- The collective actions of millions of individual investors to bid-up the highly-shorted shares of generally underperforming companies have been viewed by some as an act of rebellion against financial authority in the form of wealthy hedge fund operators and their investors.
- The rapid trading of speculative shares that achieve unsustainable valuations has happened before. Such periods have not ended well for small investors. In equities markets, the period from 1999-2000 is an analogue. Then, many “dot.com” concept firms attracted mass investor appeal in the absence of viable business models. Many of them fell to zero, leaving small investors with billions of dollars in losses.
- Presently, the 100 most shorted shares in the US equity market represent just 0.7% of its total value. In Citi analysts’ view, the dangers of “naked shorting” - multiplied by the power of options and the power of the internet as an organizing mechanism – could become apparent in the days and weeks ahead. In the meantime, as stressed investors close their positions, it may not be surprising if there are ripple effects that drive prices of quality, liquid investments down, distorting broader markets for a short time.
Hedge Fund losses are real, so is the need for capital
- While it is not possible to calculate the exact amount of losses over the week of 25 January, headlines indicate that short positions of just one company, GameStop, may have cost investors more than US$10 bln (Market Insider, 29 January 2021). Sophisticated hedge funds were among those who realized substantial losses exiting short trades.
- There were many other unusual events this past week. Robinhood, the trading company whose investing platform enabled many of the trades recommended on Reddit, was required to raise US$1bln overnight from its investors and also tapped credit lines of US$500 mln.
- Robinhood placed trading restrictions on the shares of 50 companies on Friday 29 January 2021. It did so to meet the capital requirements associated with Wall Street’s stock settlement and custody rules. Many other Wall Street firms also restricted trading in certain shares during the week. In addition, there were service outages at several online brokerage firms whose sites became slow or inactive. There were also required exchange mandates to halt the trading of certain company stocks given their unusual intra-day volatility.
- When such events happen at the same time, it indicates that markets are operating inefficiently and that checks and balances built in to protect normal market function have been triggered.
Factors that have led to these events:
- The first is the “democratization” of investing. The simplicity of accessing “Wall Street” has never been greater. New “technology” firms have simplified everything from account opening, to account funding, to the completion of forms required to allow options trading. This has driven a massive increase in the number of investor accounts.
- Second is the plunge in the cost of trading. Retail trading commissions – away from bid-offer spreads – were commonly US$40 per trade when “online discount brokers” came into existence 30 years ago. The decision by many firms to drop commissions to zero has made trading appear frictionless. Of course, these firms do not trade for free. They sell their trades in bulk to third parties who, in return, pay them for “flow”. So, there are hidden charges that cost investors money.
- A third factor is time and capital. COVID-19 has caused people to stay home and screen time is way up. There are many new, small investors with liquidity at hand due to less spending and an increase in subsidized income during the pandemic. Finally, there is leverage due to the increased use of options to express investor positions that greatly exceed their true trading capital.
- The fourth factor is social media and personal examples of “easy” profits. On some websites and media sites, stories of fast wealth are rampant with self-identified experts providing advice on buys and sells, without regulatory oversight. These sites also contain narratives about people who have lost all of their savings trading in these markets. They are regarded as heroes in the campaign against Wall Street. The traditional media has played into this hype, which draws ever more interest into the “opportunity.”
- The final factor is our times. Populism has been on the rise for more than a decade now. For many in the US, it is framed as a struggle of the working class against Big Business or Wall Street; a struggle between “the people” and the political establishment regardless of who’s running it. What is ironic about seeing the recent trading “against short sellers” as a populist act is that in the end, many of those who see themselves as the heroes are likely to end up taking major economic losses. Regulations are also unlikely to be eased as a result, but strengthened to maintain to protect the broader public.
Implications for portfolios
- Looking at all of these factors, Citi analysts think the current episode is likely to end as a temporary mania. While there is undoubtedly real damage to certain funds who held short positions in these securities, when professional investors step away and close positions, many of the small investors are likely to be trading against themselves. This is the classic outcome of pure momentum trading. When fundamentals become unimportant, retail investors may be exposed to extraordinary movements in prices, ultimately to the downside. There are likely to be many stories of retail investors selling as their losses mount at the end of this saga.
- On a longer-term basis, there is the fundamental question of valuations to consider. Manias are not good for Wall Street generally and can hurt investor confidence. Initially, when professional traders like hedge funds are hurt in one part of the market, they are often forced to sell their profitable positions to generate liquidity. On a longer-term basis, periods like this may cause investors to question valuations more closely.
- This current episode comes at a time when several sentiment indicators have suggested growing levels of market complacency, including a spike in call option volumes relative to puts, falling intra-market correlations, and a drop in overall short interest. After the significant rally in both growth and value equities since November 2020, some market consolidation remains likely in the short-run. This episode is likely to make this period of consolidation more volatile.
- Ultimately, fundamentals drive markets. In Citi’s view, corporate cash flow and earnings, the ability to execute strategy, build and sustain market share, and to do both in an ethical way are likely to be the determinate of value and wealth creation over time.