It's a bird... It's a plane... It's NVIDIA!

Michael Green explains how an inelastic market is taking NVIDIA straight to the top

When I was in Cambodia I rented a dirt bike and went for a drive with my ex-girlfriend. We discovered a postcard quality beach with nobody on it, bought petrol from a stall selling one liter portions out of repurposed vodka bottles then we drove to the top of a hill with an advantageous view of the sunburnt and slightly brown vegetation that characterizes much of that country.

Preparing for departure I proposed that a burnout might be the perfect way to toast our lovely outing in the countryside. Now dear reader, please understand that when you see a motorcycle do a burnout it’s almost always running slick street tires that are easy to spin. Dirt bikes, on the other hand, are shod in chunky tread with knobs that stick out half an inch and are more prone to digging in than spinning. A fact that might be obvious to anyone with two cents to rub together upstairs. Alas…

I revved the bulletproof engine held the front brake and dumped the clutch but instead of spraying gravel towards the sunset the bike found traction, shot out from under us and traveled autonomously twenty feet down the road before toppling onto its side. We were bloodied and bruised, the bike had a broken clutch lever and I got to practice my apologizing techniques.

All of that stands as a way of introducing the topic for today’s article: the meteoric price rise of NVIDIA. Everyone who’s bet against this stock in the last six months has been just as successful in their trading as I was trying to do a burnout on a dirt bike. The market cap of one of the world’s largest companies has nearly tripled since the start of 2023 and to this day the stock continues to make new all-time highs. But why? We turn now to Mike Green for an explanation.

Mike Green explains

First we must dispel with the most obvious theory: short covering. A quick peek at the data reveals that NVDA’s short interest as a percentage of float stands at just 1.13%. That’s not a lot, especially when you compare it to another stock like Carvana which has an open short interest of 64%. Even if there were elements of a short squeeze that previously contributed to NVDA’s price rise, that wouldn’t explain why the stock hasn’t collapsed to previous levels of support as typically happens after a big squeeze.

So what’s going on? Well here’s what Mike had to say in a recent interview with Grant Williams on his popular Endgame podcast.

Everyone says it’s short covering, but NVIDIA only had 1% of its share sold short! And you sit there and you look at the behavior, and in all honesty look at the intra-day behavior of NVIDIA. It goes up 90 points overnight and then basically says, yeah! That’s the right price… It’s a really extraordinary phenomenon. There’s very little continuation intra-day, there will be some short covering throughout the day but I agree that there is no way that the amount of shorts could cause this type of behavior, but what can cause it are all the dynamics that I’ve talked about.

Passive investing is making markets increasingly inelastic because coming in this morning Vanguard had to buy NVIDIA, alongside the shorts, alongside the dealers who are hedging these short call positions that they’ve entered into. Those who decided to overwrite, for example, are now scrambling to reestablish their position. So all of these things are happening in an environment of extreme inelasticity for individual stocks.

Individual stocks have become increasingly inelastic which is an economic term saying how much does price move for a change in supply and demand. And it turns out that on very small moves in supply and demand we’re seeing unconscionable moves in pricing.

Mike then goes on to explain why markets have become increasingly inelastic.

One of the things about going into passive is that, remember, you’re buying into strategies that are purchasing stocks on a float weighted basis. The problem is, and this is the work of Bouchaud in 2020 and 2021 which extends the work of the inelastic market hypothesis, liquidity in the market doesn’t scale with market cap.

Liquidity in the market scales with market making activities. The profitability of market making activities is determined by the volume and the volatility of the stock. As a market maker you’ll put more capital up and you’ll facilitate more liquidity for a stock that has a ton of volume and that’s not neccessarily going to scale with market capitalization.

So just a really simple example, the largest stock by market cap we all know is Apple - although in other two days it might be NVIDIA at this rate 😅 - so when you look at Apple’s market cap somewhere in the neighborhood of two and a half trillion dollars, its market capitalization is roughly one-hundred times larger than the smallest stock in the S&P 500, but its liquidity is only about five times more.

Every time Vanguard or Blackrock or any passive entity shows up to buy the index on behalf of their investors, that purchase in turn is distorting the market by putting far more demand into Apple or Microsoft, relative to the stock’s liquidity.

To quickly recap, Mike has argued that markets are increasingly inelastic because a stock’s liquidity profile doesn’t scale with its market cap. When a large passive fund like Vanguard or BlackRock buys Apple it can easily push the price higher since there isn’t enough market making activity taking place relative to that equity’s size. So while there is certainly some truth to the AI hype in markets, a good deal of NVDA’s moonshot has more to do with market mechanics than investors embracing a new paradigm.

What could cause a turnaround in price action? As Mike has speculated in other interviews, we might not get a reversal until white collar unemployment ticks up and people stop contributing to their 401ks. If/when that happens there will be fewer passive inflows which will release some of the buying pressure keeping these giant names elevated. Until that day though there could be even more upside to these stocks as they become more and more detached from fundamentals.