And we're off to a wild start...

And we're off to a wild start...

Well 2021 is off to a wild start. It’s likely you’ve been hearing all about the GameStop action over the past week or so. We will summarize what has been happening in a moment, but first let’s briefly look at what happened to the rest of the market in the month of January.

The broad market
The pandemic still has the world in its grip with lock downs, travel and overall business restrictions. In spite of this and the political and domestic turmoil that surrounded the inauguration, global stocks moved higher with the US stock market reaching new highs on January 25th. During this same time, in response to the growing optimism, interest rates also moved higher with the 10-year T-Bill rising.

For the broad market the rally continues. Stock prices on a historic basis are at sky-high values (forward-looking earnings per share are up over 22 - historic numbers are typically in the 16 range). In general, investors are optimistic that with a vaccine there was light at the end of the tunnel and the global economy would grow significantly during 2021. The expectation is the global economy will grow significantly, but it seems some of this momentum is a result of what is called “TINA”, short for “there is no other alternative.” We have learned over the years that you just can’t time the markets. Therefore investing with a long-term perspective is often key.

GameStop and the Short Squeeze
On January 26th the “established” investor market paused as it gazed at some very unusual activity in a few smaller normally under-performing stocks. Prices of these stocks were skyrocketing led by GameStop Corp (GME). For the next three days the broad stock market, including foreign stocks, moved lower as it appeared the “system” was under attack. A normal “short squeeze”, a game generally played by institutional investors, was being orchestrated by the masses– something that had never happened before. A Reddit (social forum) group of small investors, WallStreetBets with 2 million subscribers, started buying shares of GameStop because large hedge funds were betting its price would fall by taking what we call “short positions” - betting against the company, hoping to make a quick buck.

Short sales are bearish bets in which an investor borrows shares and quickly sells them, with the intention of buying shares later at lower prices to repay the loan, pocketing the difference. But if the share prices rise instead, it could result in a short squeeze where these bearish investors are compelled to buy back shares they had sold short to cut their losses, pushing stock prices even higher.

As prices started to rise the shorts were getting squeezed (having to buy at higher prices and losing money). Many of the hedge funds began retreating by buying the stock to avoid an even greater loss and to cover their large short positions, which in turn buying the stock lead to even higher stock prices. The most notorious of these, Melvin Capital Management, is believed to have lost a whopping 53% in January, requiring a capital infusion from its partners of close to $3 billion.

During the month WallStreetBets has targeted about 10 stocks with similar, albeit much smaller, results. What alarmed established investors were some of the posts to the site that were perceived to be more interested in taking down the hedge funds than in making a wise investment. It's likely that for many of these investors this short-term gamble will end poorly, once a short squeeze comes to an end the stock price generally comes crashing back down to earth. After all, the increase in stock price during a short squeeze has absolutely nothing to do with the long-term fundamentals of a company. GameStop Corp closed its fiscal year on Sunday and is expected to show a second straight year of double-digit revenue declines. In all likelihood, after trading in the $300-$400 range last week, GameStop stock is likely to come back down below $20 (where it spent all of 2020) per share when this current frenzy over.

What impact will this have on future investing? Well the real question is whether or not this is a one off scenario, or will social media groups continue to challenge the system and start playing a larger role in market movement. Short-term perhaps. Long-term we’re not convinced, but it is certainly reason to pause. And remember the markets are heavily impacted short-term by investor behavior and emotion (read more - Are you your own worst investment enemy?).

So, while social media is likely here to stay and online trading apps will continue to provide retail investors easy access to investing in the stock market (as they should), it’s very likely that going forward hedge funds will think twice before publicly broadcasting their short picks.

In an effort for increased transparency, the Dodd-Frank Act in 2010 required the SEC to inquire into short sale reporting.¹ The SEC has since at times required investment managers, under certain circumstances, to disclose and report their short sales and positions. Regulatory authorities such as FINRA also require member investment firms to report their short positions.² The aggregate can most often be found as the short-interest information provided on any stock quote page.

One thing’s for sure, the GameStop mania certainly brought the short squeeze into the spotlight.

 
 
InvestingJuliette Cooke, CFP®, CKA®