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I like Dogecoin.
It's a great example of an asset created purely for entertainment without any economic reason behind it.
No earnings, no dividends, no fundamentals, no nothing. The manifestation of magic internet money.
Let's now imagine that Doge goes up.
People buy it for the lolz at first, then @elonmusk makes a few jokes, and it keeps rising. Many start buying Doge for serious, speculative reasons too.
Posts about massive Doge gains become popular on social media, igniting the biggest FOMO around the world.
And it goes viral.
Next thing we know, Tesla accepts Doge as a form of payment, and El Salvador makes Doge its official currency. China also gets in on the action and attempts to ban Doge, resulting in more publicity and even higher prices.
As Doge continues to rise, more and more people become rich because of Doge. Haters call it the tulips of the 21-century, but it goes up despite the criticism.
Of course, justification follows the price action. A solid narrative that puts reasons behind Doge's rise will be written.
And undoubtedly, it will make sense.
It won't just go into the simple payment or money transfer use-cases, no, no, no... It will discuss the most imaginative scenarios, where Doge becomes the world's reserve currency, where OPEC negotiates Doge-denominated (Dogenominated?) oil contracts, and where all life on planets Earth and Mars will improve substantially because of Doge.
Such cool. Much wow.
But, you and I, we are reasonable investors, right? We both know that Doge is just a fun meme. We know that nothing supports Doge at its sky-high valuations apart from peoples' beliefs. We both know it's a bubble and will end at some point. Like all the previous bubbles did.
Or will it?
As Doge stubbornly keeps rising, all of your friends and family are making good money on the back of it.
When will you hop on this train?
It’s too late now, but it keeps going up.
Well, it's too expensive now, so definitely not now either.
At what point will the most rational investor give up and buy Doge?
At what point will you partake in the madness?
A few weeks ago, I stumbled upon yet another thought-provoking tweet by @SqueezeMetrics:
There is a blue "Translate Tweet" link, but unfortunately, it doesn't translate from English into plain English. (*sigh*)
But what the tweet means is:
Tesla is to S&P 500 is what Horse is to Troy.
As in, Tesla is the Trojan Horse injected into the $SPX index. Wow, okay... @SqueezeMetrics goes on to elaborate:
There's a lot to unpack here, so let's take it slow.
A stock that keeps on giving
With many speculative stocks trading exponentially this year, call options became a preferred way to gain exposure. They provide leverage and can maximise your investment many times over.
As a result, it's no surprise that option volumes have increased substantially, and they are now an influential force in the market.
Especially so since options can also trigger a gamma squeeze - a concept that almost became a household name in 2021.
Speculative call buying has been one of the significant drivers behind Tesla and Nvidia stocks surging to all-time highs this year. The volume and open interest for short-term weeklies remain high as investors hope for another gamma driven rally.
What are the chances that they actually succeed and trigger a gamma squeeze on Tesla?
And then another one?
"Well, if we look at fundamentals..."
Seriously? Fundamentals?! Tesla is now selling CyberWhistles - what more do you need?
As with my hypothetical example of Doge earlier, an asset does not really need fundamentals to keep rising. If investors buy it for other, non-fundamental reasons, why all of a sudden would they sell it for fundamental reasons? And why would fundamentals prevent it from rising any further?
As such, a stock like Tesla can theoretically go up despite the fundamentals. Now, I'm not saying it will (especially considering Fed's turnaround last week), but let's explore a scenario that it does in order to understand the @SqueezeMetrics tweet above.
And this scenario isn't too hard to imagine. Tesla has a solid and supportive fan base (who isn't selling), high options volume, a passive demand for its shares via $SPX funds, and a continued interest among the investors.
For example, here's an investor sentiment check from last Friday:
A case can be made that $TSLA has some room to go.
The Legend of Troy
So what's the issue if Tesla (or Nvidia, for that matter) keeps on rising? What's the big deal?
Well, there wouldn't be an issue if it wasn't for one thing - they are part of the S&P 500!
Combined, Tesla and Nvidia are about 4.1% of the index. If you have a $25,000 savings account and invest passively into $SPX, around $1,000 will be invested in Tesla and Nvidia (and $5,200 in MAGA stocks - Microsoft, Apple, Google and Amazon).
Even if you consider Tesla risky and purely speculative, Tesla shares at a $1 trillion valuation is what you get when investing in $SPX.
And many passive S&P 500 index funds find themselves in this exact situation – they have no other choice but to load up on Tesla shares regardless of the current price level.
So imagine if $TSLA rips higher from here.
Rising prices attract more investors and speculators who decide to go long on Tesla calls. Option market makers are then forced to buy Tesla shares to delta hedge, further driving the stock up.
Shorts get squeezed (again), and anyone who went short $TSLA at crazy valuations is now forced to cover at even crazier valuations until no shorts are left. Literally.
The stock triples in a matter of weeks. Everyone becomes a Tesla options trader - buy weekly calls on Monday, retire rich on Friday.
At some point, Elon tweets something innocent, like "the stock is too high", and shares rip another +10% following the tweet.
Singlehandedly, Tesla drags the entire S&P index higher, while the rest of the 499 stocks are left wondering wtf is going on.
But who cares about those 499 small-cap stocks anyway - $SPX is a market-cap-weighted index! As Tesla rises, so does its weight and impact. $SPX drifts away from being a well-diversified portfolio and starts trading like a 2021 meme-stock.
Ohhhh, and what about the poor, unsuspecting income funds... They thought they were executing a call overwriting strategy on an index! It was supposed to be a low-risk strategy!
As $SPX jumps higher, index call-overwriters get squeezed and rush to cover short calls, which means..... yes, it means buying more $SPX and $TSLA, driving the prices even higher!
This fuels even more speculative buying, as everyone jumps on the bandwagon and joins the Tesla buying frenzy.
In the meantime, $TSLA grows larger, taking over 25% of the S&P 500.
Passive funds that used to buy $TSLA at $1 trillion valuation are now buying it at $40 trillion. Their mandate says it's a buy! And they keep buying whatever the level, contributing to an already excessive demand.
Eventually, $TSLA and $SPX skyrocket to the moon.
Is this unreasonable? Maybe. But who's going to stop it? Taking advantage of any correlation or mean-reversion dislocations means going short on Tesla. And who's gonna jump in front of the train? Exactly.
Moreover, why do that when you can simply buy Tesla calls or shares like everyone else!
At what point will you partake in the madness?
Pension funds and other passive funds have been investing throughout all this time. They spent public retirement funds dollar-averaging the Tesla spike and chasing the gamma-squeezed bubble higher.
But at some point, the balance will tip over, and the Tesla bubble will unwind, taking the S&P index along with it. So, in addition to buying near the top and at the top, passive funds are now buying on the way down as well, delivering significant losses for investors.
And all that was simply due to Tesla being part of the S&P 500. The inclusion of Tesla in the index exposed trillions of dollars worldwide to Elon Musk's tweet risk.
When things normalise, the task of delivering returns will fall on the shoulders of the remaining 499 stocks. But how long will it take them to get $SPX to the same level?
And how long will it take pension funds that bought $SPX at the peak of this Tesla bubble to break even? And what will happen to the pensioners who lost most of their pension funds?
It might take years for SPX to recover and return to those levels again.
But hey - wasn't passive investing ruined already anyway?
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