Random Musings on Markets VIII: Musings Take Manhattan

Editors’ Note: MarketMinder does not recommend individual securities or ETFs. The below merely represent broader themes we wish to highlight.

In this (certainly-not-weekly) collection of randomness, we cover an odd critique of this week’s S&P 500 “milestone,” the IRS cracking down on state creativity, Britain’s war on pennies, Tesla’s missing shorts and the lesson from covered-call ETF advertising.

A Weird Critique of the S&P 500’s Milestone

The S&P 500 milestone we covered in our Very Special Wednesday Musing this week set off a media furor, with several outlets looking at it, bizarrely, from a fairness standpoint. Some say the record-long bull market disproportionately benefits the wealthy, who tend to own more stocks.

Now, disclosure: We are not and will not weigh in on wealth (or income) inequality here. This is, in our view, a purely sociopolitical debate, and you are free to have whatever view you like. Our interest is in the oddity of citing it as a “yeah, but” involving a stock market record.

It is of course true wealthier Americans tend to own more stocks, so bulls benefit them more. And it would probably be better if more Americans owned stocks^[i] (assuming they are commensurate with those folks’ financial goals). That said, the idea Scrooge McDuck is the sole beneficiary of the bull market is, well, wrong—and not just because he has historically favored swimming pools full of gold coins. A Gallup poll showed an average 54% of Americans owned stock directly through funds, individual stocks and 401(k)s during the period 2009 – 2017. While that is down from 62% in the period from 2001 – 2008, it is still over half!^[ii] And that doesn’t even include those who still have pensions, giving them indirect exposure.

Moreover, this idea—looking at a bull market askance because of wealth inequality—is weird. If you enter a bull market with $10 million in stocks, you will benefit much more in dollar terms than someone who owns $10,000 in stocks. That is … math. (The same percentage off a larger base number is a larger number.) Math has problems,^[iii] but this seems like a weird thing to bemoan as though policy should fix it. We mean, what are you gonna do, mandate a Universal Basic Equity Allocation? Redistribute returns from portfolios above a certain value?

Besides, the stock market is perhaps the best example of the underappreciated fact that the financial and economic world isn’t a fixed pie. Look no further than the S&P 500’s irregular-but-long journey up and to the right since inception.

SALT of the Earth

Last year’s US tax reform package capped the federal deductibility of state and local taxes (SALT) at $10,000 annually, a choice the two authors of this column lament, as we reside in high-tax states.

It seems many others lament alongside us, as New York, New Jersey and Connecticut have all objected, and their state governments have been getting, shall we say, creative in their means of trying to get around the cap. The primary means? Convert certain state and/or local taxes like property taxes to be technically charitable contributions, which maintain full federal deductibility.

It is a creative solution! And one that is technically legal! Yet the IRS caught wind and issued guidance Friday that amounted to, “Nope.”

It is highly like this “nope” will be challenged in court, alongside a challenge to the tax change (on the grounds it is a partisan shot at blue states). But in our view, these seem to stand little chance of success.^[iv] The federal government, not the states, has purview over what is and is not deductible at the federal level. So we would suggest those planning on using this local-tax-as-charity loophole should maybe think again.^[v] Hey! Perhaps try a fully legal, less creative means! Like lobby New York and others to cut state taxes.

But What Would Tommy and Tuppence Make of It?

In a much-discussed report this week, two Bank of England economists made a splash by daring to suggest the UK’s penny and two-penny coins had outlived their usefulness and needed to go the way of the florin (or the strong bolivar, as it were). According to the bank’s research, 60% of all 1p and 2p coins get used exactly once before ending up in jars, automobile consoles and sofa cushions. To head off fears about prices spiking if retailers rounded up to the nearest 5p, the economists assured us all abolishing small coins wouldn’t actually cause inflation, as few prices ended in .99 anyway. The UK’s lack of a sales tax—the primary cause of pennies’ continued ubiquity in America—further reduces the chance of shoppers needing to fork over small change amounts that don’t end in 5 or 10.

We are coin-agnostic, of course. While the Bank’s argument that the penny and tuppence cost more to produce than they are worth is quite sound, charities have also made a strong case for keeping them, arguing pennies comprise much of their cash donations and abolishing them could reduce contributions. With that said, we think this whole debate is nothing more than an after-effect of growth and inflation—much as the halfpenny’s abolition in 1984 and the farthing’s 1961 demise. When you could buy a loaf of bread for a penny in Victorian times, having fractional penny coins made sense. Back in 1962, when seeing the Beatles play at the local youth club cost five shillings, having 1/20^th of a pound be its own coin made sense. But in 1971, when the UK decimalized its currency system, changing the pound’s worth from 240p to 100p, non-base-10 denominations like the shilling and florin made less sense. The shilling lingered another 19 years, with its value debased from 12p to 5p, but by 1990, it was gone. By then, concert tickets for up-and-coming bands were measured in pounds and pence, with a ticket to see Blur at Sheffield University that October costing a whopping £2 at the door—no 5p coins needed.

We would say slang and literary understanding might be the biggest casualties of the penny and tuppence’s demise, but then again, the farthing’s abolition didn’t render Dickens incomprehensible. Sixpence None the Richer hit the charts in the late-1990s without confusing folks, even though the sixpence coin bit the dust in 1980. Googling the value of a guinea makes Poldark easy enough to follow. So we are pretty confident Agatha Christie’s Tommy and Tuppence mysteries will survive this change, if it happens.

An Investing Lesson From Twitter’s Missing Tesla Shorts

As ElonWatch 2018 continued this week, the most interesting item wasn’t his colorful New York Times interview, the SEC’s subpoenas or his bizarre feud with a rapper named Azealia Banks. Nope, it was an item that flew largely under the radar: his alleged involvement in the recent “doxxing” of some people on finance Twitter, better known as fintwit.

In recent months, one of our guilty pleasures has been browsing fintwit to see the arguments, evidence and jokes posted by Tesla bears, most of whom were openly short Tesla stock. Known collectively as the “Tesla Shorts,” they were clever. They were funny (though occasionally off-color). They posted pictures of their delicious-looking weekend bbq. But in the days surrounding Elon Musk’s infamous “funding secured” tweet, some of these accounts started disappearing. Our curiosity piqued, we did a little digging and determined some deleted their accounts after being doxxed—or exposed, for those not fluent in Twitterese—by Twitter’s Tesla bulls.

Most of the Twitter evidence is gone, as the doxxers apparently deleted their own accounts after the deed was done. However, one left an Internet paper trail on Seeking Alpha, where he was a contributor. In his final post explaining why he went dark, he claimed Musk called his employer (a family office), complained about his posts and threatened to sue if they continued. The short apparently discussed with his publicity-shy employer and voluntarily departed Twitter and Seeking Alpha.

Not being professional investigative reporters and whatnot, we won’t venture an opinion on whether these allegations are true—we don’t know, we weren’t there, and this is all hearsay, much of it from anonymous sources. However, this speaks to some larger misperceptions surrounding short sellers. Regardless of whether Musk was involved in these cases, he has openly feuded on Twitter with the Tesla Shorts. He even referred to pressure from short sellers as one of his reasons for wanting to take Tesla private.

There is a fallacy underlying all of this: the belief short sellers have meaningful negative influence on a stock’s price. They don’t! When you short a stock, you borrow the stock and sell it, hoping it will fall. Then you buy it back cheaper, repay the loan and the difference is your profit. (Securities-licensing prep part two, sorry.) But the only action you have that influences the stock price is the initial sell—and the later “buy” when you close the transaction and return the stock to the broker you borrowed from. A heavy amount of short interest in a stock does not drive its price lower. The only time shorting really has a material impact is if sellers short en masse and there is little liquidity. Unlikely.

Further, shorts don’t jeopardize the viability of businesses. If you can sell widgets, solar panels, electric cars or surfboards at a profit, short sellers are no factor. In that case, it seems to us a short squeeze—shorts incurring losses by repaying their loan with shares they bought higher than they sold—would be more likely. We aren’t saying Tesla isn’t viable. But the short-seller war is a distraction built on mythology.

Further, short sellers sometimes have the beneficial impact of identifying issues at companies. There is value in that. We point this out because short selling often gets a bad rap. But overall and on average, it doesn’t manipulate markets, and it boosts liquidity. Remember this the next time you read something speculating (pun intended) that shorts are driving the market lower.

Covered What?

Work in finance long enough, and you become numb to a near-endless stream of product solicitation. (Regardless of whether you sell products, which Fisher Investments doesn’t.) One of our musers can remember a stream of unsolicited faxes hyping penny stocks—hokey-looking flyers claiming some stock trading at pennies per share was sure to shoot to the moon. (Obvious pump-and-dump schemes.) The faxes are gone now, but email solicitation comes fast and furious. Over-the-top claims, complex strategies and bizarre promises that a financial product will do the impossible and provide growth and capital preservation abound. Recently, one such solicitation did the rare thing: catch our eye. Although surely not for the reasons the marketers intended.

The products were Exchange-Traded Funds (ETFs) offering exposure to covered-call strategies based on the S&P 500 and Nasdaq 100 indexes. Yes, there is an ETF for just about everything. For the uninitiated, selling covered calls is an options tactic. You own a stock and sell call options against it. Calls give buyers the right to purchase the stock at a pre-determined price (the “strike price”) within a window of time. They hope the stock rises a bunch more than the strike, allowing them to buy it lower and flip it for a cool profit. Covered call sellers hope, well, that doesn’t happen. For offering these rights, the seller receives a small premium. If the call option doesn’t breach the strike price before the time window is up, the seller gets to keep the stock and the premium. That premium (plus or minus the stock’s movement) is your return.

Whew. Thankfully, your securities-licensing primer is now over. Anyway, some think this tactic is the bee’s knees, juicing returns. But it isn’t. The primary reason most own stocks is to harness growth. Selling a covered call caps gains—problematic!—and the ETFs we were peddled prove our point. The first, the Horizons S&P 500 Covered Call ETF, has returned 66.6% since its June 24, 2013 inception.^[vi] That includes income from premiums. Including dividends, the S&P 500 is up 102.1%.^[vii] The second, the Recon Capital NASDAQ 100 Covered Call ETF, is up 54.9% since its inception.^[viii] The NASDAQ 100 Index, though, rose 125.3% over that period.^[ix] Yikes!

Now, maybe the ETFs’ returns would benefit from a different approach to writing calls. Possible! But we don’t think that is the core issue. Again, the whole philosophical argument for stocks is, in the medium to long term, growth usually outweighs downside by orders of magnitude. Capping your upside in an equity strategy cuts against this.^[x] We think folks get attracted to this stuff because the flashy tactic seems exotic and offers the appearance of control: If you aren’t getting the return you want, sell calls to boost it. But that is usually illusory, as these ETFs illustrate.

Enjoy your weekend!