The retail trading phenomenon driving up shares of GameStop, AMC and a few other stocks has become one of the biggest investment stories in recent memory, in large part because a battle between Wall Street hedge funds and Main Street investors makes for a compelling story. But when the momentum fizzles out, we believe there are both ramifications and lessons to learn from the event.
In an interview Friday, Dana portfolio managers Michael Honkamp and David Weinstein shared their perspectives on some of the things the financial community should take away from what’s happened.
Q: Beyond the Reddit posts, what are the forces feeding this phenomenon?
Michael Honkamp: Current market conditions are ripe for all sorts of asset appreciation, and we’re seeing that in commodity prices and other pockets of the market. In short, we’re coming out of a sharp recession with many consumers in good shape, and with central banks and governments practically spraying money on the economy. If you look at the money supply growth, the slope is unlike anything we’ve ever seen. At the same time, consumers have limited spending options. The rise in retail trading of some of these stocks is just another sign of excess.
David Weinstein: I would just add that there were some industry forces that converged to help fuel the rise in these stocks. We’ve all been stuck at home, with little to do. Retail investors have become more sophisticated. You’re seeing them participate in options markets like never before. At the same time, Robinhood has been disruptive to the brokerage industry, making trading cheaper and taking it to the masses. Buying fractional shares has also allowed more people to participate in investing. These are long-term positives – we want everyone to have access to stock markets – but it can also lead to events like we saw last week.
Q: What are the broader implications for markets going forward? Aside from these select stocks, does this make it a bad time to participate in equity markets?
Michael Honkamp: The long-term backdrop for a buy-and-hold investor remains positive. As the economy rebounds and corporate earnings improve, stocks should continue to rally. Low interest rates also support stocks. None of that has changed.
However, the short squeezes could cause near-term pullbacks, and not just in the list of names that retail investors have driven up. Hedge funds caught up in the short squeeze are long many other stocks. When the shorts go up, they may be forced to sell their longs to get out of those short positions. Even if hedge funds don’t close their shorts, prime brokers are almost certainly increasing margin (i.e. cash) requirements. Hedge funds may have to sell longs to post cash and maintain their shorts. More generally, sustained spikes in market volatility can trigger quantitative strategies to reduce equity exposure.
Q: Are there any positives?
Michael Honkamp: When you have events like this, they are often accompanied by rotations in and out of select pockets of stocks. That can create victims of sloppy price discovery. For institutional investment managers, it presents an opportunity to shop for securities we’ve had our eyes on for a while.
Q: Is there a ‘new normal’ in terms of trading, and what does it mean for active managers?
David Weinstein: The new normal is that stocks will continue to trade faster. That’s due to a confluence of factors from retail participation to high frequency trading. Things are happening in compressed timelines. Individual securities are loved, hated and back to being loved within weeks or months. In that environment, you need to be ready to exit positions and enter new stocks that had previously been out of reach quickly. We’ve done things as a firm, both from a product standpoint and for existing strategies, to be more nimble in our trading.
Q: Getting back to individual stocks, what stops the market from having other experiences similar to what has happened to GameStop’s stock?
David Weinstein: Over the long term, I think you can expect some type of regulation that prevents this volatile activity from continuing. A certain amount of volatility is good, but you don’t want stocks exhibiting this type of volatility. It reduces confidence in capital markets and destabilizes the financial establishment, which usually doesn’t end well for anyone. So, while we don’t know what it will look like yet, I expect some type of regulation and for much of that scrutiny to be focused on options markets.
Q: Does last week teach us anything about shorting?
Michael Honkamp: I think it reinforces the risks in shorting. There are broken companies out there that receive shorting attention, but sometimes these trades are as crowded as the long investments in some of the market’s tech darlings. When the herd thinks a company is broken it only takes one news event to shift the tide the other way. And, as this week has shown, it doesn’t even have to be good news about the company. It can simply be news that there are too many people short a position and they may need to get out of it.
Another thing people tend to misunderstand about shorting is that when you are short a stock and it goes down in value, your exposure to the market decreases. So, if you want to keep that same market exposure, you have to continue shorting that stock. It’s an inherently riskier way to manage a portfolio than a long-only strategy.
Q: Do these short squeezes from retail investors pose a systemic risk to markets?
David Weinstein: No, although I’ll caveat that answer by saying that the next few weeks could be choppy. The current squeeze does not present a systemic risk equivalent to, for example, the financial crisis. The notional values aren’t large enough and I expect exchanges and regulators to step in if things deteriorate further. It can really hurt some hedge funds and the people who invest in them, but this is not big enough to be a systemic risk.
It is easy to get caught up in the frenzy and hype of the recent market events. Everyone likes to find winners for their portfolios and outsized winners are even better. But chasing speculative investments is a risky proposition.
In our view, these types of environments underscore the importance of financial advisors, consultants and other fiduciaries. They keep investors’ worst impulses in check, and keep them focused on a long-term goal. In the end, their clients will probably be thankful they sat this one out.
