What GameStop Tells Us About Deflation

Artificial inflation does not last.

The incredible phenomena of retail traders herding together that was attributed to the ‘mahoosive’ short squeezes in the likes of GameStop (ticker GME) and others is being touted as a revolution in the financial markets. If you cut through all the emotion that has been produced over the episode and, if you are a student of market history, you will find that this is simply another manifestation of something that occurs time and again in cycles.

Charles Dow, founder of the Dow Averages and the Wall Street Journal, noticed it way back in the late-1800s and it later became embodied in the Dow Theory principles that Robert Rhea wrote about. Dow had pointed out that primary uptrends in the stock market had three phases: accumulation, participation and distribution. The accumulation phase occurs at the very start of a bull market when, as Dow put it, “strong hands” (those with cash) are accumulating stock from “weak hands” (those who need to sell stock for cash). Generally, “strong hands” are considered to be financial market institutions and “weak hands” are retail investors. During the participation phase of an uptrend there is solid, consistent buying of stocks from most participants as the “news” on the economy improves. Finally, during the distribution phase, speculation and leverage become predominant, with the “strong hands” then distributing their stock (an IPO boom is a sign) to the “weak hands,” whose eyes are now wide with $ signs. That’s when the stock market tops and asset price deflation occurs, many times bringing on debt deflation too.

This is the cycle. It has happened time and again in history and this time should be no different. No, forget that. It will be different. The deflation will be even more intense.

Look, I am not saying that retail investors are somehow less sophisticated than institutional investors. Far from it. Having worked most of my (now 30+ year) career in institutions I can testify to the fact that there are many people in charge of our pension funds etc., that really shouldn’t be.

Individuals such as retail traders can be rational and sophisticated, but put them in a crowd (which is what the market is) and the game becomes non-rational. Which isn’t saying that going against the huge short-interest in GameStop wasn’t rational; it’s merely pointing out the non-rationality of the associated mania.

And what a mania! This latest episode is far from the first sign of retail non-rational exuberance over the past few years. The headlong, relentless rush into passive investment vehicles like ETFs and the call option buying mania of 2020 are both clear signs of a stock market that is in the final throes of a multi-decade uptrend.

And that uptrend has been fuelled by the biggest debt bubble in history. More than anything else, what the GameStop episode tells us is that leverage (which is debt) has reached even more absurd levels than was thought possible. A little-known fact about the economist J.M. Keynes, who most people think was anti-capitalist, is that he made a fortune trading the markets from his bed (whilst sipping champagne) before starting his day at lunchtime. I thought of this when hearing about teenagers trading the options market in their pyjamas. Keynes used leverage in the late-1920s, taking a bath (figuratively!) in the ’29 crash, and the prevalence of such easily-accessible leverage now could be pointing to a similar deflation in the not-too-distant future.

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US Stock Market Valuation- FEB 2021