Capitulation or Forced Selling?

The extreme sell-off we saw in markets yesterday reminded me very much of the big moves in the 2008-2009 bear market where correlations went to 1 and multiple asset classes declined simultaneously. We had multiple bubbles brewing simultaneously and as is often the case with mean reversion, the pendulum is likely to swing well beyond the mean. It took Japan the better part of two decades to work off the excesses of its late 1980s dual stock and real estate bubbles and the Nikkei 225 has not yet surpassed its late 1980s peak more than three decades later. In our last Insider Weekends article I wrote,

Some market participants are seeing the action last week as signs of capitulation but if this is anything like the bear market after the dot com bubble burst, we have a ways to go before the market stabilizes.

The action on Monday with the Nasdaq dropping more than 4% and a large number of growth companies dropping double digits during the regular market session and in some cases losing an additional third of their market cap in after hours trading felt very much like forced selling. Party City (PRTY), a retailer I considered for the spotlight idea for May for our Special Situations Newsletter and decided against, dropped more than 60% in a single day yesterday on a surprise loss from higher than expected costs. I wrote the following about it in the May 2022 newsletter,

I have been nibbling on the long side and plan to continue doing so even as I look at SPAC business combinations and other areas of the market for short opportunities. I think 1Life Healthcare (ONEM) and Party City (PRTY) are beaten down non-tech stocks that look interesting but I would like to see them put in a base before I start buying. I visited three different Party City stores last week, built a DCF model and did some work on the name for the spotlight idea for this month but decided to hold off.

The selling was broad based with safe havens like commodities, energy, gold and even Bitcoin dropping simultaneous. If this is indeed forced selling driven by margin calls, we are likely to see some additional big moves in the coming days. As I write this, the lending platform Upstart Holdings (UPST) is down nearly 60% today and Sofi Technologies (SOFI) is down 18% in sympathy dropping to its lowest level since going public last year through a SPAC combination. Even large-cap high quality tech names like Amazon (AMZN), Meta Platforms (FB) and Netflix (NFLX) are down 35%, 42% and 71% year-to-date respectively.

In this environment, Twitter (TWTR) is lucky to have the merger agreement from Elon Musk to hold its stock up. We are seeing significant expansion of spreads for merger arbitrage situations with Twitter trading at a spread of nearly 15% or 23% annualized if the deal closes by year end. Activision Blizzard (ATVI), which appears to be Warren Buffett’s favorite merger arbitrage play right now is trading at a spread of over 24% and even relatively safe all cash deals by private equity firms like the acquisition of SailPoint Technologies by Thoma Bravo now has a spread of over 5% (h/t @ArbStocktipster).

SAIL Spread History

We will most likely dive into some merger arbitrage opportunities during our mid-month update this weekend. We are seeing a big uptick in insider buying including a purchase by Dara Khosrowshahi, the CEO of Uber (UBER), where he paid $5.35 million last Friday to pick up 200,000 shares at an average price of $26.73. In case you missed it, Mr. Khosrowshahi’s letter to employees highlighting the renewed focus on generating free cash flow is worth reading. It will be interesting to see if we once again see insider buying surpass insider selling like we did for the first time in over a decade in March 2020. We are also going to find instances of insiders being forced to sell on account of margin calls as outlined in the footnotes of form 4 filings.

While this feels like forced selling, I am still not seeing enough signs of capitulation. Instead of throwing in the towel, I am getting multiple questions about what I am buying right now. When most retail investors who have not experienced multiple cycles reach the “how can it go any lower” stage or no longer want to discuss stocks, we will be closer to capitulation. As I mentioned in our November 2021 mid-month update, I am not a parma-bear and don’t want to repeat the mistakes I made coming out of 2008-2009 where I remained bearish longer than I should have. I have removed the paywall for the article November 2021 Mid-Month Update: A Time For Caution as it still reflects my current view of the market.

Once the indiscriminate selling ends, I think certain segments of the market including commodities will do well and certain strategies like merger arbitrage will lend themselves well to a directionless market. The three signs I will be paying special attention to to determine if conditions are likely to change are, the Fed pausing or slowing down its interest rate hikes, insider buying exceeding insider selling for a few weeks and the war in Ukraine coming to an end.

Voluntary Disclosure: I hold long positions in Twitter (TWTR) and Netflix (NFLX).

 

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