January Markets for Stock Prices January 2021 month-end stock market figures showed little change, even though there was considerable volatility within the month. The big new news for the financial media was the action in a few small stocks that made huge gains, most likely because they were part of a so-called “short squeeze” by relatively new traders in the financial markets. There has been widespread publicity on this matter, with some observers thinking that a new financial model is at hand, while others consider it not likely to be a lasting event. We present some of the initial views on the subject.
- First and foremost, much of the activity was done by traders looking to profit from short-term price movements. This is much more like gambling than the kind of long-term investing done on your behalf by PPA.
- That said, we would explain events as follows: (A) a group of traders, communicating on social media and able to trade stocks at no cost at various online brokerage sites, identified a few stocks that had very large short positions held primarily by hedge funds; (B) short positions involve selling stock you borrow, typically from a brokerage firm, in the hope that once it declines in price, you can buy it back at the lower price, pay off the loan, and pocket the profits; (C) even if that doesn’t happen, when the position has to be covered, the short sellers must buy the stock, which creates upward pressure on the stock price; (D) since short sellers profit when the stock price goes down, and in this case they were being forced to buy stock to cover their short positions at higher and higher prices, the hedge funds suffered major losses and some were forced to close down; (E) a few firms that the short sellers used to maintain their positions had to raise new money to cover some of the short seller activity; and (F) in the meantime, many of the early buyers of the stock were being paid higher and higher prices to provide the stock that had to be delivered to the short sellers.
- While some in the financial media opined that this kind of trading, urged on by social media and expedited by free stock trading sites, would have a lasting impact on the financial markets, others were not so sure. Some sample thinking follows:
Kevin Roose (NY Times, 1/29/21, page B1) wrote: “This week, the biggest story in the financial markets is the absurdist, pretty-sure-I-hallucinated drama involving GameStop, a struggling video game retailer that became the rope in a high stakes tug-of-war between Wall Street suits and a crusading internet mob. The simplest explanation of what happened is that a bunch of hyper-online-mischief makers in Redditt’s r/Wall Street-Bets forum… decided it would be funny and righteous (and maybe even profitable, though that part was less important) to execute a “short squeeze” by pushing up the price of GameStop’s stock, entrapping the big money hedge funds that bet against it. The strategy worked… And even if GameStop stock crashes or regulators step in and call off the party, these disillusioned day traders will keep trying to create chaos for the elites they feel have spent decades profiting at their expense. The rebels may not win in the long run. Institutional power has a way of reasserting itself after sudden shocks… But for the Redditt day traders, the important victory was always the symbolic one. They might lose their shirts, but they have sent the message that with enough passion and rocket ship emojis, a crowd of profane, irreverent degenerates – their words, not mine – can turn the stock market on its head. The hordes are here, and Wall Street will never be the same.”
A front-page NY Times article (1/28/21, page A1) said that “no one knows how this will end…Some analysts say the intense activity could eventually prompt a wider sell-off in the market by forcing hedge funds on the losing side of these trades to sell parts of their portfolios to raise cash to cover their losses.” The article has the following quote from a Wall Street professional: “What happens in situations of stress is that people are forced to raise funds and that often means selling your winners…. How does it end? Badly. Eventually the bigger the balloon, the louder the pop…When does it end? I don’t know.”
Jason Zweig (WSJ, 1/30/21) wrote the following: “For all the hyperventilating over this week’s financial revolution, investors should regard it as the latest phase in a long evolution – and not likely to disrupt the markets overall.… Now, however, amateur traders are asserting their advantages. They can communicate instantaneously, band together by the thousands – millions, perhaps – and buy or sell commission free. Thousands of members of WallStreetBets, a forum at the online community reddit.com, have been leading the swarm of amateur individual traders buying stocks that hedge funds and other institutional investors were betting against.” (PPA note: Zweig refers to the newcomers as traders and the hedge fund short sellers as investors. We think of them all as traders, even though the hedge funds might have a somewhat longer time frame for holding their positions). Zweig discussed the small market value of the stocks being traded compared to the overall value of the US stock market (at $42 trillion), and also the fact that volatility in the broad stock market is only “up a bit” in 2021 so far. He concludes that “taken together, these indicators suggest the flash mobs have not had significant impacts outside the two to three dozen stocks they love to trade the most…This latest upheaval is likely to have a bigger impact on investor attention than their portfolios.”
In the midst of the extreme price gains in GameStop stock, Jeff Sommer wrote in the NY Times (1/31/21, page BU8): “The stock’s gains had nothing to do with its merits. The company is losing money, as you might expect when you look at its business model (i.e., selling physical copies of computer games at retail malls)…While there is a David versus Goliath element to the GameStop stock saga, it is likely to be a cautionary tale…Tempting as it may be to join in the fun, at moments like these most long-term investors are usually better off if they stay sober and avoid the urge to make quick profits. A better option would be salting away money in dull, well-diversified stock and bond portfolios, these days preferably in low-cost index funds.”
In the same spirit, Neil Irwin wrote in the NY Times (2/5/21, page B3): “Many of the traders driving the recent GameStop mania want to strike it rich and bring down what they view as a corrupt, rigged system along the way…. But the reality is that the stock market has offered a path for ordinary people to build wealth – and more so in the last generation than ever before. All you had to do is take the laziest, simplest approach to stock investing imaginable, and have a little patience. Ever since the Vanguard S&P 500 index fund was introduced 45 years ago, ordinary investors have been able to invest in broad stock indexes in a tax efficient manner with extremely low fees… owning a small share of the earnings of hundreds of leading companies.” The article then reviews some annualized returns based on when money was invested and concludes that “There are no guarantees in life. Index funds will not generate the kind of overnight payoffs that buyers of GameStop options are evidently looking for. And the decades ahead may offer lower returns to stock investors than the decades just past. But the payoffs of being a passive stock market investor are not something to overlook.”
The Economist magazine (2/6/21, page 9), taking a much broader view of potential changes, observed that “[t]echnology is being used to make trading free, shift information flows and catalyze new business models, transforming how markets work…. While the whiff of mania is alarming, you can find reasons to support today’s (broad stock market) prices. When interest rates are so low, other assets look relatively attractive… Yet the excitement also reflects a fundamental shift in finance…. Far from being a passing fad, the disruption of markets will intensify.”
And finally, providing balance to this early discussion, Andrew Ross Sorkin wrote (NYT, 2/3/21, page B1): “There will be academic case studies on the mania around GameStop’s stock. There will be philosophical debates about whether this was a genuine protest against hedge funds and inequality, or a pump-and-dump scheme masquerading as a moral crusade. Eventually we will learn whether this was a transformational moment powered by social media that will shift the investing landscape forever, or a blip that soon fades away.” The remainder of the article discusses the public’s “deep distrust” of the stock market, and ways to overcome this feeling.
We join Mr. Sorkin in acknowledging we do not know how this will all play out over time. But we certainly hope that this kind of trading activity goes away quickly, and that those who participate become investors for the long-term, leaving the gambling to other activities (e.g., sports events).
January Markets for Bond Prices also showed little change, even with a rise in interest rates from 0.93% to 1.11% on the ten-year benchmark US Treasury rate. As recently as June-July 2020, the rate was approximately 50 bp lower than at the end of January 2021. Also noteworthy is that the year-end 2019 rate was about one full percent higher than that of year-end 2020. All these rates are obviously still very low, and do not provide enough interest income for most long-term investors, which in turn forces them to look for other sources of investment return to meet their goals.
In discussing the recent rise in interest rates, the financial media point to a variety of factors: (A) the growing likelihood of another substantial COVID financial relief package from Congress, designed to stimulate the economy; and (B) the financial market’s anticipation of an improving economy, based on the increasing number of people receiving the vaccination against the virus. Even if these factors prove correct in improving the economy, the Federal Reserve has indicated its desire to keep rates low, focusing on improving the employment situation and not being overly concerned about rising budget deficits. The real fear of bond investors is that an economy that grows too strongly has the potential of bringing about a re-emergence of harmful inflation, which makes the value/purchasing power of money received some number of years in the future lower than anticipated. Typically, when an economy has slack, as the US economy does now, growth can occur with inflation remaining subdued.
As with all forward-looking concepts, the outcome of the interplay among the benefits of the vaccine, a stronger economy, a rising budget deficit, Fed interest rate policy, and possible inflation is unknown. Even if we knew the outcome, we are also aware that financial markets act in strangely contrarian ways at certain times (e.g., extensive stock price gains while the Coronavirus continues strong). As always, we suggest maintaining your previously established asset allocations, without trying to guess which assets will outperform others in a given time frame.