Friday Reflection | January 29, 2021
This week brought earnings reports from major companies like Apple and Facebook, an announcement from the Fed about continued low rates and monetary support, and a flurry of executive orders from new President Joe Biden. One story ruled them all: the bizarre and meteoric rise of GameStop stock.
The broad stock market finished the week slightly lower despite the GameStop (also referred to by its ticker symbol GME) short squeeze rally, which also included AMC Entertainment, BlackBerry, Bed Bath & Beyond, and American Airlines. We believe this particular volatility is a short term phenomenon, but it highlights some concerning aspects of the current market landscape.
First, a quick overview of what is going on.
The Short Squeeze Explained
Traditional equity investing is based on the simple premise that you buy a small portion of a business via a share of stock and you get to participate in the future profits and growth of that business. You may receive dividends along the way, and you bear some risk of loss if the business doesn’t succeed as expected. The investment is made because the investor expects the company to do better in the future.
What if, instead, an investor expects a negative outcome for a particular company? Say, a company whose business model is based on selling physical video games in malls while the world moves to streaming. Can the investor do anything other than avoiding buying? They can. They can “short” the stock, which is a bet that it will go down. The investor borrows shares that they sell and then anticipates being able to buy back shares at a lower price later to return to the firm that loaned them. If the stock goes up they lose money, which can potentially exceed the initial investment if the stock keeps rising. Importantly, if a short seller wants to close out their investment they need to buy the stock. The entire concept is the inverse of normal investing.
The current situation is driven by retail investors who saw both an opportunity to profit from a technical trade as well as a way to punish the hedge fund elite by hitting them where it hurts, in their portfolio. And while recent tech disruption and zero commission trading in the finance industry makes widespread participation possible, stock price manipulation is an old story.
In this particular case, a popular Reddit forum known as WallStreetBets was able to encourage many of its members to buy GME stock at the same time. They did this because they knew many large hedge funds had significant short positions, and they knew that if they could push the price higher the hedge funds would be forced to close their short position by buying the stock, which in turn pushes it even higher.1 This is what’s known as a short squeeze. This crowdsourced market manipulation has worked in spectacular fashion, and there was no lack of schadenfreude as the hedge funds scrambled to cope with billions of dollars in losses. None of these new investors really think GameStop is a great long term business, they just saw an opportunity to create short term distortion and turn the tables.
This article by NBC offers a more thorough overview of short selling and the GameStop saga for anyone who hasn’t yet read through the gory details.
Investing vs Trading
We believe the stock market is a powerful way to grow and protect your financial resources over time by investing in high-quality companies. Investing is inherently different than short-term trading. Short-term trades look to take advantage of investor psychology or predict the direction of crowds in order to make a profit. This approach can be exciting and might seem to assuage the fear of missing out, but it is not a reliable way to protect and grow a portfolio. Long term, the fundamental value of innovative and resilient businesses endures and investors in those companies are rewarded.
This long-term approach can seem slow or boring to some in the age of instant gratification and the immediacy of tech and information. And it can be slow – the creation of new value via innovation doesn’t happen overnight. We hew to the parable of the tortoise and the hare, understanding that the racecourse is long, sometimes spanning generations, and includes unexpected twists that require periodic adjustments. A careful approach, whether holding steady or deliberately changing course, allows our client families to not stress about risky bets and short-term gyrations, and instead walk a quieter path to long-term financial security.
1 The average short interest for stocks in the Dow Jones Industrial Average is less than 2%. The average short interest for stocks in the Russell 2000 small-capitalization index is about 6%. Before this trade started a few weeks ago, the short interest in GameStop was approximately 58% of the shares. Barrons.com
About Brian Kozel, CFP®
Brian Kozel works as a partner and lead advisor at North Berkeley Wealth to help his clients feel confident in their financial decisions.
This commentary on this website reflects the personal opinions, viewpoints, and analyses of the North Berkeley Wealth Management (“North Berkeley”) employees providing such comments, and should not be regarded as a description of advisory services provided by North Berkeley or performance returns of any North Berkeley client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. North Berkeley manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.