The broad equity market is off to a quiet start with the S&P 500 off -1% through January. The same cannot be said for a couple of stocks. GameStop and AMC Entertainment were up 1,587% and 514%, respectively. There have been many headlines about these stocks’ gains and the clashes between short sellers on Wall Street and Reddit users on Main Street. So, what’s going on and what does it mean for a portfolio?
To begin, an explanation of short selling is useful. Instead of the traditional path to profit, which entails finding an opportunity, buying low, and selling high (a.k.a. being “long”), short selling reverses the process. Rather than look for an asset that will appreciate, “shorts” seek assets that are perceived to be overvalued and will depreciate. To execute, the stock is borrowed and sold in the market. Assuming the stock depreciates, it is then bought back at a lower price and returned to the lender.
Shorting a stock is a legal way to financially express an opinion on its value. In theory, shorting helps markets. It enables those who feel that a stock is overpriced to try to push its price to fair value. Having this capability is more effective than simply abstaining from purchase. There is, admittedly, an ethical line that can be crossed when pushing a stock to fair value leads to attempts to make it worthless (which would maximize the profit for a short seller).
Shorting is not without risk, though. As a stock’s rise has no upper bound, the losses to a short seller can magnify extensively. What we see is that- when a stock rises- the short sellers unwind their positions by buying the shares back to stop losses. This phenomenon, known as a “short squeeze”, leads to further price increases. Managers know this risk and should not cry foul when markets move against them.
What’s unusual about recent market gyrations is the source of the stocks’ advances. Retail investors trying to coordinate buys via social media have driven a handful of stocks higher. Some retail investors are seeking quick profits while others have expressed a desire to inflict losses on hedge fund managers who are openly short these stocks. (Here, too, an ethical line is being crossed.) Exacerbating the issue is the expanded access to stock and option trading by retail investors homebound by the pandemic.
We’d expect markets, as they always do, to adapt. At risk of being the next target, hedge funds may close out short positions for fear of succumbing to a short squeeze. The involvement of systematic funds which use algorithmic trading to try to profit from trends, may magnify the issue in the short term. Retail investors may continue these coordinated efforts, or they may cease actions at the fear of loss or legal action. In general, though, market participants (large and small) will adjust their behavior to generate profits and avoid losses.
The situation is very fluid:
- Trading platforms are limiting trading activity, increasing margin requirements.
- Members of Congress are calling for investigations into why retail investors are being restricted while hedge funds are not.
- The SEC may act if retail investors appear to be colluding or manipulating markets with false information.
The recent price swings and uptick in trading volume of these few companies have captured much attention. It does not change our advice to clients, however. Our clients are insulated from these moves by being broadly diversified. Targeting empirically-proven sources of higher return is more reliable than attempting to identify the next stocks to benefit or hedge funds to suffer from these recent actions. Having an asset mix that’s appropriate for your specific goals and executing that at a low cost are controllable factors that will lead to investment success.
As Chief Investment Officer, Dan is responsible for developing Trust Company’s investment strategy and managing client portfolios.