hedge funds that are short — with tens of billions of dollars on the line — could have decided to play a high-stakes trick.

The trick would be: “Make it look like we’ve covered our shorts when we really haven’t (because we can’t), so that short interest falls and the Reddit army gets demoralized, thus breaking the squeeze.”

The way the hedge funds could have done this — made it appear as if they covered their shorts, even when they really didn’t — involves trickery in the options market.

The tactics involved are not a secret. In fact, the Securities and Exchange Commission (SEC) knows all about such tactics, and published a “risk alert” memo on the topic in August 2013.

The SEC memo is titled “Strengthening Practices for Preventing and Detecting Illegal Options Trading Used to Reset Reg SHO Close-out Obligations.” You can read it here via the SEC website.

The memo contains a dozen pages of highly technical language, but here’s a quick rundown:

• If short sellers are facing a squeeze because shares are hard to buy, or scrutiny for holding an illegal short position, they can create an appearance of having closed their short position through the use of deceptive options trades.

• A hedge fund that is short a stock can write call options on a stock — meaning they are now “short” the call options, having sold the call options to someone else (typically a market maker) — and simultaneously buy shares against the call options.

• The shares bought against the call options could be “synthetic” longs — meaning they are not part of the original share float of the stock — as sold to the hedge fund by the market maker that takes the other side of the options trade.

• This works because, if a market maker buys options from an options writer, the market maker has legal privileges to do a version of “naked shorting” as part of their hedging function. This is necessary, under the current rules and the current system, for market makers to protect themselves when facilitating options trades.

• As a result of the above transaction, the hedge fund that sold short calls was able to buy synthetic long shares against the calls. (A synthetic share is one that has a long on one side and a short on the other but wasn’t part of the original float.) The synthetic long shares are the other side of the naked shorts, legally initiated by the market maker, so the market maker can hedge.

• The hedge fund that bought the shares can now report that they have “bought back” their short position via buying long shares — except they actually haven’t! The synthetic shares they bought are canceled out against the short call positions they initiated, a necessity of the maneuver by way of the market maker’s hedging of the call position they bought from the hedge fund.

It gets very complicated, very fast.

But the gist is that hedge funds can use tricks to make it look like they’ve covered their shorts — even if they haven’t truly covered, and can’t, for lack of available float — by way of exploiting loopholes that exist due to an interplay of reporting rule delays, market maker naked shorting exceptions, and legal practices of synthetic share creation (new longs and shorts made from thin air) relating to market-making.

Below is a section of the SEC memo (from page 8) that gets to the heart of it:

“Trader A may enter a buy-write transaction, consisting of selling deep-in-the-money calls and buying shares of stock against the call sale. By doing so, Trader A appears to have purchased shares to meet the broker-dealer’s close-out obligation for the fail to deliver that resulted from the reverse conversion. In practice, however, the circumstances suggest that Trader A has no intention of delivering shares, and is instead re-establishing or extending a fail position.”

In plain language, “Trader A” in SEC parlance could intentionally be giving the appearance of closing their illegal short position — when in reality they have no intention of doing so (or no ability to do so).

Under normal circumstances, tricks like these were used to help hedge funds maintain short positions that, legally speaking, they weren’t supposed to have because the shares were never properly located.

The GameStop squeeze is a unique scenario, however, because it is a very public fight to the finish between the Reddit army and the hedge funds that are short. Either the Reddit army wins and the hedge funds pay four-digit prices ($1,000 or more) to cover their shorts because of margin calls, or the hedge funds win and the GME share price falls back to the low double-digits.

In a battle like that, with public coverage influencing both sides, perception is a weapon. As such, if the hedge funds can generate the appearance of having covered most of their shorts, while driving down the GME share price through aggressive selling on low volume (something known as a “short ladder attack”), then the hedge funds increase their odds of breaking the squeeze — in part because media outlets will report things like “GameStop Short Interest Plunges” without looking deeper.

To be clear, it is also possible the first scenario is true.

GameStop shares may have fallen precipitously, with hedge fund short interest falling alongside, because a critical mass of long GME holders simply lost faith and tried to sell before the squeeze was complete. 

But it makes a lot of sense to question that narrative, given the wide array of deceptive tricks that some hedge funds (certainly not all of them, or even most of them) have used to perpetuate questionable or even illegal shorting tactics for a very long time.

And again, these tricks are so pervasive and old, the SEC wrote a “risk alert” memo about them in 2013.

As such, whether the drop in GameStop short interest was real or smoke and mirrors, the fact that changes in the level of short interest can be faked — with hedge funds making it look like they have closed out, but haven’t — is a serious compliance loophole that should be forcefully addressed.

As a side note, the answer to this problem likely resides in the blockchain.

Apart from market maker privileges, the three big reasons hedge funds can play games with short positions — delayed reporting requirements, time windows of days (or even weeks in some cases) for trades to settle, and related transactions being executed in different places, or with different counterparties, for the sake of deception — could all be answered with a blockchain-based settling and clearing system where transactions are noted instantly and made visible to all parties (plus the SEC).

When writing about the GameStop squeeze last week, we compared it to Fight Club on Wall Street, referencing the 1999 movie with Brad Pitt and Ed Norton.

On Friday, Jan. 29, the Fight Club aspect of the game spilled over into the real world, as a Redditor purchased space on a digital billboard in New York’s Times Square. The advertisement said “$GME GO BRR” and showed a stock price candlestick pattern going vertical.

In the movie, Brad Pitt’s character gives a speech to a group of Fight Clubbers that feels almost perfectly suited to the ethos of the moment. The GameStop squeeze is part prank, part strategy, part global protest, and ultimately deadly serious:

“We’re the middle children of history, man. No purpose or place. We have no Great War. No Great Depression. Our Great War’s a spiritual war… our Great Depression is our lives. We’ve all been raised on television to believe that one day we’d all be millionaires, and movie gods, and rock stars. But we won’t. And we’re slowly learning that fact. And we’re very, very pissed off.”

A new research report from Goldman Sachs notes that “if the short squeeze continues, the entire market could crash.”

Goldman and others are worried about the ripple effects of a successful squeeze. If the price of GME is driven so high that hedge funds are forced to cover their short positions at $1,000 per share, or even $2,000 to $3,000 per share or something worse, the ripple effect created by tens of billions in losses could destabilize the entire market.

A meltdown would probably be just fine with the GameStoppers (how’s that for cosmic humor?). The attitude seems to be: “Dear Wall Street, you caused the crash of 2008, and wrecked the economy, and then got bailed out; this is the little guy paying you back.”

Meanwhile, even as the GameStop squeeze heads toward a crescendo — an endgame where the GME share price either soars beyond $1,000 or plummets into double digits — the Reddit army is turning its attention to the silver market.

The goal of the “Reddit silver squeeze” (that is what we’ll call it) is to drive the price of silver to $50 per ounce or more, while creating turmoil for the money center banks (and J.P. Morgan in particular).

As of Monday morning, as this is being written, the Reddit silver squeeze is working, with spot month silver futures and SLV, the bellwether silver ETF, both seeing one-day price moves of 10% or more. Various silver miners are also up 10% or more in concert with the silver price hitting multi-year highs.

For multiple reasons, we doubt the Reddit silver squeeze will work. It can certainly move the needle in the short-term, as we are already seeing with the silver spot price.

But ultimately, squeezing a global commodity is a whole other level of difficulty in comparison to squeezing a stock with a roughly 50 million share float sold more than 100% short.

Some of the problems the silver squeeze will face are as follows:

• There is a lot of silver stockpiled above ground relative to modest industrial supply needs, and the squeezers are likely to run into a wall of it.

• Unlike the GameStop squeeze, there is no targeted party who can be forced to cover their shorts due to margin calls; when it comes to silver, in fact, hedge funds are overall net long.

• There is a rumor that J.P. Morgan, the giant money center bank, has a vast short position that is the equivalent of a hidden naked short — but this rumor has no real basis and is literally decades old. If JP Morgan actually had such a short, it should have blown up with the silver run of 2011.

• If the silver price runs beyond its fundamental justification too far, too fast, silver miners — who are inherently long silver that is still in the ground — will be happy to hedge forward production years out by selling futures contracts.

• If the silver miners see their share prices ramped up, they will happily issue new shares to pay for more exploration and production efforts.

• The silver market has ties to the far-larger copper market on the industrial side, and to the gold market on the far-larger precious metals side: Both of those will exert gravitational pull if the spread between copper and silver or copper and gold gets too out of whack.

• WallStreetBets, the Reddit message board promoting the squeeze, is internally conflicted over whether pursuing silver is even a good idea: Some see it as a trap, because it is a means of siphoning attention and energy from GME before the GameStop battle is won.

The biggest problem with the Reddit silver squeeze — in terms of gauging the likelihood of failure or success beyond a short-term pop — is that the structural mechanics don’t really work.

The structural mechanics of the GameStop squeeze are actually brilliant.

At the start GameStop was a relatively small company, with a relatively small share float (just over 50 million shares), and a group of arrogant hedge funds shorting well over 100% of the share float.

Then, as the squeeze pressure built on GME, the hedge funds were foolish enough to stand their ground, or even double down on their shorts in some cases, rather than get out.

The GameStop squeeze has global publicity, a defined end-goal — forcing the hedge funds to buy back their shares at astronomical prices — and a rational means of getting there, by way of putting so much buying pressure on the stock that margin calls are triggered.

The silver squeeze is missing all of these factors. Rather than structural mechanics, it has rumors and misplaced analogies to the past, as juxtaposed against a group of silver market participants who are mostly long rather than short (which means they can’t be squeezed at all).

In 1979 and early 1980, the Hunt brothers — Nelson Bunker Hunt, William Herbert Hunt, and Lamar Hunt — tried to corner the silver market using Texas oil money.

The Hunt brothers came close to succeeding in their silver corner, or appeared to, before the Chicago Mercantile Exchange (CME) shut them down by changing the margin requirements for futures contracts.

But the Hunt brothers also had a much bigger counterparty to squeeze.

Bloomberg columnist David Fickling reports that, in 1979, industrial use for silver accounted for 84% of demand, across areas like photographic emulsion (think Kodak pictures), soldering, and electronics.

The stockpile of available silver supply was also minimal in 1979. Those two factors — high industrial usage and low available supply — meant that end-users like Kodak would have to pay up for silver or lose their ability to do business.

But fast forward to 2021, David Fickling reports, and there is a mountainous silver stockpile, about 2.46 billion ounces worth, coupled with a far more modest base of industrial demand relative to annual production.

What that means overall is that a whole lot of silver sits in warehouses and bank vaults that is used to satisfy investment demand and jewelry demand, rather than industrial demand.

And so, if the silver price gets crazy, much of that 2.46-billion-ounce silver pile can flood the market as investment-oriented silver holders cash out. On the jewelry side something similar can happen: If the silver price becomes wildly expensive, jewelry demand will fall even as large amounts of silver jewelry and other forms of scrap silver will be pulled into the market to get melted down and sold.

As part of their bull case, the silver squeezers are floating a rumor that J.P. Morgan has been manipulating the silver market for years, which would further imply that J.P. Morgan has a gargantuan “naked short” position because the hypothetical silver in its vaults is not actually there.

The problem with the J.P. Morgan rumor is that the story is literally decades old. Your TradeSmith Daily editor heard it in his first year on the job working for a commodity broker straight out of college; that was all the way back in 1998.

While J.P. Morgan and other investment banks have done questionable things in terms of making a market in silver, it is highly doubtful they are actually suppressing the price or faking the existence of stockpiles. Such moves would not only be criminal, but they would be extremely dangerous, and would have likely created a blow-up long before now — like when silver climbed to nearly $43 per ounce in April 2011.

Other flaws in the thesis include the fact that hedge funds are net long silver futures — as evidenced by Commitment of Traders (COT) data — and have been so for 17 months.

This not only leaves the question unanswered as to who will get squeezed as the silver price runs higher, it creates an opportunity for hedge funds that are net long silver to sell into any meaningful spike. 

The silver miners could also be a problem to the extent they are inherently net long silver, in terms of their unhedged silver production still in the ground.

Not only should silver miners be happy to sell far-dated futures contracts into the market if the silver price gets ahead of itself — thus locking in a high price for future production — they should also be willing to issue new shares and do capital raises in the event of a share price run-up, as a miner will almost always have ready-made justification for new exploration, or new production investment, or both.

Then, too, if the silver price gets too far out of whack with copper, or gold, or both, opportunity will exist for professional traders to short overpriced silver while buying either copper or gold, mitigating their risk to an increasing rise in the silver price.

And last but not least, even the WallStreetBets message board is divided on this whole endeavor, which is never a great sign: While some Redditors appear all in on the silver squeeze, others think it might be a trap, or a means of diverting attention from the GME squeeze (which needs all the firepower it can get).

This is not to say we are long-term bearish on silver. Nor is it to say that the silver price can’t rise in 2021.

Instead, it is mainly to point out that, whether or not the GameStop squeeze is successful, the structural mechanics for a silver squeeze are far less favorable — and thus far less likely to deliver a real victory.

You have likely heard of Robinhood, the zero-commission stock trading app that exploded in popularity during the pandemic. (It was already popular pre-Covid, but lockdown boredom and stimulus checks sent sign-ups to new heights.)

On Thursday, Jan. 28, Robinhood ignited bipartisan fury with its decision to restrict users’ ability to buy calls or shares in GameStop (GME), the stock at the heart of an epic short squeeze.

The perception was that Robinhood cut off trading access to its retail customers, who were long GME, in order to placate its hedge fund paymasters, who are short GME and would prefer the price to fall.

The main charge was that, in restricting the ability of small investors to buy GME, Robinhood was doing the bidding of Citadel, a giant hedge fund with a market-making operation and a high-frequency trading arm attached.

Citadel was also a known backer of Melvin Capital, the $12.5 billion hedge fund that received a $2.75 billion emergency cash infusion to stay afloat, after losing heavily on GME and other shorts.

Because commission revenues are zero, Robinhood makes the bulk of its profits from something called “payment for order flow,” which involves giving firms like Citadel the chance to take the other side of retail customers’ trades (a consistently profitable thing to do).

The optics of the situation made it appear as if Robinhood were in Citadel’s pocket.

This came down to a business model where Citadel is Robinhood’s No. 1 customer, because Citadel (and other giant market-making firms) are the ones who pay Robinhood. The millions of investors who use the Robinhood app for free are not customers themselves; their order flow is actually the product.

(This is a natural extension of the old Silicon Valley rule of thumb: If a product is free, the mass-market user is the product, in terms of their time, attention, or habits being monetized.)

To sum up, Citadel, a giant hedge fund, was directly involved in the GameStop short, by proxy through its Melvin Capital connection and possibly with its own short book; and was also Robinhood’s largest customer, via the “payment for order flow” arrangement; and might have been a direct beneficiary of Robinhood’s actions restricting customer ability to buy GameStop shares and call options (because hedge funds wanted the GME price to fall).

The whole thing was a very bad look for Robinhood. It genuinely appeared as if the small investor, Robinhood’s hypothetical customer, was getting abused as a favor to Robinhood’s paymaster, a giant hedge fund.

Then, too, an extra layer of irony was involved — so thick you could cut it with a knife — thanks to Robinhood’s name, positioning, and mission statement. 

• The original Robin Hood, a character of English legend, was a benevolent bandit who stole from the rich and gave to the needy; by looking out for hedge funds at the expense of small investors, Robinhood seemed to be doing the reverse.

• In March 2016, Robinhood tweeted “Let the people trade”; the tweet resurfaced to point out Robinhood’s hypocrisy in stopping people from trading (by not letting them buy GME).

• Robinhood’s stated mission is to “democratize investing”; by helping a giant hedge fund at the expense of small investors, it seemed to be reinforcing plutocracy (rule by the rich) instead.

Robinhood’s perceived hedge fund favoritism provoked a surprising surge of bipartisan fury.

If you imagine American politics as a spectrum, with the far left at one end and the far right at the other, the left-most polarity would be represented by people like Alexandria Ocasio-Cortez (AOC) and Elizabeth Warren; and the right-most polarity people like Donald Trump Jr. and Ted Cruz.

On Thursday Jan. 28, both left and right — AOC and Warren, Trump Jr. and Cruz, along with many others — came together to condemn Robinhood for its elitist anti-investor actions.

“This is unacceptable,” tweeted AOC. “We now need to know more about @RobinhoodApp’s decision to block retail investors from purchasing stock while hedge funds are freely able to trade the stock as they see fit.”

Ted Cruz then tweeted a thumbs-up in response to AOC, as Republicans and Democrats in both the House and Senate announced plans to hold hearings.

In addition to this, too many celebrities to count shared their disgust with Robinhood, and their support for the small investor trying to buy GME.

It seems like an open-and-shut case in respect to the fact that, even though GameStop buyers are trying to play a game with the market, hedge funds have been playing those same types of games for decades; so why should the playing field be tilted in favor of the hedge funds who were short?

While the deep well of anger was understandable, and legitimate, it entirely missed the real story.

Despite the way things appeared — and the way they were interpreted — Robinhood did not suspend the right to buy GME shares (and a handful of other names) at the request of Citadel.

Robinhood took the actions it did — and another popular firm, Interactive Brokers, did the same — out of fear that the whole system would break, and that Robinhood itself could be wiped out.

In the immediate aftermath of the GME halt, Robinhood tapped $600 million worth of credit lines and did a $400 million emergency capital raise from its main investors, which should indicate the severity of the situation.

Robinhood was afraid the GameStop situation would destroy not just the hedge fund shorts, but Robinhood itself.

That is why Robinhood restricted trading, and that is why Robinhood built a billion-dollar firewall of added capital buffer before allowing GME buys to resume.

Now, one may ask, why did Robinhood let an avalanche of bad press fall directly on its head?

Why would Robinhood, as a firm, let all of Washington D.C. and the whole world believe they had done an awful thing, in helping Citadel at the expense of their investors, instead of explaining what really happened?

Because if Robinhood explained what really happened, all hell would have broken loose. And it still might.

The first thing to understand is that, in the morning trading session on Thursday, Jan. 28, the Redditor army (which overlaps with the Robinhood user base) came very close to achieving their goal of setting off an “Infinity Squeeze” in GME.

Looking at what happened, and the way it did, it is clear that GameStop was mere minutes away from going completely vertical, at which point it could have run to $1,000 or more.

If the infinity squeeze had unfolded — and it was oh, so close — various Wall Street entities, including not just hedge funds but brokers and banks, could have been forced to eat more than $60 billion in losses.

That is worth emphasizing again: Sixty. Billion. Dollars.

The Redditor Army came very close to doing it. They may yet succeed in doing it. Things are moving so fast, the infinity squeeze may have already happened by the time you read this.

Or, alternatively, government authorities may have been properly read into the situation, and GameStop trading entirely halted, or the Reddit rebellion crushed. We don’t know which it will be, as of this writing.

But we know the squeezers came very, very close — and are still trying — and Robinhood panicked, and then rounded up a billion dollars in emergency funds.

The events of Thursday, Jan. 28 are related because it was the near-completion of the Infinity Squeeze that scared the daylights out of Robinhood; and it was the buy restrictions set in place by Robinhood (and Interactive Brokers, among others) that prevented the Infinity Squeeze from happening. Temporarily at least. It may yet come to pass.

There is a lot to work through here. To start we’ll walk through the $60 billion estimate and explain where that comes from. Let’s do some quick math:

• The tradable share float for GameStop Corp., according to FinViz, is 50.65 million shares.

• A recent estimate of the short float — meaning the percentage of shares that have been borrowed for a short sale — is 121.98%. (It is entirely possible for shorts to make up more than 100% of the share float, for technical reasons we won’t get into here.)

• If the Reddit army can trigger an “infinity squeeze” — meaning the price is pushed so high that margin calls force the shorts to buy back at any price, because their brokers are forcing them out of positions — the GME share price could run to $1,000 or more. (It is above $400 in the Jan. 29 premarket as of this writing.)

• If the caught-out hedge fund shorts were forced to cover 100% of the GME float at $1,000, that would cost about $50 billion (because $1,000 times 50.65 million shares is just over $50 billion).

• But the short float in GME remains above 100%. That is because, even as some hedge funds have closed out of their GME shorts, others have reshorted again, in hopes of winning the epic battle with the Reddit army to prevent the squeeze.

• If, say, the shorts had to cover 120% of the share float at $1,000 — in order to cover the short float — that would be a sum greater than $60 billion, rather than $50 billion.

• If the price were squeezed above $1,000 per share, the final cover price, forced by the brokers, could be even more than $60 billion. It could be a price tag so high, in fact, that not only would multiple large hedge funds go bust, a number of brokers and possibly even banks could get taken out alongside them.

Now, you may ask, why is $1,000 per share our reference number?

It is a rule of thumb estimate, but it also makes sense because, the higher the GME share price goes, the more that “infinity squeeze” dynamics start to accelerate:

• As the GME price rockets higher, a “gamma effect” means market makers have to buy an increasingly large volume of shares to cover their short call option risk.

• Also, as the GME price rockets higher, risk departments get nervous and various hedge fund shorts are forced to close out. This buying activity adds even more rocket fuel to the buy price.

• At a certain level for the GME price, the hedge funds lose control of their destiny, as their prime broker (the entity on the hook if the hedge fund collapses) demands that the GME short be closed — or alternatively closes the position on the hedge funds’ behalf, buying back the GME shares at market. Once again, when this happens, the added buying power sends the price even higher.

The net effect is something like pulling the stabilizer rods out of a plutonium reactor. The more rods that you pull from the reactor, the more unstable the reactor becomes as the chain of plutonium reactions speeds up.

At a certain point — or in our metaphor, a certain price threshold — the chain of plutonium reaches a critical phase and the whole thing melts down.

That is the point where the GME share price could go to $1,000 or even higher — possibly even to $3,000 or $5,000, who knows — because there aren’t any shares to buy, other than the ones that the Reddit army is sitting on.

This is how an infinity squeeze works, and it also clarifies why the attempt is rational if you can pull it off. The Reddit army does not intend to hold its GME shares forever.

They just want to hold the shares long enough so that blown-out hedge funds, or their brokers, are forced to buy in at some insane share price of $1,000 or even higher, transferring great wealth into the Reddit army’s pockets as the hedge funds and brokers go bust. 

If you execute an infinity squeeze properly, you don’t stick around forever. You exit by selling to your vanquished opponents who are forced to buy, at a price that simultaneously transfers wealth from their hands, in a process that could very well bankrupt them — while making you rich.

And again, as we said earlier, this almost happened on Thursday, Jan. 28. The Reddit army came very, very close.

• In premarket trading on Jan. 28, the GME share price briefly exceeded $500.

• In regular trading on Jan. 28, the GME share price ran above $468.

• Somewhere up in that stratosphere, probably north of $500 per share, the metaphorical plutonium reactor would have gone vertical. The price rise would have accelerated faster and faster, blasting past $1,000 and then — boom.

• The reason this did not happen was because Robinhood and Interactive Brokers pulled the plug on customer share and call buying — arguably just in time to save their own skins.

The problem, from Robinhood’s perspective, is that a successful infinity squeeze could have killed the firm. It could have ended Robinhood, the brokerage, by burying the firm in an avalanche of “failure to deliver” lawsuits.

Keep in mind that this whole thing — this whole concept of an infinity squeeze — revolves around the concept of a short book greater than 100% of the float, and not enough shares available to get out.

It’s like a game of musical chairs, where there aren’t any chairs left because they are already being held, and if you are short you have to buy a chair at any cost.  Your only alternatives are thus to pay a king’s ransom or go bankrupt.

The problem for Robinhood, in result, is that Robinhood as a firm was also “short” GameStop shares in a de facto kind of way, because of Robinhood’s obligation to deliver shares to anyone who exercised a GME call option and wanted delivery. Here is how that works:

• Buyers of out-of-the-money GME call options would have the right to exercise their call options — and take delivery of 100 GME shares per contract — if the shares closed in the money.

• If a true infinity squeeze took hold, then thousands of out-of-the-money GME call options would become in-the-money call options and get exercised.

• Robinhood, as a firm, would be contractually responsible for delivering GME shares if those call options were exercised. They would have to go out and locate hundreds of thousands of GME shares, and give them to the exercising call option holders.

• But in the midst of an infinity squeeze, where the squeezers are holding all the shares, there aren’t any shares to be found! Robinhood was looking at an impossible situation: They might be on the hook for hundreds of thousands of GME shares, in a market where nobody wanted to sell them (because the Reddit army was holding them all)!

The condensed version of the story is: Robinhood would have been on the hook to deliver hundreds of thousands of GME shares it didn’t have, at far higher prices, if the squeeze truly took hold and thousands of additional call options were exercised.

That prospect scared the living daylights out of Robinhood — and its clearing firm — and so they suspended the ability to buy shares and calls.

This also explains why Robinhood didn’t just come out and explain clearly what was going on. Imagine if Robinhood had said something like the following:

“Sorry guys, we suspended trading because there aren’t any GME shares left on the planet, and we were afraid you might bankrupt all of Wall Street, including us, if you pulled off your infinity squeeze and sent GME to $100 and beyond — and you came within minutes of actually doing it, which is why we panicked.”

Had Robinhood explained what really happened, it would have been an open admission that the Reddit army had come within minutes of pulling off the squeeze, and breaking the system in the process.

The effect would have been like waving a bloody pork chop in front of a pack of starving pit bulls. The Reddit army would have heard “you almost won” and tripled down on its efforts.

Robinhood was actually put in a nightmare situation. They couldn’t admit the real reason they blocked trading — but in refusing to speak clearly about their actions, they created a perception that might kill the firm anyway (the appearance of favoring hedge funds over small investors).

And this explains why Robinhood did a billion-dollar capital round-up. Robinhood realized it was caught between two existential threats:

• If Robinhood allowed GME trading and couldn’t find enough shares to fulfill call option exercises, they would either fail to deliver on their contractual obligations and be sued into oblivion, or run out of capital trying to pay for the GME inventory they needed to hold.

• But if Robinhood continued to block GME trading, they would look like a rotten tool of Citadel and their whole customer base would abandon them.

• So Robinhood took the third path — they tentatively allowed GME buying to resume, but got their hands on a billion dollars in emergency cash to cover financing needs if they had to round up GME shares at insane prices to fulfill contractual delivery.

The whole GameStop saga is one of the most fascinating things to ever happen on Wall Street.

As avid students of financial history, we can say with confidence we’ve never heard of anything like this dating back at least 100 years, dating back to the 1920s, and Jesse Livermore days, and the time before the Securities and Exchange Commission (SEC) even existed.

The other thing to emphasize here is that the story is far from over.

Or rather, it is far from over on the morning of Friday, Jan. 29, as we complete this piece. By later in the day it could already have ended, for all we know.

But as of right now, as we watch the GME share price again trade above $400 in premarket trading —  and the WallStreetBets message board swell by an additional 1 million members in a single day — it looks like the Reddit army understands the power that it has.

They have done the math, and the math says the Reddit army can win. Especially as they probably have professional firepower on their side, too (in the form of hedge fund managers and individual traders who are betting on the success of the squeeze).

The whole thing is not just a quest to make a lot of money — by driving the GME share price into the thousands, where dead hedge funds and their brokers will be forced to buy the shares — but a sort of global protest movement.

The GameStop squeeze is like Fight Club — if you remember that 1999 film with Brad Pitt and Ed Norton — except set on Wall Street.

Or as others have said, it is like a new version of the “Occupy Wall Street” movement, except with $60 billion (or even more) at stake.

And the Reddit army may succeed because the story is so viral, and limited-risk participation is so easy. Buy shares of GME, possibly triple your money — with the worst that happens losing a few hundred or a few thousand dollars — and be part of a movement either way.

The resulting Reddit message board testimonials from GameStop participants all over the world, including this one from New Zealand — New Zealand! — were kind of amazing:

I only have a modest 8 shares — I got in early with my play money that I can afford to use every week, but this was returning $4,000 this morning off $300. This was huge for me and my family. This is a lot of gear that we weren’t able to afford but now we can.

There’s every chance, with everyone holding and buying, that this could even double!! Boys, thank you for holding and doing your part, you’re making a massive difference!

Multiply that sentiment — gratitude for a chance to “stick it to the man” and make money at the same — by the power of understanding the infinity-squeeze math, a million people a day joining Reddit to hear the story, and professional firepower joining the squeezers too, and you get the clear conclusion: They could really pull this off, and just might.

Unless, of course, the government decides that potential losses in the tens of billions are just too much — at which point the whole thing might get halted on orders from a higher authority, optics be damned, in the way the Hunt brothers’ attempt to corner the silver market was shut down by the Chicago Mercantile Exchange in 1980.

In our humble view, the Reddit army will win — and will keep pressing hard until they do — unless the authorities decisively intervene in favor of Wall Street establishment (hedge funds, banks, brokers, and exchanges).

In too-close-to-call probability terms, that makes this whole thing something like Ace-King versus Pocket Queens in an “All-In” match-up for all the chips, at the final table of a winner-take-all poker tournament, where the ultimate prize is $60 billion (or even more).

In 2018, Elon Musk said reality as we know it is probably a simulation.

His basic rationale was that, because the universe is old enough to produce advanced-technology civilizations, there is a high probability those civilizations know how to run advanced computer simulations.

The implication is that life on earth, as you and I know it, is one of those simulations. We are all just characters in an alien version of The Sims (a popular life-simulation video game).

Neil deGrasse Tyson, the celebrated astrophysicist, thinks the simulation hypothesis could be true.

But we are more inclined to agree with Michio Kaku, the celebrated theoretical physicist, who argues that the multi-layered universe is so complex beneath the surface — think quantum physics — that its basic functions are irreducible.

The implication of Kaku’s view is that, in order to simulate the known universe, you would need a computer powerful enough to recreate an actual universe.

And so, if a civilization had that much actual power, they could just crank out real, actual universes, like popping popcorn in the microwave. This makes it likely that our own universe is the real thing.

Sometimes we wonder, though, because reality feels beset by cosmic pranks. If life on earth really is a simulation, whoever is running it seems to like “dad jokes.”

Take the GameStop short squeeze, for example. (We explained the basics on Jan. 26, which you can read about here.)

Just when markets felt like they couldn’t get any crazier, 2021 said “hold my beer.” The whole world is now focused on the GameStop saga.

And it just so happens — this is the cosmic humor part — that the stock getting squeezed has the words “Game and Stop” in its title.

What’s more, the slogan of GameStop, as displayed on its retail signage in dying malls all across America, is “Power to the Players.”

And this is the stock that gets gamed, to such an extreme degree it could make the bigger game — the Wall Street game — completely stop? You can’t make this stuff up.

While the GameStop story was all over the financial news yesterday — even the White House had to acknowledge it — the media is missing just how big this story is.

As of this writing, on the morning of Jan. 28, it looks like the sought-after “infinity squeeze” in GameStop is happening. We don’t know how this ends, but GME could go to $1,000 before this ends. Or even $5,000 or $10,000, you just can’t know.

Giant hedge funds — whose short books are getting vaporized right now, not just in GameStop but a whole suite of names — could wind up collectively losing more in this squeeze than they did in the Volkswagen squeeze of 2008 ($30 billion).

Below are some of the fund loss numbers that were anecdotally reported on Wednesday, Jan. 27.

As you ponder the numbers, keep in mind that the percentage of GameStop shares sold short is still extremely high (because the trapped shorts can’t sell without running the price up further, thus cutting their own throats); that the “infinity squeeze” in GME is still very much ongoing as of this writing; and that the funds below are getting hurt by a roster of skyrocketing short positions (not just GameStop). 

• SAC Capital, which came into 2021 with an estimated $19 billion in assets under management (AUM), is reportedly 15% down on the month (if not more). Implied loss: $2.85 billion.

• D1 Capital, which entered 2021 with $20 billion AUM, is reportedly down 20% on the month (if not more). Implied loss: $4 billion.

• Melvin Capital, which had $12.5 billion, and then received an emergency capital infusion of $2.75 billion, was reportedly down 30% before throwing in the towel on GME. (Whether they are actually out of GME is up for debate; even if they are, they could still be getting killed on other short positions that are hard to unwind.) Implied loss: $3.75 billion.

• Maplelane Capital, a slightly smaller hedge fund with AUM of $3.5 billion, was reportedly down 33% this month, for an implied loss of $1.1 billion.   

The hedge fund losses noted above (via trading desk scuttlebutt) are nearly $12 billion — and those are just the big names we’ve heard about, and the losses are still ongoing.

GameStop is the main event, but the Reddit army is going after all of the heavily shorted stocks right now. All of them. It is, quite literally, the worst nightmare these giant funds have ever seen.

They can’t just “close their positions” easily because, in the midst of a true squeeze, closing a large short position means sending buy orders into the market for shares that aren’t available to buy (because nobody is selling). That, in turn, makes the share price go up even more.

To get an idea of how widespread the squeeze game has become, Bespoke Investment Group reports that the 30 most heavily shorted stocks on U.S. exchanges, as a basket, were up more than 100% on average.

Not 100% as a basket either — 100% per name.

In some ways the “infinity squeeze” is a very old idea. A hundred years ago they called it “cornering the market.”

If a speculator can corner a market — be it a stock, a commodity, or something else — they can gain such absolute and total control over the available supply that desperate short sellers, along with anyone else who has an obligation to buy, are completely at the speculator’s mercy.

In the 19th century, there was a famous short seller named Daniel Drew, known for his powerful operations on the bearish side of the market.

But Drew made the mistake of messing with Cornelius Vanderbilt, a shrewd railroad tycoon who was even more powerful.

After trapping Drew by cornering the market on shares of the Harlem and Hudson Railroads — and forcing Drew to beg for his financial life — Vanderbilt gleefully repeated one of Drew’s own favorite sayings back to him:

“He who sells what isn’t his’n, must buy it back or go to prison!”

So, that is where many of these giant hedge funds find themselves. They have to “buy it back or go to prison.” But they can’t bid without fueling the fire, and they can’t get their hands on the shares.

If the pressure does not let off soon (very soon), then many of these funds — these gigantic, multi-billion-dollar, “master of the universe” type giants — could die.

There is a joke going around Reddit right now:

Q. How do you become a millionaire?

A. Start out as a billionaire, and then short GME.

The joke is funny because it’s accurate. There are Wall Street billionaires who will no longer be billionaires after this. There are multi-billion-dollar funds that had excellent track records coming into January 2021 that will cease to exist. The high and mighty are being toppled.

You might be wondering, how is this even possible?

How could hedge fund giants and Wall Street titans get laid low by traders on a message board?

The first thing to note is that the Reddit WallStreetBets community, or WSB for short, is not just a run-of-the-mill message board.

Prior to the GameStop story blowing up in the press, the WSB community had roughly 2.2 million members. As of this writing it has 4.4 million members. This means that:

• The Reddit WSB community more than doubled in size, from 2.2 million members to 4.4 million members, in a matter of days.

• The largest physical army in the world, the People’s Liberation Army of China, has 2.8 million soldiers. The Reddit army is 57% larger than the PLA.

• The WSB community is sophisticated in their knowledge of how an “infinity squeeze” works, and what has to be done to corner the market in a stock. They know what to do, and they are doing it. And the size of their community is growing by the minute.

Worse still for the giant hedge funds caught short, the GME short squeeze story has gone global, and retail investors on multiple continents are participating.

There are retail investors in Germany, India, and Australia buying GME. And the number of recruits is swelling due to the nature of social media and algorithmic platforms.

If you type “short squeeze” or “GameStop” into Google or YouTube or TikTok — something millions of people are doing now — you will quickly be served up viral explanations of why the GameStop squeeze is a revolution of the little guy fighting back against Wall Street, and why you should join in.

So, the GameStop story is viral, the GameStop story is global, and the market is structured in such a way that anyone with a brokerage account can participate.

There are people buying a single share of GME, simply to express solidarity with the average joe Redditors in their fight against the big bad hedge funds. (There are also people buying tens of thousands of dollars’ worth of GME and leveraging their buying power with short-dated call options.)

 The GME squeeze is being billed as a profit opportunity — if the stock goes into the thousands, the squeezers will make a killing — but also a protest movement. There is very much an attitude of “the little guy strikes back,” which makes the GME squeeze something of a moral crusade.

That, in turn, adds to the virality of the story, and the willingness of people to buy GME shares and hold them, just to see if they can make a hedge fund die.

Call it revenge for the global financial crisis; revenge for the mortgage crisis; and revenge for connected elites with ivy league pedigrees getting all the breaks in the world, while the average small investor gets none.

The GameStop squeeze has that angry, righteous fire at its core — some are calling it the “real Occupy Wall Street” movement — mixed in with a profit motive for anyone who can buy shares. That is a super-powerful combination.  

For the giant hedges caught in this vice grip, the current state of affairs sounds about as bad as it can possibly get: Trapped like rats by the world’s largest army of angry retail traders, holding fast and buying globally, a kind of 21st century Cornelius Vanderbilt dispersed across a digital swarm.

But no, the story gets even worse for the giant hedge funds. Much worse. 

That is because the WSB community has shown such solidarity and strength in the GME squeeze thus far, other hedge funds are likely to join them.

At this point, the Reddit-centric retail army is probably getting back-up from the hedge fund world itself. Professional firepower has likely joined them.

Not all hedge funds are caught in the short squeeze vice. Some have clean books, meaning, they don’t have any positions that are bleeding them out.

Those funds are now watching the GameStop price action, running their own calculations, and realizing “You know what, this infinity squeeze should actually work. We should join in — on the long side.”

For many hedge funds — those that aren’t bleeding and reeling, that is — contributing to the squeeze is a rational calculation at this point. They are doing the math, and the risk versus reward calculations favor participation if the squeezers can ride along.

Hedge fund managers, after all, are not a monolithic group. They are more than willing to turn on each other, especially when an opportunity for substantial profit is involved.

And when a large hedge fund, or better yet a group of hedge funds, is forced to unwind a losing position, other hedge funds tend to swarm like sharks in a feeding frenzy, or hyenas on a downed wildebeest.

We saw this with the famous multi-billion-dollar meltdown of Long-Term Capital Management (LTCM) in 1998. As LTCM bled out, other hedge funds up and down Wall Street figured out what LTCM’s positions were — and bet against them heavily, knowing LTCM would be forced to capitulate.

What we are witnessing now, in the GameStop infinity squeeze, is truly remarkable. It is something completely old (shades of 18th century Vanderbilt versus Drew) and completely new (a global stock market corner, coordinated by message boards, enabled by zero-commission trading apps, and strengthened through viral messaging).

How is it all going to end? Again, we don’t know. Nobody does. The world has never seen anything like this before. There are historical parallels, of course, but nothing that meets the moment.

The impact on the broader stock market could also be significant.

On Jan. 27 Wall Street had its worst day in three months, for example — with the Dow dropping 633 points — in part because the bleeding hedge fund giants were forced to cut back their long positions.

There is a phenomenon known as “portfolio contagion” that kicks in whenever a big part of the market registers severe losses.

If giant hedge funds are getting hammered in a specific area of their portfolio, they often have to cut risk all across the board, which means reducing position exposure in other areas of the portfolio.

That is why huge losses on the short side can lead to, say, large sell-offs in popular names those same funds were bullish on.

So, there is a real possibility that the GME squeeze could hasten “the end” — as in, the end of this wild bull market — by feeding large-scale sell-offs as giant hedge fund players go into their death throes.

But it’s also possible the broader market shakes this off, and that the game does not, in fact, stop (pun intended). After all, there is another round of stimulus checks coming.

What about the regulators? Isn’t this kind of market manipulation illegal?

That’s a tricky one, because expressing a bullish opinion on a stock is a free speech issue. There is nothing illegal, technically speaking, in deciding to buy shares or call options on a stock you like. There is no inside information, or client privilege, or any of that stuff. Just a bunch of investors on message boards, who all happen to be buying the same stock. 

The Securities and Exchange Commission (SEC) will surely find ways to better regulate options markets after this, and to more effectively detect and dampen coordinated ramp-up activity through actions taken in the market (like more circuit-breakers and halts for stocks deemed in need of a cool-off period).

It’s doubtful the SEC will find traders to prosecute for the GME squeeze, though — which makes sense because, in a funny way, the WSB community is merely doing the same kind of thing hedge funds have been doing, legally, on CNBC for years, in talking up their position in an effort to drum up buy interest.

They took that basic “talk up the stock” approach, made it go viral, and combined it with enough global-buying firepower (and righteous anger) to overwhelm anyone standing in their way.

Another question is whether the game stops after GameStop. Realistically, it might not.

Having tasted the power of unified intent, with a whole smorgasbord of communication apps available, the Reddit army — or whatever one might call it — could constitute a new player on the field, with new soldiers replacing old ones as trading accounts rise and fall.

Investors, on the whole, seem convinced that inflation will stay low; that interest rates can’t rise very much; and that passive investing is here to stay.

All three of those beliefs could be wrong, and the second two statements hinge on the first one.

If inflation comes back in a meaningful way, interest rates could rise again.

And both of those developments were structural — meaning inflation persists for a decade or more, and interest rates rise for that period — the passive investing model could be killed off.

Buying an index fund, and holding it, could then become a memory of times past.

On a global basis, accounting consultancy PwC sees passive strategies managing $36.6 trillion by 2025. If the forecast we see takes hold, that could melt away to nothing by 2030.

To see why this is not only possible, but likely, we first have to understand why inflation could return; and then second, we have to understand how inflation can utterly destroy passive investment returns.

For most investors, the possibility of inflation is hard to fathom today.

This is partly because so few remember what the last inflation-driven era was like, and partly because U.S. fiscal policy (government spending) has been relatively constrained for the past 20 years.

Over the past 20 years or so, the U.S. government has expanded the deficit for wars and tax cuts, but not for much else in comparison to decades past.

At the same time, foreign investment flows have readily funded the U.S. deficit, even as monetary policy — not fiscal policy — did the heavy lifting in terms of stimulating the economy (by driving rates to zero). 

That is a unique set of circumstances that is now going away. We are heading into a new paradigm, though most investors don’t understand what that means. It is hard to grasp the magnitude of cyclical change when a multi-decade cycle, like the long-term debt cycle, finally starts to shift. The graphic below, via the St. Louis Federal Reserve, shows the interest rate yield on the U.S. Treasury 10-year note over the past 40 years, from 1980-2020. As you can see, yields have been falling (which inversely means treasury bond prices have been rising) nearly the entire time

The peak of the 10-year treasury yield, in September 1981, roughly coincided with peak inflation fear in the United States. Toward the end of the 1970s, American investors believed inflation was relentless and unstoppable and that inflationary conditions would last forever.

That belief was not only wrong, it was the capstone to an entire inflationary era.

Just as U.S. citizens reached their maximum level of conviction that inflation would never go away, a 40-year era of disinflation, and falling interest rates coupled with rising asset prices, was starting.

Four decades later, in 2021, American investors believe the opposite thing. They think inflation has been forever vanquished; that it can’t come back; that disinflationary pressures like aging demographics and deflationary aspects of technology will keep inflation at bay, and interest rates low, for decades more.

Investors are likely wrong on this point, too. We are witnessing the conditions in which a new inflationary era is being born.

And in that era, holding a passive stock index will be a nightmare, and holding a 60/40 portfolio might be even worse. These are strategies for a disinflationary era, in which interest rates are falling and general inflation is low. When the paradigm shifts in a meaningful way, these strategies could die.

What could make inflation return with a vengeance? There are multiple factors in play. But the single largest one is probably a whole new era of government spending.

People have pointed out, rightly, that the aging demographic of the Western world is deflationary. As baby boomers head into retirement, they spend less. Their consumption footprint shrinks. Those who head into retirement with no real savings see their lifestyles constrained even more.

The impact of rapidly advancing technology is also deflationary. Technology improves productivity by removing inefficiencies. The challenge is that one man’s inefficiency is another man’s gainful employment. Think what happens when millions of truck drivers are no longer needed; millions of fast-food workers; millions of dock workers; millions of radiologists, paralegals, and so on.

And yet, it is very important to understand something. As technology creates societal dislocations through massive job loss, governments will spend money to smooth over the cracks in a fraying societal structure.

And in order to ensure the job is done right, the government’s policy reaction function will be super-sized. They will spend more and more to keep democracy from breaking. And people will vote for this.

We are already seeing this happen. The future is now. In 2020, we saw a $2.2 trillion CARES act package, followed by a $900 billion add-on. Now there is $1.9 trillion worth of additional stimulus in the works, and a multi-trillion infrastructure package coming after that.

This is only the beginning, because the people like government money. And Republican voters like government money just as much as Democrat voters do.

“72% of respondents who voted for Trump believe that the stimulus checks should be greater than $600,” wrote Business Insider in December.

Fiscal help is not a partisan issue at the grassroots level. Americans want it. And as the job-erasing impact of technology disruption grows more intense — and as half or more baby boomers enter their retirement years dead broke — the demand for more fiscal stimulus, if not a kind of permanent stimulus, like universal basic income (UBI) through a back-door channel, will intensify.

And the government will be ready to provide. Janet Yellen, now confirmed as U.S. Treasury Secretary, recently wrote the following in a memo to 84,000 U.S. Treasury employees:

“Economics isn’t just something you find in a textbook. Economic policy can be a potent tool to improve society. We can, and should, use it to address inequality, racism and climate change.”

Translation: Do you like fiscal tsunamis? Because we’re ready to make them a thing.

Some argue that governments can’t create inflation. This is nonsense.

It is true that the Federal Reserve, on its own, cannot create inflation. The Fed is not allowed to spend money, or to send funds directly to households and businesses. It can only move interest rates around, or swap out dollars for treasuries or vice versa. (The U.S. dollar is just another government security, with a duration of zero years.)

But the U.S. government is allowed to spend money, and to “helicopter drop” large amounts of currency directly into the laps of people, businesses, and state municipalities.

Thanks to the power of the purse — and a sovereign government’s ability to borrow in its own currency — Janet Yellen can fulfill her aims. A government’s ability to create inflation is only a matter of political will.

If you think about it for a moment, this has to be true, because otherwise the government could print an infinite amount of currency, and distribute it in the most aggressive way possible, with no inflationary impact. That doesn’t make sense.

So inflation will be coming in part because we are in a new era of fiscal dominance — a period where government spending matters far, far more than the actions of the Federal Reserve, and where the job of the central bank is to clean up the mess created by wave after wave of politically popular fiscal initiatives.

In this new era, those on the lower rungs of the economic ladder will have new spending power via direct payments. In terms of inflation-generative activity, that is even more powerful than raising people’s wages. (Though wage hikes are in the works too, with the $15 minimum also a bipartisan popular issue.)

In a weird way, the deflationary impacts of demographics and technology will lead directly to inflation, by triggering the much larger, and more powerful, policy reaction impulse in the form of normalized fiscal spending. Call it killing the fly with a sledge hammer, or maybe a neutron bomb.

Then, too, we know that global central banks hold far too many U.S. dollars in their currency reserves mix — instead of 60% it should be more like 30 to 40% — and that a “global rebalancing” will mean a steady erosion in the value of the U.S. dollar. This will add to inflation pressures even more.

The story then gets worse, because the Federal Reserve will eventually have to implement something called “yield curve control” to support the tanking bond market. What this means in practice is that, as selling pressure on the bond market increases, the Fed will be the buyer of last resort.

But in order to buy up the excess supply of treasuries being sold, the Fed will have to pay with dollars. This will be the de facto “debt monetization” of the U.S. national debt, in which treasuries are converted to dollars, at a rapid clip, in real time.

This, too, will contribute to inflation, as will rising demand for grains, base metals, and fossil fuels in a world where supply shortages are structural (due to underinvestment in production capacity that cannot be corrected quickly). That means more inflationary pressure.

And then, last but not least, U.S. consumers will see, and feel, all of this inflation, and develop an inflationary mindset alongside the spending power provided to them by a generous U.S. government. This will spin the inflation flywheel even faster.

The net result of this could be a nightmare for passive investment strategies.

The chief problem for passive investing is that, in a truly inflationary era — unlike the four-decade “lowflation” era coming to a close — it is possible to lose money in a stock index, even if the price of the index goes up.

Think what happens if, say, the S&P 500 gains 4% in a year where inflation was 6%. The 6% loss to inflation not only cancels out the 4% gain, it leaves the investor 2% behind on balance.

If this happens for years on end — inflation outpacing the rate of nominal index gain — then holding a stock index will feel like a “mug’s game.”

History shows us how this works.

• Between January 1966 and December 1982, the S&P 500 index saw a nominal gain — in closing price terms — of 19.6%.

• But according to research analyst Jim Bianco, the S&P 500 lost 65% of its real value between 1966 and 1982 — nearly two-thirds — as a result of persistent inflation.

• Bianco further notes that, for an investor who bought the S&P 500 in 1966, it would not have been until 1993 — 27 years later — that the holding would have delivered real, inflation-adjusted gains.

The gist is that, in a time of structural inflation, a stock index doesn’t even have to go down for passive investors to lose money. It can go sideways, or creep higher in a lackluster way, and passive holders can still lose a bundle. All the index has to do is fail to keep pace with inflation, year after year, for passive investors to see the purchasing power of their savings eaten away.

This helps explain, by the way, why the stock market doesn’t have to decline in order to correct for too-high valuations. Failing to keep pace with inflation is a form of correction in itself, as real gains are eroded via nominal gains being worth less.

Another aspect of inflationary eras is that U.S. treasuries cease to be desirable assets.

When inflation is the order of the day, interest rates are rising over an extended period of time, which means bond prices are falling.

For investors in stocks and bonds — and particularly those in 60/40 portfolios — this creates the horrifying experience of seeing their stocks and their bonds decline in price simultaneously.

Once again, that is a different deal than what investors have grown used to these past 40 years.

Between 1980 and 2020, owning a mix of stocks and bonds in the same portfolio made sense because, when the stocks were going down, the bonds were probably rising — and if the Fed cut interest rates to stimulate the economy because stocks were down, the bonds would rise even more.

That whole rationale is why the 60/40 portfolio exists. But the structure depends on a disinflationary environment — an era where inflation is low or falling, which is the thing that makes bonds attractive.

When inflation is high or rising, the mix ceases to work, and the bond side actually becomes a liability (no more protection, and not enough yield, but plenty of risk).

This furthermore has big implications for “target date” funds, popular passive retirement vehicles that automatically allocate to a preset stock-and-bond mix.

When inflation truly returns, trillions of dollars in target date funds could be jettisoned. And investors everywhere will be asking themselves, why own index funds at all, just to get ravaged by inflation like this?

When you really boil it down, passive investing strategies were a kind of free lunch that persisted for decades. Passive methodologies were a simple, low-cost way to take advantage of falling interest rates and falling inflation levels, even as the U.S. economy expanded, central banks stayed accommodative, and government spending was constrained (at least in comparison to the 1930-1980 period).

All of that is likely going away, which means the low-effort returns of passive investing go away, too. Inflation eats them up, leaving the inflation-era investor worse off than before.

So is there a solution to this problem? Is there a way for investors to make money, and successfully fund their retirements, even in an inflationary era?

Yes, certainly. But the answer is old-fashioned: Investors will have to get involved with individual stocks and industries, and actively manage their portfolios again.

If they don’t, the only alternative will be to eat inflation losses. Such losses will be inflicted even if investors sit in cash (as cash will lose value too, through eroded purchasing power, over a long stretch of inflation years).

At the same time, opportunities will exist to beat the inflation bogey — and in many cases not only beat it, but crush it — by being invested in the right places, with the right levels of concentration.

The sickness that will infect stock indexes in aggregate will not impact the entire market. There will still be pockets of investment opportunity that do incredibly well, just as there were in the 1930s, and again in the 1960s and 1970s (the last time inflation had a heyday). 

For those who are willing to be active, and who are willing to make concentrated investments while managing their risk, the shift to an inflationary era could well prove exciting and lucrative. For anyone inclined to be passive, however, there won’t be anywhere to hide.

Ten or 20 years ago, the small retail investor was supposed to be afraid of hedge funds.

To put it another way: In the old market ecosystem, hedge funds were the predators and retail investors were the prey.

And the bigger the hedge fund — as measured by billions of dollars in assets under management — the more of a predator it was considered to be. The biggest funds were the apex predators, and retail investors were lunch.

Not anymore. The relationship has flipped. In the new market ecosystem, giant hedge funds are the prey — and an army of retail investors has banded together to systematically hunt them down.

If that sounds hyperbolic, consider the case of Melvin Capital, a $12.5 billion hedge fund that was almost destroyed in the past few days.

Melvin Capital was heavily short GameStop (GME), a brick-and-mortar retailer with a bleak outlook.

Via WallStreetBets, a popular message board on Reddit, a swarm of retail investors — they behave like  a “retail investor army” — decided to buy GameStop shares en masse, putting a squeeze on the hedge funds that were short.

The idea behind a short squeeze is that, with enough aggressive buying, anyone who is “short” a stock (betting that the stock will go down) can be forced to cover their position.

We first wrote about the GME squeeze on Jan. 15, in “Scenes from an Epic Market Mania.”

This is something of a follow-up to that piece — to report that the retail army won. They squeezed GameStop hard enough to send its shares into the stratosphere, while nearly destroying the fund they were going up against.

After our first reporting on GME, the shares went from a close of $43.03 to an intraday high above $159 per share — a 269% gain — in just two days.

Melvin Capital, the aforementioned $12.5 billion hedge fund known to be short GME, was delivered a death blow — and likely would have faced shutdown if not for an emergency bailout.

The fund, which had an excellent track record heading into 2021, was reportedly down 30% as a result of the GME short squeeze (which was, once again, organized by a bunch of retail investors on a message board).

To counter the 30% drawdown — and likely to provide capital for defending the position — Melvin Capital received an emergency $2.75 billion cash injection from two other giant hedge fund operators, SAC Capital and Citadel.

And by the way, we doubt SAC Capital and Citadel ponied up that $2.75 billion out of the goodness of their hearts. It is more likely that they, too, had positional exposure in short names that the retail army was raiding — because this whole phenomenon goes well beyond GameStop.

The biggest hunters are now the hunted.

So, to recap:

• An army of retail investors on a message board decided to do a bull raid.
• They deliberately picked GameStop (GME) because of its heavy short float.
• They openly declared war on a $12.5 billion fund that was heavily short GME.
• They “squeezed” GME so hard the fund was down 30% almost instantly
• And the fund had to take a $2.75 billion capital infusion to survive.

Nor is this just about GameStop, or a single bull raid targeting a single large hedge fund.

Rather this retail investor army — as organized on WallStreetBets and elsewhere, equipped with zero-commission trading apps like Robinhood — has made “squeezing the shorts” a repeatable market tactic.

The basic strategy looks like this:

• Find a company that appears left for dead, with little hope for survival, that also has a large percentage of its shares sold short by bearish hedge funds.

• Coordinate plans for a bull raid on WallStreetBets, or some other message board or chat apparatus (these raiders are also active on Twitter and TikTok), and then point a virtual aircraft carrier railgun of money (thousands of small investors buying all at once) at the stock in question, in order to aggressively bid up the shares.

• Or, for an even more aggressive version of the bull raid, have the retail army pour money into short-dated call option buys, which in turn forces the market makers who sold the options to buy a concentrated level of shares in the open market as a form of hedging.

• Through this brute-force buying activity — which can be spread across unknown numbers of buyers, as WallStreetBets has 2.3 million members — raiders push the stock higher with such force that shorts are forced to cover at any price.

Another company that recently went through this process is AMC Entertainment Holdings Inc. (AMC), the movie theater chain.

As one can imagine, movie theaters aren’t very popular in the midst of a raging pandemic. As a result, AMC was on the ropes and headed for bankruptcy, its heavily shorted stock falling to $2 per share.

But then the retail army stepped in — running their squeeze play — and AMC’s stock price rose 250% in a matter of days on massive volume.

Not only that, but the heavy incoming volume from the retail army bull raid allowed AMC to raise $917 million in funding — which would have otherwise been impossible — which in turn means an outcome in the real world was changed. A company that was headed for bankruptcy (because of the pandemic) was given life by a squeeze play.

The ultimate prize for the retail army, which they talk about openly, would be to engineer an “infinity squeeze.”

The term “infinity squeeze” was invented to describe what happened with one of the biggest short squeezes of all time, which happened with Volkswagen in 2008.

The short version of the Volkswagen story is that Volkswagen, like many other auto companies, appeared headed straight for bankruptcy as a result of the global financial crisis back in 2008.

Because the company’s prospects were dire, hedge funds were heavily short Volkswagen shares, seeing bankruptcy as almost a lock.

But then, on Oct. 26, 2008, a surprise announcement was made by Porsche, another German auto company that had secretly acquired 74% of Volkswagen’s share float.

After the Porsche announcement, it suddenly became clear: The hedge funds with Volkswagen shorts were now completely caught out. If Porsche refused to sell, they would have to “buy back” their short positions at almost any price.

It was dubbed an “infinity squeeze” because, with no way to buy back shares, the shorts are at the total mercy of the longs, which means the price of a heavily shorted stock can go almost anywhere — and with Volkswagen, it did.

For a brief window of time, the VW infinity squeeze turned Volkswagen from a near-death bankruptcy candidate into the most valuable company in the world. The hedge funds that were short lost an estimated $30 billion, and Porsche made eight times more money on trading that year than it did from selling cars.

If the retail army succeeds in pulling off an infinity squeeze in GME (they are still trying as of this writing) or some other stock, it wouldn’t just mean a $5 stock going to $40, or a $20 stock going to $200.

It would be more like a $10 stock going to $1,000 or beyond, with a random beaten-down short name (they are always beaten down, that is why they are shorted) gaining a temporary market cap on par with Amazon or Apple.

It is hard to see how this can go on. The new bull raid, as perfected by this zero-commission retail army, has utterly destroyed the appeal of short-selling anything. Various compilations of the most heavily shorted stocks show that, in 2021, those are the stocks that have risen the most. 

Now, very few investors will shed a tear for short sellers. But it isn’t great for markets when valuations cease to mean anything at all, and when share prices can be openly and aggressively manipulated not just for a few percentage points, but gains of hundreds of percent (or even thousands of percent).

The broader investor danger here comes when the GameStops of the world start falling back to earth. It may be that everyone is happy (apart from blown-out hedge funders) when cheap stocks get squeezed to astronomical levels.

But when the game of musical chairs comes to an end, we could start seeing popular stock names falling 50 to 90% in a matter of weeks or even days, collapsing as quickly as they inflated. That would wreak havoc on average confidence levels in the market.

One would think the Securities and Exchange Commission (SEC) has an open-and-shut case to put a stop to this stuff as textbook market manipulation. But it isn’t that simple. Who will they go after?

There aren’t any billionaires or famous hedge funders doing this work. It is a merry band of small investors now. And if they try to shut down one venue, like the WallStreetBets message board, there is no reason a bull raid community can’t spring up in some other venue. (And as mentioned, we are already seeing this phenomenon on Twitter and TikTok.)

So, it may be that the retail army will be eating the lunch of giant hedge funds for a while yet — or at least until either the current market mania burns itself out, or the incoming Securities and Exchange Commission Chairman, Gary Gensler, figures out what to do.

As one last observation, there is another possible side effect to all of this short-squeeze craziness. It could make the grand finale of the current market mania even more spectacular and awe-inspiring.

Chances are good we have not seen “the end” of the mania yet. Think about the grand finale of a July 4th fireworks display. In the final minute, the pyrotechnics become even more bright, more booming and dazzling, than all that came before.

Manias tend to work the same way: The grand finale is more of a spectacular blow-out than a whimper.

And now, thanks to the bull raiders, hedge funds will be too scared to death to short anything, for fear that the retail army will wade in and destroy them. (This is why current levels of shorting activity are low; the retail army is scaring the shorts out of business.)

And at the same time, hedge funds looking to make a buck will piggyback off the raiders when they can, adding buying power to positions where it looks like the retail army is at work. (Nor can we blame them; we are doing something similar in the TradeSmith Decoder portfolio.)

What this means is that, all other things being equal, we can take the forecast for a market mania grand finale and throw in an oil drum of nitroglycerine and a truckload of dynamite just for fun.

While the moves have been absolutely wild thus far, our suspicion is that the real insanity — and the mind-blowing moves that could mark the ultimate mania top — still await. 

In the TradeSmith Decoder model portfolio, we have a large position in a top-tier copper miner that was up more than 190% as of last Friday’s close. For that we say: “Thank you, China.”

There are other crucial factors driving the price of copper higher — and grains, too — but China is a big one. China has been using its exceptionally strong currency, the yuan, to stockpile copper and grains.

This activity means China is exporting inflation to the world. As China’s relentless demand pushes prices up, food costs and construction costs rise in other countries. A weak U.S. dollar — the flipside of China’s currency strength — is also contributing to global inflationary pressure, as base metals and grains are generally priced in dollars.

China by itself accounts for roughly half of global metal demand. At the same time, China’s grain demand is now breaking records.

China has a sizable corn deficit as a result of livestock needs — it is trying to rebuild its domestic hog supply after a mass-culling due to swine flu — and China wheat imports for 2020-2021 are forecast to be the highest in 25 years.

At the same time, China is ramping up copper demand as its domestic economy rebounds faster than everyone else’s, as a result of dealing with the pandemic earlier on.

“The nation’s factories are charging ahead full steam,” the New York Times reports. At the same time, the NYTadds, “China’s share of world exports rose to a record 14.3% in September.”

Because exports are still moving briskly out the door, China can focus on stockpiling grains and metals with its increasingly hard currency, rather than sweating over non-competitive export pricing.

The chart below shows the strength of China’s currency in U.S. dollar terms.  It was in the third quarter of 2020, when the yuan had rocketed off a textbook “W” bottom, that China’s stockpiling efforts got aggressive.

Of course, no fiat currency is valued in a vacuum; its quoted price always comes in relation to some other currency (or an alternative benchmark like gold). And as we mentioned earlier, the flipside of a super-strong yuan is a super-weak dollar.

That picture does not look set to change. As we explained in our recent piece on 50 years of U.S. dollar policy, there are plenty of reasons to expect ongoing dollar weakness ahead — not just for months or quarters, but years.

The dollar could have its temporary rebound periods and countertrends here and there, but overall, there is great impetus for it to fall (and then fall some more — and then still more).

For copper and grains, the twin drivers of Chinese demand and U.S. dollar weakness are making a structurally bullish supply-and-demand picture look even more bullish.

Regarding copper, the world is facing the prospect of built-in, long-term supply shortages even as demand ramps up to never-before-seen heights.

As we have said before in these pages — on July 20, 2020, we explained why “Copper is Heralding a Rise in FDR-Style Public Works Projects” — the world is about to embark on a wave of ambitious infrastructure projects in an effort to get past the pandemic slump.

The U.S. is likely to lead the way with a multi-trillion-dollar infrastructure package, but other Western nations, like Germany and the U.K., are likely to follow suit.

At the same time, the “green industrial revolution” now taking place — a process in which electric car-charging stations vie with gas stations, solar panels see exponential uptake, and millions of homes and businesses are retrofitted for energy efficiency — will demand vast amounts of copper.

That is good news for the world’s copper miners, but it is also bad news because they are nowhere near prepared. The mining business is highly cyclical, and the world’s miners come into 2021 with significant cutbacks to their production budgets.

Global mining investment has been depressed for years — it is roughly a third of the levels from five years ago, according to commodities research firm Wood Mackenzie — and is not expected to rise in 2021.

Copper’s last boom peaked out in spring 2011. By the summer of 2016, copper prices had fallen more than 50%.

That level of pain made investors gun-shy of funding new copper projects, and caused management itself to cut back on investment, devoting more capital to paying down debts instead.

What this means is that, if demand sees a sustained surge — due to the aforementioned big industrial projects and green energy rollout — it could take copper producers years to catch up.

And in the meantime, we could see relentless China demand on one side, and an ever-weakening dollar on the other.

With respect to China’s aggressive grain buying, the outlook for global food inflation is further stoked by dwindling grain stockpiles in the United States. A few weeks ago, a monthly supply-and-demand report from the U.S. Department of Agriculture (USDA) caused grain prices to skyrocket, with corn, wheat, and soybeans hitting their highest levels in seven years or more.

One of the factors there was dry weather in both the U.S. and South America impacting production more than expected: When there isn’t enough rain, the crops don’t grow. Global grain supply was also restricted by government responses to the pandemic, with multiple grain-producing countries restricting their exports.

The truly unsettling question, when it comes to grains, is what happens if we see a continuation of record-busting China demand, a weakening dollar (which boosts commodity prices), and a full-on global drought.

In the North American drought of 1988 — one of the worst drought seasons ever in the United States — soybean prices rose more than 100% in less than a year; wheat prices rose more than 70%. An event like that today could trigger a shutdown of international grain markets, or even provoke a military conflict.

Apart from a long-term bullish copper-and-grain outlook — grain demand should rise globally, alongside copper demand, as emerging market economies strengthen — another takeaway is to be cognizant of inflation risk. There were already plenty of factors pointing toward a return of inflation in 2021. A voracious China appetite for copper and grains, and a U.S. dollar in a multi-year downtrend, will only fan the flames. 

Jim Simons, the legendary mathematician, hedge fund manager, and quant, retired a few weeks ago from board chairman duties for Renaissance Technologies (RenTech), the firm he started with partners more than 40 years ago. He is stepping back at 82 years old.

Simons and his firm are best known for their Medallion Fund, which first began trading in 1988.

The Medallion Fund is the most profitable quant hedge fund of all time. Simons, as chief architect of the Medallion Fund, thus has one of the greatest investor track records of all time. As of 2021, his personal wealth had compounded to more than $25 billion.

The Medallion Fund — named after mathematical awards that Simons and an early partner had won — is closed to new investors, and mostly runs money for employees of the firm. The fund stopped accepting outside money in 2005.

The size of the Medallion Fund is capped around $10 billion in assets due to size constraints. For more than three decades, the fund has averaged about 40% returns per year, net of all management fees.

If you take out the fees, the Medallion fund has average annual returns in the range of 60 to 70%.

On top of that, the Medallion fund has very few losing weeks, let alone losing months or quarters. Their consistency is remarkable; the fact they’ve kept it up for decades is even more remarkable still.

Normally, when a quant hedge fund finds a series of exploitable edges, other quant funds eventually discover the same edges and profitability erodes. Not with Renaissance. After 30-plus years, they seem uncatchable.

Nor does volatility hurt them. The fund likes “action,” as Simons has called it. The Medallion Fund reportedly made 76% — or more than 116% before its hefty fees — in 2020.

The “secret sauce” of the Medallion fund cannot be replicated, though many have tried.

But it could be eye-opening, and possibly instructive, to get a sense of how they do it.

Simons, a brilliant mathematician, is a recipient of the Oswald Veblen Prize, a kind of lesser-known Nobel Prize for geometry. He is also the co-discoverer of a breakthrough mathematical theory, known as Chern-Simons theory, that is actively used in a range of fields to this day.

In his early twenties, Simons was a “code cracker” — a specialist in detecting and decoding encrypted messages for the Pentagon.

After World War II, code crackers were in a kind of arms race with the senders and receivers of code, who tried to make their transmissions invisible.

If a group of soldiers on the ground had to communicate with air support, or a submarine had to communicate with central command, the idea was to make the coded transmission as hard to detect as possible — ideally to make it seem like static or white noise, and not a transmission at all. 

Simons and other code crackers would attempt to identify these coded signals — which meant spotting faintly detectable patterns in the midst of random noise — and then to figure out the encryption method.

Early in his career, Simons worked for the Pentagon’s Institute for Defense Analyses, a highly secretive outfit that shielded its work from the outside world.

At the Institute for Defense Analyses, Simons learned about more than code-cracking techniques. He also learned how to build a research team, with an atmosphere that was open and collaborative on the inside but closed and secret to the outside world.

Simons was eventually fired from the Institute for Defense Analyses for making public statements in opposition to the Vietnam War. But this gave Simons the chance to recruit other brilliant researchers, from the Institute and elsewhere, to help him start Renaissance Technologies (RenTech).

Through much of the 1980s, RenTech focused on traditional trend-following strategies in commodity markets. But as the years passed, the strategies started to feel crowded.

In the mid-1980s, one of the brilliant researchers on Simons’ team started looking for “ghost patterns” in market prices. This work was grounded in the same type of code cracking that Simons and others had done for the Pentagon: It was all about finding faintly detectable patterns that others could not see. 

In 1988, the Medallion Fund was launched as a combination trend-following fund and quant fund. By 1990, the fund had relaunched with a total focus on the quant side and earned 56% in its first year. That was the beginning of an incredible run that continues to this day. 

The Medallion Fund is unique in many ways.

For example, Simons only hires scientists and mathematicians whose minds are far from Wall Street. There are no economists or fundamental analysts or traditional Wall Street investors or traders. The more removed they are from traditional investing, the better.

The Medallion Fund maintains a library of at least 8,000 signals, based on the short-term patterns detected by the hundreds of scientists who work for Renaissance Technologies.

The Medallion Fund then uses these signals to trade in and out of markets, thousands if not tens of thousands of times per day, with a trading reach that covers exchanges around the globe.

The win/loss ratio for Medallion’s trades is said to be just 2% — a difference of 51% versus 49%.

But because they can apply this edge thousands of times per day, the fund’s performance has the consistency of a giant casino. For a single trade, a 51% edge is almost the same as pure randomness. But with thousands of trades per day, day in and day out, the iron law of averages means that a tiny2% edge, 51% versus 49%, can deliver profitability on a near-constant basis.

The reason the Medallion Fund is size-capped at $10 billion is almost certainly due to leverage. Because profits are so reliable, the fund can use a lot of leverage, and could easily be levered as much as 10 to 1, meaning $9 of borrowed funds for every $1 of capital.

That would mean a $10 billion max size actually means a $100 billion trading footprint, and would further mean the fund’s 60-70% return on $10 billion is, in reality, more like 6-7% on $100 billion (with $90 billion of it borrowed).

One of the reasons the Medallion Fund is so hard to copy — and so hard to beat — is surely because of the infrastructure required to run such a high-precision operation.

In 2016, Simons’ firm quietly filed a 16-page technical document with the U.S. Patent and Trademark Office for “executing synchronized trades in multiple exchanges.” The concept involved using atomic clocks, the most high-precision time instruments on earth, to synchronize order transmissions down to a few billionths of a second.

To replicate the success of the Medallion Fund, a competitor would not only need a close-knit team of some of the most brilliant scientists in the world — with deep training in code cracking and machine-language translation — they would need the ability to not only execute thousands of orders per day, but also to absorb, interpret, and incorporate trillions of data points per day.

In order to keep its signal library updated and refreshed, while constantly rotating into signals that are working and out of ones that have stopped working, Renaissance Technologies has to process insane amounts of data, constantly, and incorporate it into minor system adjustments in real time.

Not only do the fund’s researchers look at all the price data one could imagine — including all of the bid and ask orders that don’t get filled — they consider any form of clean data to be grist for their signal extraction mill, even down to the level of snowfall in New York’s Central Park. (Back when trading floors were physical, weather could have an impact on floor traders coming into the exchange.)

If you want to know more about Simons, and the fascinating journey he took in building the Medallion Fund into a success, an excellent read is The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution by Gregory Zuckerman.

It should be noted, though, that even the Medallion Fund has limits to its success. They likely keep the fund capped around $10 billion because, after the leverage of borrowed money is applied, their signals simply can’t handle greater size.

Then, too, Renaissance Technologies has launched other funds, making them available to institutional investors — but the other funds aren’t nearly as successful, and have even had painful losing years. Why? Because the other funds can’t make use of the same “ghost signals” the Medallion Fund does — so they have to do more conventional things, and thus return to earth in their results.

Looking beyond the spectacular profits, one of the most notable things Jim Simons did — which wound up being a cornerstone of his success — was figuring out how to build a collaborative, tight-knit research team that functions like a family.

The doors to the outside world are closed, but on the inside all doors are open. From the beginning it was a spirit of teamwork, and close partnership among like minds, that made the Medallion Fund a success (and still do to this day).

“It was the best of times, it was the worst of times…”

You might remember that line from A Tale of Two Cities by Charles Dickens.

We reference it now, in 2021, because never before has the line been more true.

As the pandemic raged last spring, a debate raged alongside as to what kind of economic recovery the United States would have.

This debate provided an alphabet soup of capital letters, each one describing a different “shape” of recovery. Some argued for a V-shaped recovery — the most optimistic outcome. Others expected a W, which is sort of like a V with a bump in the road.

Still others called for a U shape — implying a long, flat stretch prior to a sharp bounce back — while true pessimists called for an L, meaning a drop and a long, hard slog. Nouriel Roubini, an economist with the nickname “Dr. Doom,” even proposed an “I” shape, meaning a drop straight down with no return.

In retrospect, the winner of the alphabet contest was Peter Atwater, an adjunct professor at William & Mary College.

Atwater, an expert in human behavior and decision-making, coined the term “K-shaped recovery,” implying two different outcome branches.

Those in the well-off portion of the economy had an outcome represented by the top half of the K, going up and to the right, while those less fortunate experienced the bottom of the K — down and to the right.

With kudos to Atwater (no letter joke intended), we would argue the pandemic has delivered not just a K-shaped recovery, but a “Super-K.”

The impact of the pandemic — and the various monetary, fiscal, and public health responses to it — has created the widest divergence of outcomes America has ever seen, with income inequality at its highest levels in nearly half a century.

The shape of the Super-K explains why investors, and many other observers of the U.S. economy, seem divided into two camps.

In one camp, you have those who think everything is fine — or better than fine, even. This camp has compelling data to point to (as we shall soon see).

In another camp, however, you have those who think the economic outlook is horrible. They also have a compelling suite of data points.

One such bearish analyst, James Rickards, even wrote a book titled The New Great Depression: Winners and Losers in a Post-Pandemic World. Rickards believes we are in the midst of a depression here and now. It’s hard to get gloomier than that.

And yet, even as much of the data justifies extreme gloom — Rickards filled a whole book with such data points — U.S. household net worth hit an all-time high in the third quarter of 2020, rising by 3.2% to more than $123 trillion.

And at the same time, the corporate earnings outlook is genuinely strong.

“Stocks Hit Records on Upbeat Earnings,” said a Wall Street Journal headline on Jan. 20.

“Earnings results so far have been better than expected,” the WSJ went on to observe, “with 88% of companies beating estimates through Wednesday morning.”

How can this be? How can the outlook be so good, and so bad, simultaneously? It’s because of the Super-K, and the fact that there is no such thing as “average” anymore.

We are used to thinking about economic statistics as if the U.S. economy is one monolithic entity. It is not. There are different experiences happening — the two branches of the K — and they are far apart.

In statistics terms, U.S. economic outcomes are not following a standard bell curve distribution — the kind with a large group in the middle and outlier experiences at the tails.

Instead, the Super-K has created a “bimodal distribution,” as demonstrated in the graphic below.

In a bimodal distribution, you have two data peaks instead of one, and the peaks have different shapes.

The basic idea, as the graphic above shows, is that the top 30% of the U.S. economy is having a very different pandemic experience than the bottom 70%. Their sense of economic health and well-being is high, and for the top 1% it is off the charts.

For the bottom 70% of the U.S. economy, meanwhile, the experience has been horrible — and for tens of millions of Americans, the “New Great Depression” experience is all too real.

Why is it happening this way?

There are multiple reasons, but a big one has to do with technology.

• Knowledge workers, executives, and those doing virtual-type work like call center employees — i.e., those who can do their job with a laptop, a telephone, and a Zoom connection — did not see their workflow truly disrupted by the pandemic. They had to adopt to work from home (WFH) conditions, but by and large the WFH adjustment was a speed bump.

• Anyone whose job required a physical presence or tending to a physical flow of customers, on the other hand — a category that still composes more than two-thirds of U.S. jobs — saw their world turned upside down by the pandemic, and may have seen their business or their livelihood shut down entirely.

We can see the dramatic split in the data from the December jobs report.

The surface-level outcome for the December jobs report was ugly, with a net loss of 140,000 jobs (seasonally adjusted). But if you dig into the data, a very different picture emerges.

The December 2020 jobs report showed that the leisure and hospitality sector got crushed, with a net loss of 498,000 jobs. Those are primarily restaurant and hotel jobs, along with other forms of physical hospitality work.

Employment in state and local government positions also fell by a net 51,000 jobs, illustrating the dire state of finances at the state level. As budgets get crushed by losses of tax revenue via the pandemic, city and state employees are getting laid off.

Switch over to the technology sector, however, and it’s a whole different world.

The December jobs report showed the U.S. technology sector adding 22,000 jobs overall. Not only did the tech sector not lose employees — they posted a net gain.

And the really eye-opening number came from the IT (information technology) industry, where a whopping 391,000 jobs were added in December, according to CompTIA, an information technology trade group.

That is a stunning juxtaposition. Even as service workers and local government employees (whose jobs are largely physical, too) lost more than half a million jobs, the IT industry alone picked up nearly 400K.

Why are IT jobs in such demand right now? In part because of the pandemic.

With so many companies coordinating work-from-home arrangements and doing more with collaborative data flows and virtual meetings, more IT specialists are needed to keep everything secure and running.

The boom in tech jobs is further expected to continue into 2021. A survey from Robert Half International, a global staffing agency, showed that, out of 3,000 leading corporations worldwide, more than 90% planned to either fill IT vacancies or create new IT positions in the coming year.

And that’s not all. When you take a look up close, the disparities of the Super-K recovery are staggering.

• According to a study from Opportunity Insights, a research institute affiliated with Harvard University, American workers who earn more than $60,000 a year (the top quartile) have already seen average income levels surpass the January 2020 threshold — meaning that, financially speaking, they are already past the pandemic.

• At the same time, employment for Americans earning less than $27,000 per year (the bottom quartile) is still 20% below pre-pandemic levels. At the same time, eviction risk is soaring, hundreds of thousands of businesses have shut their doors forever, and an estimated one in five Americans live in households where there isn’t enough to eat.

One way to view the split is between two different worlds of work.

For those whose work is grounded in the physical world, the pandemic was a catastrophe. For those whose work is grounded in the virtual world, or had a natural ability to shift that way, the pandemic was a large inconvenience.

But the disparity grows wider still, because the government response to the pandemic also accelerated the divide.

The actions taken by government authorities, at all levels, widened the Super-K in both directions.

Regarding the lower half of the K, an inconsistent patchwork of lockdown rules and business closure requirements likely added to the wholesale destruction of small and medium-sized businesses, while also contributing to mass layoffs in the service sector.

But regarding the top half of the K, a multi-trillion-dollar flood of fiscal stimulus, coupled with “QE infinity,” led to an explosive run-up in the value of paper assets and a historic drop in the cost of mortgage refinancing, even as those in the top 30% of the economic strata were investing more (via fewer discretionary purchases in a pandemic) and going on a home-buying spree. 

The government, more or less, made the pandemic worse for everyone who had a physical job, while simultaneously giving a huge gift to anyone with meaningful exposure to real estate or the stock market.

According to data from Fannie Mae, the mortgage giant, refinanced mortgages are being snapped up at their fastest pace in two decades, with a hunger for second homes fueling a new real estate boom.

At this point, you might be wondering two things: “When does this end?” and “How does it end?”

The answer to both questions is “nobody knows” — there are too many variables in play to pin down a reliable timeframe for when the Super-K recovery will burn itself out, or morph into something else.

But we do know that further government actions to help the bottom half of the economy — think more fiscal stimulus to the tune of trillions — will wind up doing more to juice the top half.

When the U.S. government practices a “helicopter drop” of sending money directly to people’s bank accounts, it does a world of good for Americans who are literally facing starvation or homelessness.

As a result, blanket efforts to help the tens of millions of Americans now literally experiencing Great Depression conditions can certainly be morally justified. There are better ways to do it — far more efficient, far less wasteful — but those better ways are not in place right now, and the time to act is now.

At the same time, whenever a big tsunami of fiscal stimulus washes through the economy, it is inevitably Wall Street, and the upper tier of the economy, that tends to reap the benefits first.

We saw this directly, and literally, with the $1,200 stimulus checks that millions of Americans — the ones who didn’t need the funds — wound up punting directly into the stock market.

The whole situation is wild, and unprecedented, in ways the country has never before seen. As a result of that, we can’t be sure what is next in the story.

But we do know that a perverse feature of the Super-K is that, the more the lower half of the economy suffers, the more that heroic fiscal and monetary efforts to help them wind up juicing the top half.

And that is why we can’t be sure, by any means, that the liquidity-driven mania we are living through now will end any time soon. 

With a daily volume of $6.6 trillion, the foreign exchange market is larger than any government.

Given that reality, no U.S. presidential administration has true control over the direction of the dollar. But all of them like to pretend that they do.

On Tuesday, incoming Treasury Secretary Janet Yellen gave confirmation testimony to the U.S. Senate.

In that testimony, Yellen firmly stated that the Biden administration would not “seek a weaker currency to gain competitive advantage.”

This was a masterful bit of gamesmanship. The dollar is likely to continue weakening under the Biden administration — perhaps by a great deal — and Yellen almost certainly knows this.

Her confirmation testimony was designed to manage the political optics of what comes next, while also leaving room to maneuver.

Before we get to Yellen’s strategy, let’s pull some highlights from the past half-century of dollar policy statements — and presidential administrations trying to project an image of U.S. dollar control.

In August 1971, President Richard M. Nixon “shut the gold window,” meaning that, from August 1971 onward, U.S. dollars were no longer automatically redeemable for a fixed quantity of gold.

What few people realize is that Nixon had no choice: If he hadn’t shut the gold window, some other U.S. president would have been forced to.

That is because the U.S. dollar, as set up under the Bretton Woods system, had the ability to expand its supply — as based on fractional reserve lending, deficit spending, and international trade demand — whereas America’s gold reserves were finite and limited in supply.

When you have something that is expandable in its supply (the dollar) that is redeemable for something fixed in its supply (gold reserves), against a backdrop of rising demand, you eventually run out of road.

Nixon’s 1971 choice was thus to either shut the gold window or deplete America’s gold reserves to zero.

Bretton Woods, in this sense, was guaranteed to fail.

The way the agreement was set up — the U.S. dollar redeemable in gold, where the dollar supply could expand as the gold supply remained fixed — was doomed from the start.

And yet, as a strategic policy matter, Bretton Woods was a huge success for the United States.

By the time Bretton Woods actually failed — when Nixon shut the gold window in 1971 — the U.S. dollar was so entrenched as the world’s reserve currency, in global usage and international trade terms, that the dollar’s world reserve currency status continued.

In a manner of speaking, the U.S. convinced the world to accept the dollar as the world’s reserve currency by promising to back it with gold — and then 26 years later said “guess what, instead of gold you get U.S. Treasury bonds.”

America’s attitude at that point was exemplified by one man: John Connally, the U.S. Treasury Secretary at the time. Connally was a bold, brash Texan who treated policy like a poker game.

After Nixon’s actions in 1971, the newly free-floating dollar was a cause for serious concern. It wasn’t yet clear, at that point, whether Bretton Woods was dead or just badly wounded.

At a meeting of the G10 countries in Rome, Italy, in December 1971, the other members of the G10, shocked by the dollar’s fall, asked Treasury Secretary Connally what America planned to do.

Connally’s answer was brutal: “The dollar is our currency, but your problem.”

Following Connally’s statement, the dollar quickly lost 20% of its value, and the world adjusted to a free-floating exchange rate era (which continues to this day).

The sharp drop in the dollar’s value was something Connally wanted, because it meant an easier time for manufacturers and American exporters (as a weaker currency meant U.S. goods would be more competitive abroad).

Now we can fast-forward to 1985, when U.S. dollar strength, not weakness, had become a big problem.

After Federal Reserve Chairman Paul Volcker successfully “broke the back of inflation” by the year 1980 — having done so with interest rates in the teens — large amounts of capital began flowing into the United States, making the dollar stronger.

Too much dollar strength is a deal-killer for exporters, who see their goods become more expensive in foreign currency terms as the currency gets stronger.

And so, after a 1980 – 85 period where the dollar appreciated in value by 50% against other major currencies, the U.S. manufacturing sector was loudly complaining.

So, in 1985, to counteract excessive dollar strength, the G5 group of nations (the U.S., U.K., France, Germany, and Japan) agreed to coordinate exchange rate policies to drive the value of the dollar lower. 

But the 1985 agreement, known as the Plaza Accord, was so successful in countering dollar strength that two years later, in 1987, they came up with another deal, known as the Louvre Accord, to counteract excessive dollar weakness.

The dollar, in other words, was too strong for the first half of the 1980s, so the top-dog industrial nations got together to bash its value down — and then two years later they had to try and prop the dollar up.

If all of this back-and-forth movement sounds goofy, that’s because it is.

Foreign exchange movements have always been driven by government policy choices — but often not in the way that governments intended.

That is why Bruce Kovner, a retired multi-billionaire known as one of the greatest forex traders of all time, once remarked that “stupid governments” were his best source of profits.

Fast forward again to the mid-1990s, and Treasury Secretary Robert Rubin — a former co-chairman of Goldman Sachs — famously instituted a “strong dollar policy.”

Rubin was a master of optics. His “strong dollar policy” played well politically because the U.S. dollar was already strong in the 1990s.

The dollar was strong, at that point, because capital was flowing heavily into U.S. equity markets (stirrings of the later tech bubble) and because U.S. government spending had fallen on balance through most of the 1990s, mainly due to cuts in defense spending after America won the Cold War (the Soviet Union collapsed in 1989) and then the first Gulf War of 1990-91.

While manufacturers and exporters don’t like currency strength, other economic players prefer a strong dollar to a weak one. A strong currency makes foreign goods cheaper to purchase, for example, and increases profits for American corporations that employ workers abroad and manufacture things abroad, and then sell domestically in the United States.

So Rubin, a natural strategist, saw a set of conditions for a strong dollar that the Clinton administration didn’t really control, officially declared “strong dollar policy” a good thing for America, and thus projected an image of competence and control over what was happening to the currency.

But then, in 2001, the new Treasury Secretary for the incoming Bush administration, Paul O’Neill, caused a stir when he openly questioned the strong-dollar policy of the 1990s.

O’Neill, before becoming Treasury Secretary under George W. Bush, had been CEO of Alcoa, the aluminum giant. That meant O’Neill intimately understood the downside of a strong currency policy: It tends to hurt exporters and commodity producers.

Later in O’Neill’s tenure, the joke became that the Bush administration still supported a strong-dollar policy — but it now meant strong in the sense of “a currency that isn’t easily counterfeited.”

Of course, too, it made sense for the Bush administration to soften its attitude toward dollar policy because the government was spending like crazy again (paying for new wars in Iraq and Afghanistan, new tax cuts, and so on) and because monetary policy was kept extremely loose after the dot-com bubble burst (with Alan Greenspan cutting the federal funds rate to 1%, a shocking move at the time).

The emerging pattern here is that the direction of the dollar is determined by big-picture factors the White House doesn’t truly control, except in extreme circumstances.

At the same time, the optics are such that every administration wants to claim a measure of control — so they look at what the dollar is doing, and then sort of say, like Pee Wee Herman after falling off his bike, “I meant to do that,” meaning the official policy pretends to be in sync with whatever the dollar is doing in the cycle dynamics of the moment.

The other thing we can get a sense of here is the big, rhythmic cycles that the dollar tends to move in, where trends of strength or weakness tend to run for many years, if not a whole decade or more.

• In the 1970s, the dollar was weak (after Nixon shut the gold window)
• In the early 1980s, the dollar was very strong (after Volcker beat inflation)
• Then the dollar weakened from 1985 to 1990 through deliberate efforts
• In the 1990s, the dollar was strong, and in the 2000s, it was weak again  
• And so go the multi-year cycles, strong and then weak, ad infinitum

In the period from 2002 to 2011, the U.S. dollar was weak, so it’s little surprise that 2002 to 2011 was also a boom time for hard assets of all kinds (and particularly gold).

Then, from 2011 to 2017, the dollar entered another cycle of strength, with the “U.S. exceptionalism” trade in full swing: Even as Europe was in and out of crisis in those years, U.S. equities went from strength to strength, with fiscal policy constrained and monetary policy loose (a perfect recipe for stocks).

But in 2017 the outlook changed again, as the Trump administration openly embraced an aggressively weak dollar policy for the first time in decades.

President Trump, in fact, was the first president since Nixon — if not the first U.S. president ever — to openly and aggressively advocate for a weak dollar policy, making stronger policy statements than his own Treasury Secretary.

Trump tweeted the following in August 2019, which captures the flavor of weak-dollar shout-outs over his four-year tenure:

“As your President, one would think that I would be thrilled with our very strong dollar. I am not!”

President Trump also sought ways to actively weaken the dollar — attempting to do more than just jawbone its value lower (to help close the trade deficit, boost exports higher, and boost international corporate profits).

“President Donald Trump has grown concerned that the strengthening U.S. dollar is a threat to his economic agenda,” Bloomberg reported in July 2019, “and has asked aides to cast about for ways to weaken the greenback…”

The dollar weakened meaningfully in the first 18 months of the Trump administration, but then strengthened again in the years that followed — until the onset of the pandemic, that is, when the picture changed dramatically due to a tsunami of U.S. fiscal spending (with more waves yet to come).

Now, at the onset of the incoming Biden administration, we appear to be in the “weak dollar” part of the cycle — and in our view the weak dollar trend could last for years, if not through the end of the decade.

The U.S. Dollar Index spiked to its highest levels since 2003 in March of 2020, and then immediately turned tail to fall nearly 20% from that point. The U.S. dollar downtrend looks persistent and powerful, and shows clear signs of continuation, as you can see in the chart below.

Now, getting back to Yellen and her congressional testimony: Yellen, almost certainly, knows that the U.S. dollar is going to weaken on her watch, perhaps by a lot.

The dollar is set to weaken under a Biden administration because the amount of fiscal stimulus deployed by the United States will dwarf that of Europe and Japan, which in turn will translate into a weaker currency via greater spending and a larger supply of treasury bonds.

There are other reasons in addition to that, some of them important — but U.S. fiscal capacity is the big one. Then, too, because a weaker dollar helps manufacturers and exporters, a Biden administration may well in fact welcome a weaker dollar. A little bit of inflationary heat, aided by a falling, could also help inflate away the debt burden faster (another inevitable policy goal).

But of course, the Treasury Secretary can’t say any of that stuff out loud. Yellen cannot say, “We welcome a weaker dollar and our policies will likely accelerate that weakness.”

Instead, Yellen has to say the opposite. It is all about the optics, you see, combined with plausible deniability when a weaker dollar outcome manifests aggressively in the coming years.

That is why, in her confirmation testimony yesterday, Yellen said the following:

“The intentional targeting of exchange rates to gain commercial advantage is unacceptable…”

“The United States does not seek a weaker currency to gain competitive advantage and we should oppose attempts by other countries to do so…”

“The value of the U.S. dollar and other currencies should be determined by markets. Markets adjust to reflect variations in economic performance and generally facilitate adjustments in the global economy.”

Technically speaking, all of Yellen’s statements are probably 100% true.

The Biden administration is not at all likely to weaken the dollar on purpose. But that is part of the point: They won’t have to try, because it is going to happen anyway, as an indirect result of other policies.

So what Yellen is doing here — which is brilliant in its own subtle way — is laying the groundwork for plausible deniability and righteous indignation, if and when the point comes where the dollar’s value declines so far, so fast, that America’s trading partners openly question whether the Biden administration is weakening the greenback on purpose.

At which point Yellen will be able to say: “Who, us? No, we would never do that. Remember what I said in my confirmation testimony. ‘This is all just the market doing its own thing…’”