Why Tech Crashed



Over the last two weeks technology stocks tumbled. The initial cause was clearly the rapid rise in rates...but does it explain the magnitude of the crash in companies like Tesla? We don't believe so and we explained why in Periscope. Basically it comes down to the bubble in the call option market. In this article show why the rise in rates has very little impact on tech valuations using simple examples and historical data.


What happened?


First, let's be clear about what happened over the past two weeks. This was not a normal correction in stocks. Financials and energy rose during the rapid rise in the 10 year from 1.2 to 1.6% in two weeks. Meanwhile... over 10 trading days...

  1. S&P 500 fell 4%

  2. NASDAQ and QQQ fell 10%

  3. Tesla and Ark Invest funds fell 25-30%

  4. Small cap tech in Ark Invest funds fell 40-60%

Basically...what happened comes down to concentrated leveraged bets retail investors were taking on their favorite companies from 2020...and those just so happened to be "technology" ... especially Tesla.


Ark Invest got hit particularly bad because Tesla made their founder and CEO Cathie Wood famous with her $4,000 price target back in 2019 (pre-stock split) when many thought Tesla was going bankrupt and valued at $200. Many haters out there were looking for a chance to short and they got it after Tesla missed on earning for the first time in nearly two years.


Call Option Bubble


We did an extensive analysis of what we call the Call Option Bubble...which is how retails were leveraging their bets on Tesla in particular. We found that Tesla had more call options outstanding than any other company ... even after adjusting for market capitalization. We wrote on December 13th 2020...


"Investors have 30 times more options exposure to TSLA than the average company ... and 50% more than the next runner up "Fastly".


Here is the table we published in the Call Option Bubble...

Incidentally...this was a big reason why we sold most of our stock a month ago and started shorting Tesla. This worked out for the most part. One wrinkle was Ethereum which got hit but a leveraged bet made possible by DeFi, but that's another story.

https://twitter.com/IntuitEcon/status/1354934347766370305?s=20


In this piece we also talked about why the Call Option Bubble was likely to cause a crash in Tesla and bring down ETFs with high call option volumes such as QQQ and ARKK. Here is just one chart illustrating the enormity of the bubble. Basically...retail investors have been buying 300% more call options and paying 300% higher premiums for them then they did in 2019. When they do broker dealers buy the underlying stock to hedge their delta exposure...an exposure that largely evaporated last week.

As buyers of all these call options went from being "Retired at 20" to broke...broker dealers sold their stocks because they no longer needed thome to hedge their call option exposures. That's why Tesla crashed so fast and this probably explains QQQ and the Ark Funds as well.



What about interest rates?


Well...the narrative about rising rates probably popped the Call Option Bubble..but its a bad explanation for why risky technology companies like Materialize fell 60% in two weeks. The reason treasury bond yields have little impact on risky assets is qsimple. Risky assets have high risk premiums, and those premiums make the impact of benchmark rates largely immaterial.


To illustrate, consider two stocks. Stock RSKY is growing fast but not currently profitable. Stock SAFE is mature with predictable cash flows. You think RSKY can make a lot more money over time, but it's going to take a decade to play out.


Let's assume that RSKY deserves a risk premium of 10% while SAFE is perhaps just 3%.


What impact did the rise in Treasury Bond yields from 1% to 1.6% have on the discount rates you use to value both company future cash flows?

  • RSKY's discount rate went from 10+1= 11% to 10+1.6 = 11.6%.

  • SAFE's discount rate went from 3+1= 4% to 3+1.6 = 4.6%.

We could go through calculating a discounted cash flow model, but its not even worth the trouble. Changing a discount rate from 11% to 11.6% will barely move the needle on a decision to buy and hold a risky stock. Now in contrast...going to 4% to 4.6% probably does have a material impact...even if those cash flows occur in the near term.


So ask yourself...do you really think Tesla or Ark investors sold because they worry that the value of their companies fell as a result of a strong economy pushing down the price of Treasury Bonds?


Its kinda silly when you think about it.


But how can most everyone on Bloomberg and the WSJ be wrong?


I don't know. People like narratives.


Still not convinced?


Historical (lack of) Relationship between Bond vs Stock Yields


We wanted to be sure also ... so we did some back testing. Take a look at the relationship between S&P 500 daily returns and the difference between Treasury Bonds vs Dividend Yields. We also broke this out by regime since 1996. Notice anything? Neither do we.

The second table shows outperformance of the S&P 500 vs NASDAQ. This is a test to see if more mature companies really outperform tech when Treasury Bond yields are higher relative to dividends on the S&P 500. Notice anything? Neither do we.


Perhaps the most obvious historical evidence of the lack of tech sensitivity to treasury bond yields in the period leading up to and after the Dot Com Bubble. Treasury Bonds fell year over year from 1996 to 2004 from 7% to 4%. At the peak of the Bobble the S&P 500 dividend yield was 1% compared to 6% on the S&P 500. The only period where value outperformed tech in the past 25 years was the five year period after 2000...and that whole period had lower Treasury Bond yields than the 1990s.


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Be careful what you believe.


Sincerely,

Bernard