Much ink has already been spilled with respect to the concerted “attack” by small, but not necessarily inexperienced, investors on hedge fund short positions (e.g. GameStop shares). Their trades are mostly done on the free Robinhood app and their actions coordinated via social media (notably the Reddit/Wallstreetbets forum). The matter is now in the hands of Congress and, ultimately, the Securities and Exchange Commission. The questions that will need to be addressed are numerous. Was there a deliberate attempt to manipulate the market (which is of course prohibited)? If so, by whom: the Robinhood platform when it decided to block traders from buying GameStop shares, or the social media that served to federate the small traders in the first place? How to ensure that retail investors have a proper assessment of financial market risk – yet not impose upon them excessive barriers to trade that could be seen as further biasing the odds in favour of institutional players? Should short selling be regulated more strictly?
At this point in time, what strikes us most is the attitude of the Reddit Wallstreetbets participants. Some of them made huge amounts of money in the space of a few days but actually seemed little recognizant or even interested about that. It is almost as though, to them, the stock market is but another video game, part of a virtual reality.
We also find the impact on popular and widespread ETFs worrisome. In going against the shorters, “Robinhooders” are massively buying shares of companies with poor fundamentals (GameStop being a case in point), pushing their share prices through the roof. By their very nature, being mutual funds designed to track stock indices, ETFs are then forced to also buy, driving prices even further away from underlying value. “Bad” companies thus take on an increasing weight in the portfolios of (prudent) ETFs, which ultimately threatens to cause a painful correction.
Source : Bloomberg
And then there is the attitude of the majority of analysts, another matter of concern to us. Confronted with extreme valuations, particularly in the information technology and green energy sectors, they are feverishly looking for ways to justify them and still be able to generate “buy” recommendations. Traditional metrics are being set aside and “new insights” touted, just as was the case during the 1999 dotcom hype, when heavily loss-making internet companies – that for the most part no longer exist today – were valued according to their number of employees.
But then, that is what typically occurs during the final stages of a bull move. Just as it is quite usual to see retail investors come flocking to the market when the top is nigh. They are, as it were, the buyers of last resort.
The problem, as we have often mentioned, is that this last phase of the rally can be exponential – thus very costly to miss. All the more so in a world where fixed income alternatives yield zero, if not negative, interest. And, of course, there is simply not way of knowing how and when the bubble will burst.
As such, we strive to maintain well-balanced portfolios, avoiding large directional (read: technology sector) bets and carefully monitoring the overall risk level. Focussing on company fundamentals, and by that we essentially mean the ability to generate profits that can (but do not have to) be returned, in the form of dividends, to shareholders. For that is where the true value of a firm lies. All the rest, including what the greater fool might be willing to pay, is only fiction.
We firmly believe that, sooner or later, stock prices will reconnect with the fundamental reality, at which point much money unfortunately stands to be lost by uninformed or inexperienced investors. Perhaps ironically, it will be the market’s way of flushing out all the liquidity created during the past few years by the central banks. Those who know their history books must realise that this time can be no different.
The Mechanics Of Short Selling
Amongst the best-known hedge fund categories, and one that has been the subject of much media coverage recently, is the long-short strategy. Put simply, this seeks to enhance the returns generated by traditional long positions, by making negative bets on stocks that are perceived to be overvalued.
Speculating on the downside is a high return but also high-risk business, to be undertaken only by experienced traders. It involves first borrowing the shares that are expected to drop in value, then selling these borrowed shares in the market with a view to repurchasing them later at a lower price. Given that the theoretical loss is unlimited (there is no upside limit to the price of an asset), short trading requires holding a margin account with a broker-dealer, the minimum level of which is determined by financial regulators. If the price of the stock sold short does not move in the expected direction, meaning that it does not fall, the short seller will face margin calls and have to replenish the margin account.
A “short squeeze” occurs when short sellers, unable or unwilling to meeting their margin calls, are forced to cover their positions by buying back their short positions. For heavily shorted stocks (such as GameStop was), this can set into motion a upside feedback loop, whereby the rise in price attracts more buyers, forcing other short sellers to also cover their positions, and further amplifying the rally – quite independently of fundamental considerations.