Short seller Carson Block says rolling bubbles that keep popping up show fragility of stock market

Published Tue, Feb 2 20213:42 PM EST

Longtime short seller Carson Block said Tuesday that recent frenzied trading and wild spikes in a handful of stocks show just how fragile the stock market is. Block, who sat for a special edition CNBC Pro Talks with CNBC's Mike Santoli, warned that structural changes to the way investors allocate their money is making the broader equity market more brittle. "We're in something of a bubble right now, but it's hard to say. It's not like the tech bubble, it's not like the housing bubble where you can say, 'OK, over here, this class of assets: This is a bubble,'" Block said. "It's more like water's boiling and you get these really fast bubbles being blown and bursting," he added. Block, founder of Muddy Waters Research, joined CNBC Pro on Tuesday in the wake of wild speculative trading that saw a coordinated group of retail investors force massive short squeezes in a handful of stocks like GameStop and AMC Entertainment. Many analysts last week warned that GameStop, a struggling brick-and-mortar video game retailer, has very little fundamental value and argued that its 399.9% rally last week was entirely divorced from economic reality. Last week's mania appears to have been short-lived , with GameStop down 68% so far this week. AMC has lost 43% of its value over the same period. Many were quick to blame the wild trading on over-extended short sellers, a group of investors that borrow shares of a stock at a certain price in hopes that the market value will fall below that level when it's time to pay for the borrowed shares. If a stock sold short rises instead of falls, the short seller may try to buy to cover their position before suffering further losses. But if many other short sellers are in the same position, and also move to cover, their collaborative purchases can actually drive the stock price higher and add to their losses. For his part, Block said last week's financial fireworks speak to a growing disconnect between equity prices and business fundamentals like profits and sales. He argued that it's now far tougher to be a short seller since the extensive research his firm conducts takes longer to matter to passive investors. "It sucks, in many respects, that fundamentals take longer to matter. But I think, ultimately, fundamentals do matter," he said. "We've adapted before, we've been doing this a long time, and I've had to make a number of adaptations in the past. We'll continue to make adaptations and hope for some more sanity," Block added. "If there are bubbles, after people get burned, risk aversion will be back in again." Block has made a name for himself and his firm by selling short stock of companies that make exaggerated claims about the success of their business. Perhaps the most-recent, high-profile of Block's research came in January 2020, when the manager called out Luckin Coffee as a "fundamentally broken business" rife with fraud. China-based Luckin, which had seen its stock soar in 2019 as its business was touted as a new Starbucks rival, ultimately concluded that its management had fabricated a significant portion of its sales. The equity lost virtually all of its value across 2020 and the Nasdaq later delisted the stock. Block said he instead blames the advent of passive management for the apparent disconnect between stock-market prices and business fundamentals. Passive managers, tasked with mirroring an index and keeping fees low, are usually agnostic about the price they pay for a particular security or the underlying business's fundamentals so long as the fund perfectly tracks the performance of its benchmark. Critics argue that this nonchalance toward both price and fundamentals is risky and can lead to inflated valuations in certain stocks based solely on a security's membership in a particular index, like the S & P 500. Additionally, the short seller said that the popularity of low-cost passive management has shrunk the number of potential buyers should a massive manager like BlackRock or Vanguard need to sell part a position to meet redemptions. "Passive is effectively making floats much smaller. Because, as long as you're getting passive inflows, passive has to buy," Block said. But "when you have outflows from passive -- and passive runs almost entirely invested, very little cash -- it needs to sell in order to meet redemptions." "So there could be this wall of selling. And this is what I think happened in March of last year," he added. "Passive is making markets more squeeze-y, divorced from fundamentals and makes the markets a lot more fragile.

Longtime short seller Carson Block said Tuesday that recent frenzied trading and wild spikes in a handful of stocks show just how fragile the stock market is.

Block, who sat for a special edition CNBC Pro Talks with CNBC's Mike Santoli, warned that structural changes to the way investors allocate their money is making the broader equity market more brittle.

"We're in something of a bubble right now, but it's hard to say. It's not like the tech bubble, it's not like the housing bubble where you can say, 'OK, over here, this class of assets: This is a bubble,'" Block said.