A while ago, I wrote about how an index committee picking stocks for a “passive index” is a form of active management itself. You can create certain criteria for stocks to fit before their inclusion, but the point stands that the criterion for, say, the S&P 500 is sort of arbitrary. The Intelligent Investor is likely a 2-credit business course at your local community college and a $2000-a-credit 4-credit business course at your local private college, and is now a basis of god knows how many “factor ETFs”. Is a “value investing ETF” anything more than marketing and “industry standard” at this point? So, of course, GME is now being looked at for inclusion to the S&P 500:
The index committee has the final say on index constituents, which helps explain why the S&P 500 includes 500 of the largest publicly traded U.S. companies—but not necessarily the 500 largest companies…
…Companies considered for index inclusion must have posted positive earnings for their most recent quarter. The sum of their past four quarters’ earnings must also be positive.
Along with a very useful graph
Whatever your opinion on the GME miniverse is (as there’s simply nobody left to buy or sell the stock other than ‘apes’ and intraday manipulative traders), it probably isn’t a healthy phenomenon to add another retail-intensive stock to be buoyed by the most actively traded index. As a reminder (from the very first malt liquidity!):
It’s useful to look at financial markets from a standpoint similar to Newton’s Third Law - for every movement in a financial product, there is a product tied to it that will adjust accordingly (though not “equal and opposite” - there are far too many products built on top of products with non-linear relations for anything in finance to be this simplistic.) As such, the addition of Tesla to the S&P 500 would impact every ETF tracking the index, the futures tied to the index, the options on all these theoretically - identically moving products, the volatility measures on the index that are traded, the options on those, and so forth, due to the fact that while everything is priced according to the index, the actual shares making up the ETF must be held somewhere in the weights corresponding to S&P’s weights. Generally speaking, ETF rebalancing is a humdrum occurrence at the end of every trading day - however, Tesla is a fairly illiquid and extremely volatile stock which also requires large amounts of collateral to trade, given its weighting and market capitalization. Thus the problem arises of everyone knowing that all these ETFs do, in fact, have to buy the shares in some form, and, naturally, taking the liquidity currently being provided to front-run all the big asset managers buying it.
While I am skeptical about actually being able to front-run rebalancing trades, the fact of the matter is people try to, and as a result, stock splits and additions to indices are now considered bullish. As a reminder, direct indexing is a thing! Do you really need .04% exposure to stocks 493-500? Or is it a function of the index providers needing liquidity to distribute inflows and outflows across tickers without impacting them significantly? The significance of the GME addition to the S&P 500 would not necessarily be return-impacting, but rather that the option volume is so outsized on what would probably be stock #300 by weight or something that it would turn into some sort of weird liquidity suck off the index. It already tends to do this on days where it surges or sells with volume. While index funds are meant to not have to worry about knowing what you’re buying, I’m not so sure that the index funds themselves know what they’d potentially be selling here.
A Victory Lap, of sorts
Back in December 2020, I wrote about how Chinese ‘transparency’ with allowing defaults was not all that it seemed to be:
Beijing is allowing a wave of defaults by state-linked companies in the country’s $15 trillion credit market. This week, prominent chipmaker Tsinghua Unigroup Co. defaulted on $450 million of dollar debt triggering cross-defaults on another $2 billion -- equivalent to almost two-thirds of the total defaulted debt in China’s offshore bond market in 2019…
While this may be bad news for the weakest state-owned enterprises, it’s an improvement for investors, the credit market and China overall. A more accurate pricing of risk gives buyers of bonds greater transparency in a relatively opaque economy. That would boost the allure of Chinese debt, drawing more inflows, which in turn would help reduce the reliance of the nation’s capital markets on the government.
In isolation, this quote makes it seem like a positive that high yield debt is finally being allowed to default instead of being propped up by the government, but what if this is a gamble taken by the Chinese government to sell a short term funding crisis as “transparency”?
The Shanghai Stock Exchange said in a statement that it had temporarily suspended trading in China Evergrande Group's 6.98% July 2022 corporate bond following "abnormal fluctuations." The exchange had also suspended trading in the bond on Friday.
Shanghai exchange data showed the bonds sliding more than 25% to a low of 40.18 yuan after the resumption of trade on Monday afternoon. The company's 5.9% May 2023 Shenzhen-traded bond , which was also suspended, fell more than 35% after trading resumed.
Evergrande’s debt troubles are the most commonly covered failures, but this is by no means isolated. There is no such thing as isolated volatility in the uber-connected world of finance. One wonders what kind of ‘transparency’ allowing crypto levels of volatility in one of the largest high-yield debt issuers in China is.
Bond yields at some of China’s biggest real estate companies are rising in a sign that fears over debt problems at leading developer Evergrande are spreading more widely through the sector. The bonds of Guangzhou R&F, a property developer, edged lower in Shanghai on Tuesday to 60 per cent of their face value, following falls of more than 20 per cent a day earlier. The moves came after Moody’s, the rating agency, downgraded the group’s credit rating and warned over its ability to refinance. Fantasia Group, another property developer that also faces refinancing concerns, said in a statement to the Hong Kong stock exchange yesterday evening that it had made several purchases of $6m of its own bonds, one of which matures in December and had sunk to 78 cents on the dollar. Refinancing worries have grown following a furious sell-off in the debt and equity of China Evergrande, the world’s most indebted property developer, which is undergoing a liquidity crisis that forced it last week to warn over the risk of default
The one harsh truth of life is that you cannot avoid debt when it is due. Indeed, debt being due is what incentivizes active enforcement and regulation, as you are seeing with every major Chinese stock. Oh, by the way, remember when I wrote about delisting in November 2020?
I continue to be more confused at how delusional people have gotten when it comes to investing in Chinese companies after ANT Group’s IPO was oversubscribed to an insane degree, and where the CCP bailed everyone out by disappearing Jack Ma.
The concept of “priced in” no longer seems to make a difference as everyone is so desperate for an actual return that it is now incentivized to pay a premium just to get exposure to something huge that you know other money will flow into.
For a while now, I have thought that markets have been under-pricing the potential of authoritarian regulation on Chinese stocks and ADRs, and I don’t need to repeat the slew of headlines regarding ADRs and the removal of the facade independent business practices that the CCP has decreed. The stocks will likely be relatively fine, though neutered a bit. What I’m more interested in is how the options will trade, as now, they have a higher pricing of delisting risk:
The November monthlies have an extra 18 days of theta (time to expiry) caked in from November 1 as they expire on the 19th, but if I don’t expect the stock to be trading past the 1st on the revised policy, this should be discounted as well. This should also happen to the delta sensitivity in deep ITM options, which behave closer to a stock than any other option - perhaps you’d see delta convergence along with volatility convergence between the November monthly and the end of October expiry, but clearly delta behavior will be skewed in some manner to account for trading halt risk, and that there might be a scenario where you’d want to exercise early if spreads are too wide and liquidate your position through straight equity, though I’m partially assuming that the person short options is hoping they expire OTM
While the post is too long to copy and paste here, I’d highly recommend taking a gander at it for a discussion of potential options weirdness on any China stock.
I can’t help but think about this scene more and more as the days go by
Anyhow, going forward, I’ll try to do less crypto/NFT/GME/AMC/meme stock/TSLA discussion, because quite frankly, there’s really nothing left to say on these markets. I might be tilting more towards fiction for the time being, but we’ll see. Thanks for continuing to read - it makes pre-market more enjoyable than I ever thought possible.
