The Blowoff!

Via Praetorian Capital,

Last summer, I was having lunch with a friend at a plain vanilla shop, who kept checking his phone and muttering, “this NVIDIA is killing me.”

After the third time in five minutes, I had to ask:

Me: You run a long-only fund. You don’t short. How is NVIDIA killing you?

Him: Kuppy, you don’t get it. You do your own thing. I’m benchmarked. I’m underweight NVIDIA and trailing massively. There are guys at my firm who are 500bps overweight. One guy is even 700bps overweight. They’re killing it.

Me: Who cares?? Just buy something else.

Him: NVIDIA goes up every day. Clients keep asking about it. I feel like an idiot to be underweight.

Me: So, then why don’t you buy some if it’s worrying you so much?

Him: I keep waiting for a pullback. Damn thing is up another 3% today. It never pulls back. I’m getting further and further behind. Not sure what I’m going to do. NVIDIA is killing my year…

The whole experience was surreal. I miss all sorts of trades. I don’t let them bother me. If something is killing me, it’s because I’m losing money. I’ve never worried about making less. It’s just not an emotion that I’ve experienced. Besides, my friend was trailing his benchmark by a few hundred basis points. To me, that’s a bad day, a rounding error—certainly not a crisis. However, I don’t live in the benchmarked world. In that world, trailing your benchmark is existential. Sure, you can do it for a quarter, or maybe even a full year. When that happens, your bonus will suffer, but if you trail for two years in a row, it becomes existential. You’ll get fired. My friend was really sweating it.

His whole way of thinking was so foreign to me. I buy cheap stocks with tailwinds. I don’t know when they’ll work, and I mostly don’t care. If I have a bad quarter or even a bad year, that’s just part of the process. I built my firm specifically to support my investing style. I wanted the flexibility to underperform, to be volatile, to have nasty drawdowns, to be able to avoid owning overpriced garbage if it enters a bubble. My friend didn’t have that luxury and a few hundred basis points of tracking error were killing him. It was impairing his ability to think. He couldn’t even enjoy lunch.

Did my friend ever buy NVIDIA?? I assume he did. It was probably the day of a local peak when he couldn’t take the pain any longer, right before a nasty pullback. He likely swept the book and then got drunk. I’m almost sure the pain of missing got the better of him, and he paid up. One can never underestimate the pain of underperformance.

I mention this because I’m reading a lot of year-end fund letters. Everyone is bemoaning the MAG7, their disproportionate effect on the S&P 500 (which is effectively the index that everyone competes against), and the fact that their funds underperformed. It’s amazing how few funds owned the MAG7 last year. It seems like only retail boomers owned them, as no self-respecting hedge fund will ask for 2 and 20, only to buy Apple. As a result, many funds dramatically trailed their index, even worse, they trailed the MAG7 that their boomer clients are clustered in. Trust me, it feels mighty embarrassing to trail your clients, and still pretend you’re the expert in the room.

Even in the hedge fund game, there are performance pressures. In some cases, they’re even worse than in the closet indexing world. You’re given a pass if you underperform for a year, as long as you’re not down on the year, but you’re not allowed to keep underperforming. At some point, the redemptions start, and they don’t stop. No one wants to pay 2 and 20, when they can buy an ETF that charges 15bps and tracks the index.

Look at the MAG7 screaming higher in January. Every day, portfolio managers are falling further behind. They’re saying to themselves, “Not again! I gotta catch up!!” They’re rolling out of their core portfolio positions, and they’re telling their brokers to, “get me some MAG7!!” Maybe they’re not lifting every name, but they’re going for the ones like NVIDIA that are making new highs every day. They’re not investing, they’re surviving. This is existential. If NVIDIA goes up another $100 and they don’t have it, they’re out of a job. This is how blowoff tops get made.

Do you remember the first quarter of 2000?? Tech screamed. Everyone chased. Sure, there was a bubble in speculative internet stocks. We all remember Pets.Com. What’s less remembered is the mad rush into mega-cap tech names. Plain vanilla funds had spent years ignoring these names as they were overvalued. Eventually, they had no choice but to pay crazy multiples for the big liquid names that dominated the indexes. The underperformance led to redemptions; it became existential to trail the indexes. They had to close their eyes and buy overpriced tech. Cisco, Nortel, Microsoft, Sun Microsystems, AOL, JDS Uniphase, Yahoo, etc. These stocks went up every day, relentlessly. Everything else got sold to fund it. Even the greats of our industry, guys like Druck, got sucked in. He simply couldn’t stand to underperform. That pressure is powerful, and it makes guys do stupid things.

I feel like we’re reliving the first quarter of 2000, but in the narrow world of the MAG7. On one side, capital keeps flowing into a handful of names. On the other side, there is a relentless undertow in everything else—as it’s sold to fund more NVIDIA. I look at my book and feel my names under pressure, names that I think are going to report amazing year-end quarters. These names shouldn’t be getting sold, but they are—guys need to fund more MAG7.

I don’t know when this ends, as these things have a way of feeding on themselves. I just know that it eventually ends. I also know that it usually doesn’t end in a gradual way. Rather, it ends with a violent sector rotation, as capital floods back into the companies that have underperformed, and out of the MAG7. Think back to the first quarter of 2022. I think it’s going to be like that, but even more violent. The catalyst is likely going to be a big break in bonds. They’re starting to leak again. They’re sick, and I think it’s terminal. In that case, I feel like we’re a few points away from bonds infecting other duration assets.

I cannot time when this rotation happens, but I can recognize what’s happening. I’m immune to these performance pressures. If I’m destined to underperform for a period, then I’ll underperform. I’m not going to do something foolish, just to have a few months with better numbers. A lot of portfolio managers do not have that luxury. They’re stampeding in, fully expecting that they can get out in time. They’ll all get trapped.

But at least they’ll track their benchmarks…