For long-term investors, the most important takeaway is that volatility seems to be a feature, not a bug, of today’s investment environment.
2021 has been nothing short of eventful, and last week was no exception. Investors were focused on the saga of GameStop, r/wallstreetbets, Robinhood and the hedge funds that “shorted” the stock, which caused significant volatility in equity markets globally. Although the story is still unfolding and there’s still a lot that we don’t know, we are able to draw some conclusions on what it means for your investments.
But before we go there, let’s briefly take a look at how shorting works.
So imagine you have a friend who deals in collectible coins. After studying the coin market, you have a view that certain coins are going to go down in value. So how can you profit from this view? First, you borrow a few of the coins from your friend, promising to give them back later, for a small fee. Next, you sell the coins for their current market value…say, $100 per coin. Over the next six months, the value of the coins falls by 50%—you were right! Now, you buy back the coins for $50 each, return them to your friend, and pocket the $50 profit you made (minus whatever fee you paid to borrow the coins). So that’s pretty much it.
Now, for GameStop.
If you hadn’t heard of GameStop before, we wouldn’t blame you. GameStop sells video games in shopping malls throughout America. At face value, it is a brick-and-mortar retail business in secular decline, so it was an easy “short” for hedge funds. They borrowed shares in the company and sold them in the hope they could buy them back on the cheap if they lost value.
But some Reddit-ers thought GameStop might actually turn their prospects around. They started to buy shares, and as the share price started to rise, others realized they might be able to force the short-seller hedge funds to buy back their shares and cause a “short squeeze,” which can cause parabolic increases in stock prices.
The increase in price for heavily shorted names can be self-reinforcing for a few reasons. It gets complicated quickly, but the basics are that as the price of the shorted security starts to rise, the entities that have “shorted” the shares start losing money. The potential loss on a short position can be infinite, so it can get very risky very quickly. Short sellers need to buy the stock back to close their positions, which forces the price higher.
Further, when bullish investors buy call options on the stock to implement a positive view, the entity that sold them the option also needs to buy the stock so that it neutralizes its own risk (the options dealer is effectively “short” the stock when it sells the call option). That’s a lot of buying! The schematic below helps understand how this works in practice.
The graphic shows the cycle of options trading, short squeezes and hedge fund positioning. It’s described as: 1. r/wallstreetbets identifies a stock and buys call options. 2. Options dealers buy the underlying stock to neutralize their exposures (delta). 3. The stock starts to rise, and short sellers have to start posting collateral or buying back shares. 4. Options dealers buy even more underlying to keep their exposures neutralized. 5. The stock rockets higher, forcing more short covering. Meanwhile: 1. As shorts get squeezed, hedge funds need to liquidate long positions to access funds and/or de-risk. 2. Momentum stocks and hedge fund favorites sell off. 3. Momentum indicators turn negative, and trend-following traders sell. 4. Long/short hedge funds replace single-name shorts with broad market hedges. 5. Broad market implied volatility rises.
In a vacuum, there is nothing concerning or uncommon about a short squeeze. They don’t happen all the time, but they definitely happen more frequently than a cicada hatch. The beginning of Tesla’s torrid rise last year was described as a short squeeze. The Volkswagen episode during the Global Financial Crisis is another example. What is different this time is that the short squeeze hit many different names at once. Blackberry, American Airlines, AMC Theatres and Nokia are some examples.
What we are watching closely is the impact the short squeeze is having on the broader market. In order to access liquidity and take down risk, a number of hedge funds needed to sell out of stocks they actually owned. As a result, the S&P 500 lost -3.3% last week, alongside losses in the Stoxx Europe 600 (-3.1%), CSI 300 (-3.9%), and Hang Seng (-4.0%) (though Asian shares were also notably hit by an unexpected liquidity drain from China’s central bank that sent the overnight interbank rate to a six-year high, and a comment made by a senior policy advisor on concerns over an asset price bubble). Further, implied volatility in both single names and the broad market spiked. At its peak, the VIX (which indicates the implied volatility of the S&P 500) jumped nearly 70% higher than where it was the prior Friday. The short squeeze went viral.
To be clear, there is still a lot we don’t know:
- We don’t know where GameStop stock will settle eventually, but wherever it does, either the short squeezers or the squeezed will have some pretty serious losses to reckon with.
- We don’t know how solid Robinhood’s balance sheet really is. It reportedly drew on at least some of its credit lines last week, and raised more capital from investors. It also added further restrictions on trading a number of names.
- We don’t know how much more hedge fund selling could come if they feel they need to take down risk further.
- We don’t know if, how or when regulators may start to restrict this kind of market activity.
- Most importantly, we don’t know how lasting the influence of the individual investor will be.
While the story is still unfolding, we are relying on what we have more confidence in:
- So far, we haven’t found a link between this episode and something that is systemically important to the equity market or the economy. There could be more volatility as we work through the aftershocks. Indeed, after a +1% gain on Thursday, the S&P 500 was back down ~2% on Friday.
- The key forces we identified in our 2021 Outlook are still progressing largely as we expected. Despite early challenges, vaccine programs are showing promise. Policymakers continue to deliver abundant support. Inflation is stable. And the broad-based earnings recovery we expect throughout this year seems on track based on results from earnings season so far.
Day trading and stock market volatility are nothing new, but what is captivating about the current episode is that the characters are so compelling and the perceived archetypes so well known. It’s easy to imagine r/wallstreetbets as the unpolished underdogs, the hedge funds as the pretentious incumbents, Robinhood as the conflicted sidekick, and GameStop as the unpopular kid who gets a makeover before the big dance.
For long-term investors, the most important takeaway is that volatility seems to be a feature (not a bug) of today’s investment environment. That’s why we continue to emphasize the importance of bolstering portfolios with allocations to assets with a lower correlation to equities, and portfolio managers that focus on high-quality companies with competitive edges. We also see compelling opportunities for investors to use volatility to their advantage by buying equities on dips or pursuing strategies that generate income by selling that volatility.
The GameStop story isn’t over yet, but market history is rife with examples of esoteric volatility spikes and the demise of notable investment funds. Based on what we currently know, we think this episode will be added to the list. For now, our optimistic outlook for the year ahead hasn’t changed. We continue to encourage investors to focus on the forest, not the trees.
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