Humanity's Biggest, Weirdest Carnival Ever

It keeps getting weirder and weirder... The tail is wagging the dog in this market... 'Gamma squeezes' and other esoteric options phenomena... Making toilet paper, resurrecting woolly mammoths, and living on Mars... Excess in the junk-bond market... Kicking the can down the road farther than anyone... Implying that it can last forever... Humanity's biggest, weirdest carnival ever...

You may have noticed something about many of my recent Digests...

I (Dan Ferris) keep mentioning the weird art-market stories we've covered over the past year or so... before ratcheting up the weirdness with another mystifying example – including recent cases from the stock and crypto markets.

Every single time I write one of these stories, I think, "OK, this is it... last one. It won't get any weirder than this. Now, I can get back to business."

But it's never true... It just gets weirder and weirder. I could spend the rest of my life writing this type of stuff.

And I promise you that it's not just art, cryptos, and stocks... Extreme speculative excesses have generated weirdness in every market you can name.

In today's Digest, we'll prove that point... We'll look at how speculators clamoring for the worst deals in history have created bizarre outcomes in a trio of other markets today – options, venture capital, and high-yield ("junk") bonds.

We might as well start with the options market, since it's more likely than ever that you're involved in it...

You might think of stock options as a large market that sort of sits next to the stock market and is ultimately controlled by it...

After all, when you buy a call option, it only goes up in value if the underlying stock's price goes up, right? And it's sort of the same thing when you own a put option... It only goes up when a stock goes down, right?

The stock market is the dog wagging the options market's tail, right?

Um, well, no... not anymore. Today, the tail is wagging the dog...

Electric-vehicle maker Tesla (TSLA) is a perfect example of the tail-wagging-dog phenomenon these days...

Tesla's stock has soared roughly 180% over the past year. And it has gained almost 60% in the past month alone.

This incredible surge higher pushed the company beyond $1 trillion in market cap and turned founder Elon Musk into the world's richest man... He now has a net worth of roughly $340 billion. Musk's 170.5 million Tesla shares are worth roughly $208 billion at its recent share price around $1,222 per share.

Here's the kicker... The stock's massive move was spurred on – if not caused outright – by the options market.

You see, when investors buy call options, the dealer who sold them has effectively shorted the stock... That means the dealer will lose money if the stock goes higher.

Dealers just want to be neutral counterparties, though... They're not in the business of betting a stock will go up or down.

So after the dealer sells call options, it must purchase the stock to neutralize its position. And the higher the stock goes, the more the dealer has to buy to hedge the rising value of the call options it has sold.

When day traders stampede into call options like they've done with Tesla, it creates a feedback loop... As the stock rises higher, it attracts more call-option buyers, ultimately leading options dealers to buy more stock, propelling its price still higher, attracting even more call-option buyers, and so on.

According to a recent Bloomberg article, that's why Tesla's stock is up so much recently...

In the final days of October, Tesla's call-option volume spiked to its highest level in more than a year. The most active Tesla call-option contract – at a strike price of $1,000 and expiring on October 29 – rose from $1.60 to $39.34 in one day... That's a 2,360% gain.

So if you're wondering how Tesla's market cap could get to $1.2 trillion – more than the next 12 public carmakers combined – look no further than the day traders looking for a quick buck... They're throwing their weight around in the options market, causing the stock to pop straight up.

Of course, most of these folks likely don't have any idea of what they're really buying, or what it's really worth. As one equity analyst noted...

We've seen a clear lack of regard for the cost of options... Tesla continues to make a mockery of analysts' valuation models.

And as our friend Jason Goepfert of SentimenTrader.com told Bloomberg last week...

Net call buying to open – a gauge of bullish bets – was in the top 2% of all weeks since the year 2000 and not solely thanks to demand for Tesla Inc. options.

This phenomenon of options dealers needing to buy shares after selling calls as a stock soars is called a 'gamma squeeze'...

Meme stocks GameStop (GME) and AMC Entertainment (AMC) both came totally unhinged from their fundamentals by combining a gamma squeeze with a classic "short squeeze" earlier this year.

As those stocks soared on the back of strong interest from day traders – including call-option buying – big hedge funds like Melvin Capital and Citadel had to cover their short positions... That led to even more buying.

Gamma squeezes have moved markets several times this year, becoming a fact of life... So have even weirder, more esoteric options phenomena like "vanna" and "charm." (Please don't ask me to explain them... I have no idea. Just e-mail Retirement Trader editor Dr. David "Doc" Eifrig, DailyWealth Trader editor Ben Morris, or Ten Stock Trader editor Greg Diamond instead!)

And of course, nothing feeds a speculative frenzy like a cheap, new product aimed at the most naïve, least wealthy participants...

The options market is no exception.

The Chicago Board Options Exchange ("CBOE") is currently planning to launch "nano" options for the S&P 500 Index early next year. These options are one-hundredth the size of S&P 500 mini options and one-thousandth the size of options used by institutional traders.

So, in other words, if a normal S&P 500 option is priced at $1,000... the mini is $100 and the nano is just $1. And as if to underscore that these nano options are aimed at the most ardent gamblers in the market, they have a maximum expiration time of just one week.

If nano options don't scream "the end is near" to you, nothing will.

I realize CBOE is a business looking for new products to offer its customers... But how could the folks running the business not know that they're just trying to feed a gambling habit?

Of course they know.

The loop in the options market is complete... Stocks go up. Speculators buy call options. Option dealers buy stocks. Stocks go up more. That pushes option values up more. And that causes dealers to buy more stock.

It doesn't take Albert Einstein to figure out that this is a recipe for disaster... or to ask if the same thing can happen on the way down.

It's all fun and games as long as gamma squeezes propel stocks higher. But what do you think the world will look like when things go in reverse?

Let's keep things pleasant and leave the answer to that question for another day. For now, it's time to move on and check out the speculative excesses – and frankly, just plain weird deals – happening in the venture capital ("VC") market...

The VC market is where small private startups go to find their first investors...

Companies like Facebook and Google began this way. (Oops, you'll have to forgive me... I meant to say Meta Platforms and Alphabet. How could I make such a silly mistake?)

Anyway, VC investors tend to spread their bets around to many different companies... They know most new businesses fail, and it's too hard to figure out which one will be the next big winner. Instead, they give themselves plenty of chances to find that company.

Private capital markets like VC have been rising in popularity and value for a couple of decades. As Allison Herren Lee, the commissioner of the U.S. Securities and Exchange Commission ("SEC"), began an October 12 speech...

Perhaps the single most significant development in securities markets in the new millennium has been the explosive growth of private markets. We've become all too familiar with the statistics: more capital has been raised in these markets than in public markets each year for over a decade with no signs of a change in the trend.

In 2011, the VC industry invested a record $30.6 billion. That is child's play nowadays... Through the first nine months of this year, it has invested more than $200 billion.

In 2015, when two journalists coined the term "unicorn" for private companies worth $1 billion or more, there were roughly 80 of them. Today, more than 1,000 unicorns exist – with more than $3.4 trillion of total private market value. During the past two quarters alone, more than 280 companies became unicorns. (That's more than one a day.)

The torrid pace of rising VC valuations is as completely unhinged from fundamentals as the stock market...

For example, VC firm Andreessen Horowitz made an investment in social audio app Clubhouse in January that valued the business at $1 billion. Then, just three months later, Andreessen Horowitz invested again... But this time, it valued the company at $4 billion.

If you're thinking that rapid growth can result in rapid escalations in market value, I agree.

That's why you need this little bit of additional context... As Clubhouse's valuation quadrupled in three months, data showed that fewer people were downloading the app.

Rapid growth wasn't happening... The company's business was going the other way.

VC investors today will invest in anything, no matter how utterly stupid it sounds...

No, really...

An Australian company called Who Gives a Crap raised $31 million in VC funding back in September. It plans to grow a business of making toilet paper from environmentally friendly materials and giving half the profits to charity.

Around the same time, a biotech firm called Colossal announced that it had raised $15 million for its plan to resurrect the long extinct woolly mammoth. A guy who makes electric motors and has no business plan raised $55 million. A company that claims to print 3D houses – including those suitable for life on Mars – was able to raise more than $200 million.

If none of this qualifies as weird to you, I'd bet you were a hoot on Halloween.

VC firms are run by an optimistic group of folks looking for the next Facebook, but they're not oblivious...

Even they seem to know the writing is on the wall for their entire industry. A recent article on Vice.com quoted VC investors saying things like "The fear of missing out right now is extreme" and "People have to make quicker decisions... do less diligence... pay more."

In the weird world we're living in today, private companies can name their price... and some VC firm will feel like it absolutely needs to pay it. Some of these private companies require a response from VC firms within hours of hearing their pitch – and they're getting it.

The SEC requires private-equity and VC investors to be accredited... That just means they must be rich enough to seem like they know what they're doing.

But I hope it's obvious to you by now that they don't know what they're doing... The only thing they're accredited to do is light bigger sums of money on fire. And by all accounts, the flames of the VC bonfire are licking at clouds today.

Importantly, investors in VC deals don't tend to get paid until the company goes public...

Therefore, a red-hot initial public offering ("IPO") market is required to keep a red-hot VC market from cooling off.

In the final week of July, 20 companies went public on the Nasdaq or the New York Stock Exchange – more than in any seven-day period since 2000. And in a July article in Fortune magazine, a senior market strategist at investment bank Renaissance Capital called the 2021 IPO market, "Record-breaking, on fire, historic, extremely active, very busy."

If you're one of those people who pester bearish equity investors (like me) for a possible catalyst that will bring the great bull market of 2009 to 2021 to a halt... consider what will happen if investors get tired of all the money-losing bets they're backing in the VC market.

That would put a damper on IPOs... which would create a negative feedback loop... which would cause all the VC money to dry up fast. If that were to happen, who would fund the next toilet-paper maker, dead-animal resurrector, or out-of-this-world house maker?

At that point, investors trapped in illiquid private VC funds will want to raise cash to make up for the money they've lost... So they'll sell whatever they can – including everything from the so-called "FAANG" stocks to Tesla to GameStop and more. If you can name it, they'll sell it.

But before you contemplate any of that, we need to get to even more weirdness...

Next, we must take a look at similar dynamics in the junk-bond market today...

Now, it's not as weird as the options and VC markets – at least not yet. Still, it's worth checking out the record extremes in this market these days...

A record 149 new companies have issued junk bonds for the first time this year. Only three previous years – 2007, 2013, and 2014 – saw more than 100 new junk-bond market entrants. The flood of new money has sent the outstanding balance of junk bonds to more than $1.5 trillion for the first time ever.

VC investors depend on IPOs because that's how they cash out of their investments. In a similar way, the junk-bond market depends on demand to finance mergers and acquisitions (M&A), many of them by private-equity investment firms.

And of course, as you might've guessed, M&A activity today is at levels not seen in at least 41 years. As data provider Refinitiv reported in early October...

Worldwide dealmaking has topped $4.4 trillion from more than 40,000 transactions, making it the strongest opening nine months of any year since records began in 1980.

Human nature being what it is, the most money tends to flood into financial markets when they are least attractive – and junk bonds are no different. As you can see in the following chart, current junk-bond spreads over U.S. Treasurys are at lows not seen since 2007...

Perhaps the weirdest thing related to the junk-bond market is how some private-equity firms exit their investments...

Traditionally, they have either taken them public in an IPO or sold them to another company. Well, now... they're also just buying their own portfolio companies.

Big firms like Blackstone (BX) and EQT were among private-equity investors who've sold companies they held to other funds they controlled last year.

The buyer funds are called "continuation funds." The private-equity firm raises new money. But instead of doing a new M&A deal... it just uses the money to buy another company it's already holding, providing those investors with an exit.

For now, the surge in popularity of continuation funds in 2020 appears to be a COVID-related phenomenon... It appears that the pandemic-induced recession made the traditional exits more difficult to execute.

But who knows?

If the stock market sours, making most M&A less attractive, maybe private-equity firms will try to use their record $2.5 trillion cash hoard to buy their own portfolio companies more often.

If not, investors will get tired of not being able to exit, and the private-equity firms won't be able to raise any new money. There's something to be said for an industry that appears to be able to kick the can farther down the road than everybody else.

Now, before we sign off for the weekend, let's put it all together...

In short, investors are pouring record amounts of money into options, VC opportunities, and junk bonds today. Plus, they're paying more than ever in many cases... and more than they paid since the last financial crisis in others.

Since record-high prices mean record-low returns in financial markets, we can reach a simple conclusion...

Investors in options, VC opportunities, and junk bonds – just like folks investing in the stock market today – are more excited and optimistic at precisely the moment when they should be more worried than any time in decades.

I realize what I'm about to say is typical of a bearish, soon-to-be sexagenarian, but...

This never ends well. It's classic bubble stuff. Everybody gets in at the top.

And right on cue, you'll always get somebody implying that it can last forever...

Last week, a Financial Times article suggested it's possible that money could flow into stocks forever... causing them to go up forever.

The article is more nuanced than that... But there's a clear message to bears that continuing to doubt the market's stellar returns is more likely to be a mistake. The writer even casts doubt that inflation is much of a risk.

Part of the problem at times like this is that investors fail to realize that stock prices don't represent current wealth. Rather, as economist John Hussman recently wrote...

What investors view as "wealth" is actually just the current price of their future wealth.

In other words, stock prices represent wealth that has yet to be created.

It's all in the future. And that's true of all securities... The value ultimately comes from the cash flows that investors receive over the life of the security.

You don't buy a stock today for what it has earned in the past. You buy it for what it will earn in the future, starting the day you buy it.

When securities trade at record prices, they must grow earnings at high rates for a very long time just to keep from disappointing investors' high expectations. Since nothing goes up in a straight line and every business produces disappointing earnings sooner or later, paying a record-high valuation for any investment virtually guarantees that folks will be disappointed by the returns.

If a stock, option, VC stake, junk bond, or other investment is priced for perfection – as so many are today – and the company underlying that investment generates results that are less than perfection, you could lose money even if you're right and it becomes a great business.

Paying record-high prices for investments is virtually indistinguishable from a prediction that the future performance of the business will be absolutely stellar every day, week, and month for years to come – or perhaps "forever" if you listen to the Financial Times.

Something close enough to that came true with Amazon (AMZN), but investors still had to ride out a 90% drawdown and wait seven years to break even if they bought at its peak during the dot-com era.

So even if investors are right about many of the speculative (and many not-so-speculative) companies they're buying today, they're predicting a future that can't possibly materialize... they're paying way too much... and they will, at best, earn a lousy return and, at worst, lose money.

It sure sounds like I'm telling you not to buy stocks at all...

If only it were that simple.

You'll never catch me giving simpleminded advice like that or trying to predict market tops or bottoms. I've always said, "Prepare, don't predict."

You can't afford not to own stocks. Nor can you afford not to own plenty of cash, gold, silver, and maybe some bitcoin.

A truly diversified portfolio including all of the above will allow you to prepare for a wide range of outcomes. You won't get caught off-guard if you're ready for anything.

And for now, until market conditions change, I'll keep showing you what it feels like to be an investor during the biggest asset bubble in history... I'll continue to pass along all the sights, sounds, and smells of the biggest, weirdest carnival humanity has ever held.

As long as you're well-prepared, it should be a lot of fun to watch it all unfold!

New 52-week highs (as of 11/4/21): Analog Devices (ADI), Automatic Data Processing (ADP), Applied Materials (AMAT), Bath & Body Works (BBWI), Best Buy (BBY), CBRE Group (CBRE), Costco Wholesale (COST), Cintas (CTAS), Expeditors International of Washington (EXPD), Alphabet (GOOGL), W.W. Grainger (GWW), Harrow Health (HROW), Ingersoll Rand (IR), Liberty SiriusXM (LSXMA), McDonald's (MCD), Martin Marietta Materials (MLM), Microsoft (MSFT), Cloudflare (NET), Nestlé (NSRGY), Novo Nordisk (NVO), Invesco S&P 500 BuyWrite Fund (PBP), ProShares Ultra QQQ Fund (QLD), Construction Partners (ROAD), ProShares Ultra Technology Fund (ROM), The Shyft Group (SHYF), First Trust Cloud Computing Fund (SKYY), ProShares Ultra S&P 500 Fund (SSO), ShockWave Medical (SWAV), Teradyne (TER), ProShares Ultra Semiconductors Fund (USD), Vanguard S&P 500 Fund (VOO), Verisk Analytics (VRSK), and Zebra Technologies (ZBRA).

The mailbag is overflowing with comments – both good and bad – for our two-part exclusive interview with economist and TV show host Larry Kudlow. (Read Part I and Part II if you haven't already.) As always, you can send us a note at feedback@stansberryresearch.com.

"I appreciate you sharing the Kudlow interviews! I have always been a fan of his and believe he is a straight shooter. I would [appreciate] more of his thoughts if and when you have the opportunity.

"I depart from Larry and others who try to portray their party (Dems or Republicans) as doing the most for America or their constituency. I would describe the parties as 'two sides of the same coin' and they essentially just argue taxes. Since the monetary system changed with Nixon and the credit expansion accelerated under Reagan, both parties decided that corporations and people of wealth would supersede the needs of the majority. It's left 70% of our population trying to get a piece of the American dream that was promised during and after the 1980s.

"So when Larry claims free trade and other benefits of Republican rule has made the country better, it rings hollow to me. I'm hopeful for the next generation of citizens to 'do it better' as the baby boomer's leadership has been pathetic. Again, I don't distinguish between parties. They're both responsible and it hasn't been good.

"Keep these articles coming. I enjoy the points of view." – Stansberry Alliance member Bill F.

"Hi all, that was a very enjoyable couple of Digests this week, hearing from insider Larry Kudlow. Geoffrey Morris did a great job covering so much ground with him. I look forward to a recurrence – with both of them! Keep up the excellent work." – Paid-up subscriber B.T.

"I enjoyed your interview with Larry Kudlow immensely. I also watch him on Fox Business. He is definitely pro capitalist and pro small government, which is how the country thrives. He explains economics in succinct language that everyone should understand. Thank you for the interview." – Paid-up subscriber Mary Beth C.

"Excellent interview. But it would have better had you asked him to elaborate on why he was disappointed over January 6th.

"Well done though. Keep interviewing more guests like Larry." – Paid-up subscriber Bill W.

"I enjoyed the whole interview and generally agreed with his economic approach, hoping in 27 months we can get back on that track. I'm a fan of his TV show.

"His concern about China and the military buildup scares me. He dodged the Jan. 6th issue.

"Overall an A+ effort. Thanks for sharing." – Paid-up subscriber Bob J.

"Great service you provided here. I have followed him for years, Reagan years, Kudlow and Cramer show and forward to today. He is factual and will back it up, and you [can] disagree with his view, but not the facts. [In my honest opinion,] he seems to be well prepared and explains things very well. Thank you." – Paid up subscriber Edward H.

"Thanks for the two segments with Kudlow. Very interesting interview. I thank him for all his service, and [I am] amazed at his work ethic. I hope the USA can turn back to rewarding success as opposed to the redistribution. There has to be a balance that promotes growth and not entitlements." – Paid-up subscriber Bill W.

"Please have much, much, much, more of Larry Kudlow. He is a straight shooter with no BS that so many of your guests have. An interesting segment would be his straightforward analysis of the policies that Biden has or is currently initiating and specifically why they are so dangerous for our future capitalist economy and our 'Constitution' and 'Bill of Rights.' Such an interview will be Stansberry's top interview since Porter started the company. Regards." – Paid-up subscriber William O.

"Larry Kudlow is skewed. He sees everything through a 'Wall Street' lens. He caters to the rich. Under Trump, the rich got a lot richer, and the poor got a lot poorer. Wall Street CEO fatcats and drug companies filled their coffers. Trickle down doesn't work. Tax cuts don't work if they are going to the rich and the corporations. History has proven this." – Paid-up subscriber Steve S.

"Kudlow is quick to point at Biden's tax proposal to tax the top 10% and sell that old trickle-down theory for cutting tax for the rich. Trump added $8 trillion on his so-called economic watch.

"There's no Psychology about this, the FED must stop printing dollars. This will turn out bad. They went down the wrong road in 2007-08 and didn't let the market correct, now they can't stop printing dollars. This is fundamentally a bad outcome for the U.S. and world economy.

"Buy a farm and move your family and like-minded friends out on it, plant gardens, and buy Gold and Silver Eagle coins and crypto. Dollars in the bank (cash) is like a 100-pound block of ice melting with inflation.

"The ununited states (united we stand and divided we fall) is headed into civil unrest and possibly war. The third-most gunned-up army on the planet is the American citizens!! Trust God, but tie up your horse, or it will wander off. May peace be with you and your family." – Paid-up subscriber Jeremiah O.

"So superficial as to be worthless." – Paid-up subscriber Jesse W.

"Kudlow is of the 'I've got mine; raise the drawbridge' class. Laissez faire works for the wealthy. They like things just fine the way things are.

"They're against welfare except when it comes to tax cuts for the 1% and making no-bid deals to help fellow billionaires." – Paid-up subscriber Karissa W.

Good investing,

Dan Ferris
Eagle Point, Oregon
November 5, 2021