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We Saw a Flight to Quality.  How About a Flight to Crap?

We Saw a Flight to Quality. How About a Flight to Crap?

Posted June 9, 2020 at 10:41 am
Steve Sosnick
Interactive Brokers

Experienced investors have almost surely heard the phrase “flight to quality.”  “Flight to quality” is shorthand for a shift in the market’s tolerance for risk and a gloomier overall sentiment.  During uncertain times, investors usually seek a lower risk profile for their investments.  During a flight to quality, bondholders seek higher-rated and shorter-term fixed income instruments and stockholders gravitate toward companies with more stable earnings and revenues.    Markets are continually seeking an equilibrium between fear and greed.  A flight to quality occurs when fear dominates greed.

Yet I know of no equivalent term for the inverse of flight to quality, a term that applies when greed all but abolishes fear; when investors are willing to embrace even the riskiest assets seemingly without regard for valuation.  I propose the term “flight to crap”.

“Flight to crap” is an inelegant phrase, but I fear that it does a reasonable job describing the speculative mania that has gripped certain segments of the equity markets.  The recent rebound in the broader equity indices may be overextended in the near term, but I have heard many reasonable arguments for why current valuations could make sense if the economy rebounds quickly after the unprecedented levels of stimulus.  A potentially overbought market does not signify a flight to crap.  If levelheaded investors can choose whether they agree with that narrative or not, and make an informed decision as to whether greed has outpaced fear in the short term, that is not the scenario that applies. 

No, a flight to crap occurs when we see money piling into stocks or sectors strictly because they are going up, because speculative traders see the possibility of profit by jumping on a trend.  This is momentum investment on steroids, when speculators see a trend and the only thing that matters to them is price movement.  Fundamental valuations matter little, if at all.

Let’s take a look at some of the biggest winners of the past few days:

Closing prices

Symbol1-Jun8-Jun% Change

To many, Hertz (HTZ) is the poster child for flight to crap.  The company declared bankruptcy on May 26, and Carl Icahn, their largest investor, sold his holdings the next day for less than $1 per share.  Mr. Icahn makes mistakes like everyone – and HTZ was a big one – but I find it nearly impossible to believe that this veteran of high stakes takeover battles would dump his holdings if he saw any residual value in the shares.  How could someone rationally expect that the value of the share was worth over 5 times more than the largest holder’s assessment?

Luckin Coffee (LK) is the Chinese ADR of a company that has acknowledged fraud.  I have no idea what the true value of this company might be since their financial reporting may be misleading or even fictional.  I also have no idea of the process in China is for recovering money from a tainted company.  How many of the current investors know the answers themselves?   There may be value in the shares, but I see no reason why there is twice as much value this week over last.

American Airlines (AAL) is a well-known company with a global presence.  Another investor with an enviable track record, Warren Buffett, exited his airline shares amidst the global pandemic.  In recent sessions, airline stocks have shown improvement as the markets view worst of the crisis to be behind us.  Last week a case could be made for investing in the sector at those valuations.  I also find it hard to believe that the market and a legendary investor were that far off from fair value in a well-analyzed company.

Chesapeake Energy (CHK) has been on the ropes for weeks.  On April 15th, they underwent a 1:200 reverse split to maintain compliance with listing standards.   Healthy companies don’t need to take measures of that sort.  At yesterday’s close there was a headline that the stock nearly tripled after 22 trading halts.  Literally the next headline was that the company was said to be preparing a Chapter 11 bankruptcy filing.  Anyone who had been paying attention would have known that this was a risk. 

The common theme between these and other shares with sharp rallies is that there was a short squeeze on the shares.  Those who want to short a stock must borrow it.  When stocks divorce themselves from fair value, short sellers smell an opportunity.  So do stock lenders.  The borrow rate on these stocks soars.  At that point other investors smell a different sort of opportunity.  They attempt to squeeze the shorts, hoping that the short sellers will cover at ever increasing prices.  Over recent sessions, we have seen enormous short squeezes that have taken on a life of their own, attracting traders sniffing the momentum in those stock prices. 

Over time, these situations usually resolve themselves.  Large investors eventually move bigger stocks closer to fair value.  Bankrupt stocks resolve themselves more painfully, when a court decides that the residual equity is worthless or something close to it. 

There is a term for those who buy a stock not because of its value but strictly on the hope that someone else will pay more for it.  That’s called the “Greater Fool Theory”.  If that is the sole premise behind your purchase of a given stock, how can you be sure that you will not be the last one holding the bag?  There are no certainties in investing – why make it harder on yourself?

Over time I expect that cooler heads will prevail, and that markets will return to an equilibrium between fear and greed.  In the meantime, try to avoid being swept up in a flight to crap.

Disclosure: Interactive Brokers

The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Interactive Brokers, its affiliates, or its employees.

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