Positive fundamentals, a short squeeze, and day traders contribute to huge moves in the electric-vehicle maker’s share price.
Depending on whom you ask, electric-vehicle maker Tesla Inc. is either a Ponzi scheme or the manufacturer of the future. These clashing views came to a head last week as Tesla’s market capitalization — the total value of the company’s shares — went from $100 billion in January to a peak of $175 billion on February 4, only to fall back down to $126 billion the next day.
The volatile surge in Tesla’s stock has left investors scratching their heads. Is this irrational exuberance, a visionary company proving itself, or something else? The possibilities are numerous.
Fundamentals
Tesla reported strong earnings in January, beating expectations and meeting CEO Elon Musk’s goal of selling more than 360,000 vehicles, largely thanks to its new factory in Shanghai.
The market’s response to Tesla’s earnings report reflects the extent to which Musk’s company is a binary bet: Either it succeeds beyond our wildest expectations, or it fails spectacularly. The first-order meaning of these earnings — that the company performed well last year — is less important than the second-order meaning: that Tesla is much less likely to fail outright. A decent increase in revenue and production, which might normally push shares up 10 percent, is amplified by the reduced likelihood that the stock will go to zero.
Short squeeze
A group of high-profile hedge-fund managers — most notably David Einhorn and Jim Chanos — have conspicuously bet against Tesla stock. After two positive earnings reports, some Tesla bears have had to exit their positions as losses were piling up. Steve Eisman (of The Big Short fame) covered his short position this week, saying in a Bloomberg interview: “When a stock becomes unmoored from valuation …you just have to walk away.”
Tesla has among the highest “short interest” (the portion of outstanding shares borrowed to sell short) of any large public company. But as an IHS Markit report points out, short interest in Tesla has declined much less than one would expect in recent months. Many investors bullish on Tesla hold bonds that are convertible to equity, and when the stock performs well, they hedge their convertible positions by selling the stock short. This dampens the effect of “short squeezes,” whereby short sellers are forced out of their positions. As Bloomberg’s Matt Levine explains:
Convertible arbitrageurs tend to sell stock short to hedge their long convertible positions, and when the stock goes up they tend to sell more stock. So even as outright short sellers are getting squeezed, their short positions are being replaced by convertible arbitrageurs who are shorting more stock.
Still, Tesla’s short interest fell 22 percent from the end of November to the end of January, the last time short interest was reported. And it has likely declined even more this week, further driving the rally.
Retail investors
As CNBC reported, “More than 22,000 investors bought Tesla’s stock for the first time on millennial-favored Silicon Valley stock trading app” between February 3 and February 5. Presumably, other day traders who were holding the stock increased their positions. Critics of Tesla point to the cult-like following of retail investors to explain the recent rally. Online forums such as Reddit’s Wall Street Bets board provide anecdotal evidence that large numbers of inexperienced investors have piled into the stock, as do search-engine autofill results. While it’s hard to calculate the impact of day traders, their newfound interest in the stock is likely a partial driver of Tesla’s performance.
Reflexivity
George Soros famously explained that financial markets tend to be driven by “reflexivity,” wherein a security’s performance drives a feedback loop that further influences its price. As investors buy into a given stock, high expectations can alter the underlying fundamentals, driving the stock higher. In the case of Tesla, reflexivity has played out in two ways.
First, as investors buy call options, which allow but do not obligate investors to buy equity at a given price, in Tesla, brokers selling those options effectively have a short position on the stock. They will lose money if the share price increases. To offset this exposure, those brokers buy the stock — so the option demand increases the stock price as does the demand for equity by brokers looking to hedge.
As Bloomberg’s Luke Kawa reported Tuesday:
When a trader buys a call, the dealer who sells it will typically buy a certain amount of stock in the underlying to offset their exposure. If the shares continue to rise, dynamically managing that hedge can entail increasing purchases.
This reflexive dynamic — in which long positions beget more long positions — also plays out in analyst expectations of the stock. As Wall Street analysts upgrade Tesla’s price target, investors buy more of the stock. As seen in the chart below, the stock price has moved more or less in lockstep with analysts’ increased targets (via KoyFin):
The wild fluctuations in Tesla’s share price have stunned market observers. The fundamental explanation is likely the most relevant factor behind the recent moves, though it can’t explain everything. Tesla’s share price is as volatile as its future is uncertain. While the company remains risky, the cumulative effect of two profitable quarters and a string of positive headlines is a decrease in the risk that Tesla will fail. By all indications, the company is here to stay. Markets are reacting accordingly.