Monday, May 10, 2021

GameStop is just the latest sorry case of misallocated capital

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The commercial frenzy of GameStop actions over the past week has provided further evidence of a gaping disconnect in the markets.

This is another example of the gap between stock market valuations from Alice in Wonderland and the deeply uncertain outlook for profits and savings from the coronavirus.

The success of retail investors in putting pressure on hedge funds betting on a drop in stocks such as GameStop was as unexpected as their pleasure in the David and Goliath battle was palpable. Yet the resulting extraordinary market fluctuations raise difficult questions about market efficiency, regulation and financial stability.

An increasingly pressing issue for global markets is the extent to which they are influenced by price insensitive investors. The point more clearly applies to central bank asset buying programs since the great financial crisis, which now extend beyond government bonds to corporate debt and stocks.

But long before the financial crisis, the growth of index funds dampened price signals and amplified shocks to stock prices. Meanwhile, the fashion for risk reduction and liability matching among pension funds has produced an army of buyers of low-yielding or negative-yielding government securities.

Then there are those who are intensely price sensitive but don’t care about economic fundamentals, including momentum traders who follow short-term price trends based on mechanistic algorithms.

In this category, if in the form of inferior technology, now come the day traders in the options markets who declare war on hedge funds who bet on falling prices. Their coordinated attacks via discussion forums and hedge fund message boards produce bizarre valuations and could constitute market manipulation.

All of these changes in market structure constitute a powerful recipe for misallocation of capital. This can be seen in the rush of the recent frothy wave of initial public offerings, the bubble valuations of struggling companies like GameStop and the backing of zombie companies – companies that continue to have access to debt despite their insufficient operating profits to provide exceptional service. debt.

At the same time, the ultra-flexible monetary policies of central banks encourage companies to invest in sub-optimal projects.

All of this has worrying implications for the outlook beyond the pandemic. In one report Last year, the World Bank noted that labor productivity growth in advanced economies had halved since the 1980s in a downward trend accelerated by the great financial crisis. Weak investment explains the lion’s share of this slowdown over the past decade.

Today, the pandemic intensifies the story of low investment while eroding human capital through unemployment and loss of education. Global supply chains may be further disrupted and the reallocation of labor from low productivity sectors to low productivity sectors.

The report highlights that long-term productivity losses resulting from adverse shocks are greater and more prolonged in debt-vulnerable economies. Considering the huge build-up of debt since the financial crisis, now increasingly turbocharged by the pandemic, this is worrying.

Still, World Bank economists hope to offset opportunities for productivity improvements if Covid-19 triggers lasting organizational and technological changes in the way businesses operate. The pandemic could “become a source of ‘cleaning up’ effects that eliminate less efficient companies and encourage the adoption of more efficient production technologies.”

The problem here is precisely that changes in capital markets and ultra-loose monetary policy will prevent such a cleanup. The creative destruction, the engine of capitalist dynamism, has been anesthetized.

This is what makes the assault on short hedge funds blatant. Many find it understandably gratifying to see a crowd of retailers subverting the behemoths of Wall Street. But these funds can be an antidote to the structural changes that have contributed to the divide between stock valuations and fundamentals. Never forget that hedge funds also played
central role in exposing the weaknesses and fraud of Enron, Lehman Brothers and Wirecard.

It’s also worrying to see a repeat of the near-collapse and bailout of Long-Term Capital Management hedge fund in 1998. No doubt most investors assume the Federal Reserve will come to the rescue if a struggling hedge fund looks too bad. big and too interconnected fail. But that’s where a big part of the explanation for all of those Alice in Wonderland ratings lies.

john.plender@ft.com

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