Retail takes centre stage

It is a story that is difficult not to take personally, particularly because it tugs at people’s innate sense of justice. It also evokes the biblical tale of “David versus Goliath,” where seemingly amateurish retail traders take on deep pocketed Wall Street hedge funders at their own game. Indeed, the socio-political implications of the recent Reddit saga are plenty.

As it is, Congress has taken notice and we will probably see debates about this later, which may trigger potential regulation ahead. But until then, we would much rather focus on what the rise of Reddit speculators means for long-term investors

The lowdown about the showdown (skip this if you already know)

US-based GameStop is the world's largest video game retailer. Founded in 1984, the company’s prospects have declined since the mid-to-late 2010s in the face of rising e-Commerce challenge. The company’s business outlook was further decimated with the emergence of the Covid-19 pandemic which forced millions of people indoors and away from stores.

Amid the difficult operating environment, GameStop became the focus of short bets on Wall Street. Short interest in the stock was extremely high. At one point, the total value of short positions exceeded 100% of the company’s market capitalisation. At the same time, several famous investors were questioning the wisdom of such shorts, believing it to be overdone. A shuffling of top management in the company supported this view, that in fact such a huge short position in the stock seemed unwarranted in the face of potential radical, positive changes to the company. Ultimately, this started drawing mainstream attention.

Stock punters got ready and through Reddit – an online forum – organised to bid up the price of the stock. Aside from buying the stock outright, retail investors favoured buying far out-of-the-money call options. Market makers or brokers selling these options typically buy the underlying shares to hedge their positions as the price rises. In addition, institutional investors that hold short positions in the shares were also forced to buy the stock as prices climbed to limit their potential losses.

Typically, this would not be a problem. But the onslaught of retail money into plain stock and call options pushed prices even higher, which in turn forced brokers who sold those call options to gobble up even more shares. Investors with huge short positions were also forced to buy the shares to mitigate potential losses on their shorts. A spiral started and the result was a parabolic rise in the price of GameStop, from the low double digits to the mid triple digits. The sentiment was very much that of fundamentals be damned, as momentum took over. At its peak, GameStop stock rose some 1700% year-to-date.

The media sensation surrounding the story caused even more retail money to flow into the trade. Many retail investors ploughed through Reddit forums, in search of other speculative stock ideas with the WallStreetBets stamp of approval. AMC, Nokia, Bed, Bath and Beyond and BlackBerry were among the companies that saw their share prices spiral higher.

History is not kind to speculative trades

Indeed, the stock market frenzy took a life of its own and successfully squeezed out existing short positions on the stock, forcing some hedge funds to recognise losses on the trade.

The question many are asking is how will this end? If history is a guide, not well. After all, this is not the first time that speculative forces caused stock prices to spiral out of control.

Volkswagen and Eastman Kodak were two examples of short squeezes that ended on a bad note. Share prices spiked as institutional players with short positions on these stocks were forced to buy back the shares at prices higher than the point at which they sold, booking losses on their books, but powering a sharp rally in the stock price as a result.

Given that they were forced to buy a stock that they had marked to dip in the coming weeks or months, it was unlikely for these institutional investors to hold on to these stocks indefinitely and sustain the rally. Their exit from the trade caused stock prices to eventually plummet. In fact, we have seen this repeating in the current iteration of the short squeeze mania.

Why the GameStop saga matters

Typically, such speculative mania comes and goes, and are seldom of systemic significance. The GameStop saga however, triggered jitters in the broader market. Much of the concerns had to do with how hedge funds would respond to a short squeeze of seemingly historic proportions.

Hedge funds with huge short positions in these stocks were essentially caught off guard by the deluge of retail money hell bent on squeezing their short positions.

It was certainly possible that hedge funds caught wrong-footed by these unexpected flows would be forced to sell shares of otherwise solid companies elsewhere to cover the losses in short positions that were being targeted by Reddit traders. Indeed, speculative action affecting a few small cap stocks could potentially lead to major losses elsewhere, even if the underlying economic conditions and businesses were robust and healthy. These concerns were among the reasons that led to a near 3% decline of the S&P 500 index last week.

While these concerns are valid, it is likely a long tail risk. As it stands, regulators were alerted to the risks of seemingly abnormal speculative behaviour in certain pockets of the market and the Securities and Exchange Commission (SEC) was prepared to act if the situation deteriorated further to maintain market stability. Reddit traders were seen as the modern-day equivalent of an angry mob holding pitchforks and torches, protesting against the Wall Street elites.

Brokers like Robinhood quickly responded by restricting the purchases of these highly speculative stocks to meet liquidity requirements. Of course, they drew the ire of politicians across both sides of the aisles and progressive billionaires who accused the company of tilting the game in favour of the big guys on Wall Street. Politics aside, their intervention helped to cool the retail investor mania somewhat, even if for a day.

The new normal

Beyond the populist elements of this event, questions beckon as to what could have triggered such a mania. Many reasons have been posited; none particularly robust or persuasive, but all holding some modicum of truth.

Irrational exuberance in certain pockets of the market is often seen as the unintended consequences of the financial repression policies of the US central bank. Interest rates have been slashed to close to zero and the money printing presses have been kept on overdrive to buy financial assets to keep financial markets flushed with liquidity.

As a result, the average citizen is not earning very much in the way of interest paid out in savings accounts, which leads them to hunt for returns elsewhere, often taking on higher risks – some taking on more risks than they can handle. Reports of market benchmarks achieving fresh record highs, almost on a regular basis further stoked risk taking as many may have internalised a deeply erroneous view that they cannot miss with investments, at least not with a central bank acting as a backstop with loose monetary policy.

Some also point to the fact that the income windfalls from stimulus cheques paid out last year had found its way into the markets as social restriction measures constrained what people could necessarily spend on. This is facilitated by almost frictionless trading in the markets, with plenty of brokers offering a plethora of investment products to trade using very intuitive platforms and at very little or even negligible costs. The availability of fresh funds through stimulus cheques, coupled with plenty of time to spare yet constrained at how to spend it due to partial lockdown measures, and frictionless channels which minimised the transaction costs to trade may have triggered massive retail fund flows into the markets as day traders hunt for returns, some of which speculative.

Social media’s role in the GameStop saga is certainly crucial. Reddit was a potent platform that helped galvanise support for a singular objective, much to the surprise of many. Yet, if we think about it, Twitter and Facebook were crucial in organising political protests during the Arab Spring. More recently, social media platforms were instrumental in helping fringe groups organise mass demonstrations and incite the violence seen on Capitol Hill. As such, it should not have come as a surprise that a Reddit forum could effectively band a rather large yet random group of day traders together to stick it to Wall Street.

A more audacious reason provided is the possibility that gamblers have joined the ranks of traders in the market en masse. With casinos closed, financial markets became an alternative outlet to play with chance. How robust this is as a plausible reason is anybody’s guess.

Whatever the cause, one can safely say that market dynamics have changed, likely irreversibly. The GameStop saga was certainly historic and unprecedented in terms of the scale and somewhat systematic organisation of retail participation in this particular trade which was further egged on by social media. Even well-known high-profile short sellers like Carlson Block of Muddy Waters said he had not seen anything like this before and that he did not want to challenge the speculators. It is certainly conceivable that some hedge funds had bought into the surge after all, exacerbating the rally. Indeed, they would be the first to recognise an opportunity when they see one. Still, this episode underscores the new reality that retail traders will be a new force to be reckoned with in this new market environment. After all, the factors spelled out earlier will not reverse any time soon, or ever.

Shoulda, coulda, woulda, but didn’t, so don’t

This beckons yet another question: Should investors join the hype and speculate?

The success of speculative trades is largely contingent on flows and momentum moving prices in your favour. In this case, the role of social media in stoking a herd mentality among speculators and day traders to prop up a stock prevailed, to some degree. Of course, short covering by institutional traders was as much a force in pushing prices higher as was Reddit-related pressure. Social media platforms can help rally the base, but often commitment is fleeting without a mechanism to enforce cooperation. Therefore, it follows that gains are often transient and fully dependent on market timing.

We won’t deny that perfect market timing can be extremely profitable, especially in the eye of the storm. But few can credibly claim to do this well. The risk-reward may not be worthwhile given the rather narrow margin for error. Whether one should do it at all is a matter of risk preference. It all depends on the risks you are willing and can afford to take.

Ultimately, serious, long-term investors must make a distinction between speculation and underlying fundamentals. Our view has always been to invest in assets with good fundamentals at a reasonable price, with a long-term outlook. We would stay away from chasing speculative and dangerous fads and remain focused on sound asset allocation principles and long-term fundamentals in our portfolio management.

Stay cautious but don’t miss the forest for the trees

The recent market frenzy calls for some degree of caution among investors at a time when markets are worried about an equity bubble after a strong rally in the past ten months. Near-term market momentum has been on the high side and it will not be unusual to see some profit-taking triggered by hedge funds who have suffered losses and are de-risking their books, and by investors who take these short squeezes as a sign of frothiness in markets.

However, it is important for investors not to lose sight of the medium-term outlook which remains sanguine against the backdrop of better economic prospects helped in part by vaccines. Fiscal stimulus and a world awash with liquidity helped by ultra-low interest rates, are other factors which should support equity prices.

No doubt, valuations are no longer cheap, but they are not overly expensive given the near zero interest rates, which justifies a further expansion of the price-to-earnings multiples for equity markets. The history behind past stock market rallies tell us that they are often punctuated from time to time by 5-10% corrections as we saw last year. Yet, stocks resumed their rise after the short but healthy breather and closed the year higher.

So, if fundamentals are intact and improving, valuations are not overly excessive, and liquidity is abundant, stock markets will regain their composure and resume their uptrend even if we see a short-term correction.

However, the same cannot be said of some of the esoteric stocks that have surged on the back of the speculative frenzy. For these stocks, reality may bite eventually when traders get exhausted.

For discerning investors who buy prudently based on fundamentals and stay diversified, intermittent pullbacks in the markets can be a good opportunity to accumulate.