Finance

Short-seller Carson Block on GameStop, China and why a market crash could be ‘much larger, much faster’ than ever

Short-seller Carson Block, founder and chief investment officer of Muddy Waters Capital, spoke with Financial News in a Barron’s Live event earlier this month. The influential investor discussed the wild ride in markets this year, and how he approaches conditions he says are hard for short-sellers.

Below is an excerpt from the interview. It has been edited for length and clarity.

On passives and short-selling

The biggest factor for short-sellers, and often the most overlooked, is actually passive investing. The effect that passive investing has on stock prices — I previously assumed it was some kind of linear effect, and it wasn’t that great a slope. But what I’ve learned actually is that when passive buys, it pulls an active holder out of the float and replaces it with a passive, so your supply of stock ends up shrinking. When you have names that are in indices that get a lot of flows through index funds, that creates this convex upward effect on prices. That’s arguably the number-one factor that’s made it so hard to short in the past at least half decade.

But obviously, the low-rate environment, the fact that companies can extend and pretend, it has made it extremely difficult. The lack of enforcement that we’ve seen coming out of the global financial crisis — that’s not awesome for short sellers. So it’s been a it’s been a very difficult period. And these are evolutionary pressures — you either adapt or you die off. So far we’ve adapted and hopefully continue to adapt.

On investing in China

I was screaming into the abyss for many years on China. When I first started doing this, 2010 to 2012, it was just China-based issuers that were all frauds. Suddenly China was un-investable, and most of the companies from China that were listed in the US went dark, and were delisted, or they just really stopped pumping their stocks. But then an interesting thing happened. At that point, 2012, state-owned banks began financing leveraged buyouts of a number of these frauds, so US shareholders got paid a real premium on these companies and memories were wiped.

In 2014 Alibaba listed. Everybody wanted a piece of ‘Baba. Nobody cared about the voices who were saying “Wait a second, these financials seem like they can’t be correct.” Nobody cared and from basically 2014 until very recently, nobody cared.

READ Short-seller Carson Block on Spacs: ‘The incentives are all wrong’

In early 2018, I was kind of preaching the gospel. I’m saying, if you look at the US-China relationship, it’s starting to, metaphorically, take on water in almost every major aspect in which the the two countries interface. Foreign direct investors in China were actually speaking their mind publicly about how they’ve been treated, in their view, unfairly in China.

The only dry ground was public markets, and this idea that Western capital, particularly US capital, would invest in public China equities. I was making the point that I don’t think this can persist, and it certainly shouldn’t persist, because there’s been so much abuse, so much fraud committed, I think a lot of stock manipulation committed. Nobody’s been able to be held accountable in China, by the US, and and that’s actually codified in China’s securities law, so I’ve been warning that these chickens will come home to roost someday. And I think they have finally come home to roost.

Maybe I’m wrong, but I think we’re in the endgame here for the US-China listing. The Chinese government has always been wonderful at feeding misinformation to foreigners. So I’d be careful about that.

On meme stocks

GameStop gets to that point I made earlier about passive, because this wasn’t a case of a bunch of passive buying pushing the stock up. There was the nominal float, but then there was, I think 20-25% that was held by passive, and passive will never sell unless it has outflows, and passive will continue to buy regardless of the price, unless it has outflows. So every day that people are making those contributions that 401Ks, whatever passive is buying, that shrank what seemed like the float.

Take 20-25% of the outstanding, subtract that from the float, so your real float, the actual supply of stock available for sale was minuscule, and you had a sizable short position that was many times that true supply of available stock. This was identified correctly on [Reddit forum] WallStreetBets several months before the squeeze began; one or more posters, laying this case out, and saying this thing can be squeezed hard just by buying out-of-the-money calls.

And if there’s something that starts the stock moving upward, the delta hedging by the options market makers, its gonna just push it high, push it through the ceiling. Technicals are the new fundamentals of the market. It’s the new fundamentals, it’s the technicals, it’s the flows, basically, and an options-market-driven tail wagging the dog.

When GameStop really kept going up, that was mostly institutional. The narrative was around the retailer trader who made all this money. I mean, there are some institutions that killed it, doing that. But that’s just not our game. I don’t like those games. At best you’re trying to figure out whether it keeps going up or goes down or whatever. At best, that’s like a 55% game. It’s really I think, just a coin flip. So no, we don’t we don’t do that.

READ Have meme stocks had their day?

On if he sees a major correction coming

I’ve been seeing a major correction since 2011, so don’t listen to me. What the past 12 years have taught me is to be completely equivocal in these things. When you think about that dynamic of passive and how it’s just relentlessly pushing up so many of these equities, especially the ones in indexes, when those fund flows reverse, whether that’s this year, or whatever, the market is extremely fragile because you’ve taken so many active managers out of the market.

So when the flow is reversed and passive selling, it’s selling at any price, and there just aren’t enough active managers left to really cushion those falls. So maybe it’s become like a seven sigma event that the market will sell off, but the result when it does will probably be a much larger, much faster crash than has been seen.

And how do you protect from that? I don’t know. I mean, you just try not to be the one holding the bag.

To contact the author of this story with feedback or news, email Trista Kelley

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