Is the Short MSTR – Long BTC Pair Trade Washing Out?

· This article explores whether there is a huge pair trade opportunity to exploit if the too-early funds are washing out in a capitulatory fashion.

· MicroStrategy (NASDAQ: MSTR) has 97% of its assets invested long Bitcoin, yet the stock's market cap is nearly 3x the value of its Bitcoin holdings.

· This skew is being exaggerated powerfully to close the week as shares of MSTR break above their prior all-time highs – a move that smacks of capitulatory short covering for hedge funds in on this bet too early and/or too big.

 

For a little background, on August 11, 2020, MicroStrategy's CEO, Michael Saylor, announced that MSTR had purchased 21,454 bitcoins for $250 million as part of its capital allocation strategy. This marked the beginning of his at-times fanatically outspoken confidence in the long-term prospects of Bitcoin as an investment vehicle, growth asset, and store of value. It was to be the company's primary reserve asset.

As the years have passed, it has become more than that – it's the company's sole source of value for all intents and purposes.

That scenario has created a proxy relationship between Bitcoin and shares of MSTR, nailed into place by Saylor's unwillingness to do anything but double down on BTC during any of its corrections in price. But an interesting thing has happened along the way: Shares of MSTR have vastly outperformed Bitcoins in value, creating a conundrum for investors.

This conundrum has become a hill that some investors have died upon, betting that this unusual divergence must eventually correct. As of today, MicroStrategy's market capitalization is over $43 billion while its Bitcoin holdings are worth just over $15 billion (according to recent data from CoinDesk).

This skew was widened significantly on Friday as MSTR shares rose by nearly 16% while BTC popped just 4.3% higher. More to the point, shares of MSTR are now trading at an all-time high even as BTC trades in a choppy range well below its own highest recorded levels.

This disparity raises questions about the underlying factors driving MicroStrategy's stock beyond the cryptocurrency's performance.

Bitcoin's 4.5% increase today marks a recovery from the past two days of selling pressure. Despite this uptick, the cryptocurrency remains within the trading range it has occupied for the past eight months, falling short of the $50,000 to $70,000 levels that would signify a significant breakout.

In short, MSTR is trading roughly as if Bitcoin was worth over $180,000 right now. In other words, we have a simple premium to justify, and there don't seem to be many options to square this circle. This same idea has occurred to others over recent months.

 

Analyzing the Disconnect

The significant premium of MicroStrategy's market capitalization over its Bitcoin holdings suggests that investors may be assigning additional value to the company's stock beyond its cryptocurrency assets. Several factors could be contributing to this phenomenon:

1. Speculative Buying and Market Sentiment: Investors might be speculating on an imminent breakout in Bitcoin's price, anticipating that MicroStrategy's stock will benefit disproportionately. This speculative enthusiasm could be driving the stock higher in anticipation of future gains.

2. Short Squeeze Dynamics: There is a possibility that short sellers who had bet against MicroStrategy's stock are covering their positions, leading to increased buying pressure. If a significant number of investors were shorting MSTR while being long on Bitcoin, a sudden rise in the stock price could force them to buy back shares to mitigate losses, further propelling the stock upward.

3. Market Positioning and Front-Running: Traders may be front-running a potential breakout in Bitcoin by investing in MicroStrategy's stock, expecting that any substantial increase in Bitcoin's price will have an amplified effect on MSTR due to its Bitcoin holdings.

In assessing these potential explanations, both #1 and #3 are problematic – #1 in that explaining the prior disproportionality in terms of the expectation for a future further disproportionality doesn't explain anything, and #3 in that insofar as we are to assign any sense of rationality to investors, the expectation of a coming breakout in Bitcoin to new all-time is surely something that new BTC holdings stand to benefit from more on a value basis.

While it is certainly the case that some of this premium can be explained by momentum trading and the herding effect of 'irrational exuberance', #2 suggests an important piece of the puzzle.

 

The Squeeze is On

The premium of MSTR shares over BTC has been such an obvious trade that it has no doubt picked up a number of HF's along the way betting on reversion to the mean in the ratio chart shown above.

One such example is Kerrisdale Capital, who publicized a "long BTC, short MSTR" strategy several months ago: "None of the reasons commonly provided for MicroStrategy's relative attractiveness justify paying well over double for the same coin. MicroStrategy's trading history and basic common sense suggests the current inflated premium will contract, much as it has on prior occasions, providing a compelling opportunity for a pair trade."

In other words, it seems like a layup, but much of MSTR's holdings were acquired through debt financings, equity linked convertible notes, and ATM equity offerings, which grants at least some potential leveraging effect. That explanation has been enough for traders and investors to push this premium out on strength in Bitcoin, even though leverage cuts both ways and equity dilution is a major factor for the company – the total Bitcoin holdings on a per share basis has not been growing.

None of those explanations can justify the massive premium in place now. Hence, the idea that this is a layup of a trade. But so was shorting GameStop in February 2021. And we all know how that one worked out for the HF world.

Layups attract overleveraged bets by managers looking to make it big on a single historic winning idea. When these bets come in crowds, they can evolve into blowups. As Keynes famously noted, the market can stay irrational longer than you can stay liquid.

 

Once More Unto the Breach!

In many cases of past blowups, the opportunity ends up paying off for those around to pick up the shrapnel laying around on the hill. If the premium was too big at 2x, then it's a whole lot more 'too big' at 3x, which is near where we are now.

We look at the movement this week in that premium as a possible capitulation among those who thought they had a bar of gold and found out it was a stick of dynamite because they were too early, too leveraged, and/or too much a part of a popular idea among others betting too big.

The blow up we are likely seeing among those players may be an opportunity for those of us who are still dry onlookers. Kerrisdale and the like may not end up booking a profit on this pair trade. But that doesn't mean they weren't right in principle.