The title has to do with the silliness of last week’s “Reddit Rally.” Before diving into that story, we’ll have some thoughts on the parts of the markets that affect real investors.
The Normal Market
If anyone thought volatility would simply go away once we turned the calendar to 2021, those hopes were dashed within a few days. The uprising of January 6, the difficulty with the vaccine rollout, and the variants of Covid-19 made all of us a bit more nervous, and some of that unease showed up in the capital markets. Overall, U.S. stocks declined by 1% for the month, as did international developed market stocks and U.S. bonds. One of the few bright spots was emerging market stocks, which increased in value by 3%.*
About half the companies in the S&P 500 have reported 4th quarter earnings, and thus far the forecasts are slightly higher than most security analysts projected. A consensus of those analysts predicts continued growth in earnings throughout 2021, with 2nd quarter earnings rising to pre-pandemic levels.** This anticipated growth in earnings is embedded in the current values of stocks.
The risk factors we raised in our 2021 outlook remain present, but we do want to call attention to one long-term factor -- because relatively few commentators are discussing it. According to the Congressional Budget Office, the deficit for Fiscal Year 2020 (which ends in September and doesn’t include recent or proposed relief programs) was $3.1 trillion, which was the highest level as a percentage of GDP since the end of World War II 75 years ago. Some of us remember the impacts of the large deficits of the late 1960s on the economy of the 1970s, particularly with respect to inflation and interest rates. We’re not predicting similar impacts on the economy going forward – the deficits of 2009-2011 didn’t cause high inflation in the 2010s – but the deficit is something to be wary of.
The Abnormal Market
Now, on to the entertainment section. We titled this Absurd Exuberance as a call back to former Federal Reserve chairman Alan Greenspan’s view of the huge rise in values of internet stocks in the 1990s. Over time he was proven right, but at least those stocks were purchased with the belief that their revenues would grow and their profitability would eventually justify the stock price. And while many of those companies didn’t survive, you may have heard of some of the success stories, including Google and Apple. So, if the 90’s were “irrational,” last week needed a stronger adjective.
What Happened Last Week?
Last month, a few stocks – most notably GameStop, which we will use as an example, but including others such as AMC, BlackBerry, and Nokia – started getting notice on social media in part because some institutional hedge funds had taken large short positions (essentially bets that the stock would fall in price) on them. The belief was that if there was momentum on social media to buy these stocks, the price would go up, forcing the hedge funds to buy the shares back to limit their losses, which would drive the price even higher. The price of GameStop went from $20 on January 12 to $31 the next day and eventually to $77 last Monday. And then, with all the retail following, the price spiraled upward, eventually reaching nearly $500 last Thursday. There’s suspicion that at least some of the buying and commentary was an attempt at market manipulation, but thus far there’s no proof.
GameStop is not the case of a successful business whose revenues and stock price were ravaged by the pandemic. Revenues peaked ten years ago, when its stock price was around $20 per share, and have been slowly declining since then. Profits have always been modest and turned negative in 2019. A year ago, its stock price was around $4 per share. That’s why some hedge funds thought it was overvalued at $20. Fundamental value is always subjective, but it’s difficult to find any logical professional who would have assessed a value much higher than $20.
Standard brokerage arrangements allow the buyer of stock to put up only 50% of the money to buy a stock – the rest is in effect a loan from the broker, called margin, with the loan secured by the stock. On Wednesday, as the price was rising past $300 per share, some brokers tried to reduce their risk by limiting purchases of GameStop and other stocks with similar rapid increases. I can’t speak for the brokers’ motives, but I know this. If I provided secured loans to people for up to 50% of the purchase price of a product, and I learned that the collateral of the product was very uncertain – such as a $150 loan having collateral with an estimated fundamental value of $20 – I would take every step possible to reduce my risk. Can we think of a financial industry that might have lent too much collateralized money given the value of the collateral was uncertain? That’s the mortgage lending industry of the 00’s. Many of those same commentators and politicians who criticized mortgage lenders are the same ones who were chastising brokers last week for restricting trading.
Commentators, OMG, the Commentators
My space was invaded last week. The hosts of my favorite politics, sports and pop culture podcasts were all, and I mean ALL, leading off their shows with half-hour discussions of the “stonks” market, parroting the general press themes that 1) this was a victory for the “little guy,” 2) the investment industry was quaking in its boots, and 3) the evil brokers were unjustifiably trying to end the fun. First, to those podcasters, let’s make a deal – in my commentaries, I won’t talk about the electoral college, NBA title favorites, or which TV shows should be acclaimed, and you stay out of my lane.
Let’s take those three themes in reverse order. We already discussed the brokers, and I truly don’t weep for their losses. I had the opportunity to talk to many of my colleagues, competitors, and various investment managers over the past week. Pssst … no one is quaking. None of them held GameStop in their client portfolios (for reasons discussed earlier) so last week had no impact on them. A few hedge funds got badly burned, but there are a lot of hedge funds out there, and with many of my favorite local restaurants and live theaters closing over the past year, I’m not going to weep for those hedge funds either. GameStop may have had tremendous volume of shares traded, but its value is currently about $4 billion, which is less than 1/20,000 of the value of all U.S. stocks.
Which brings us to the “little guy.” We know there were many people who bought GameStop at $60 and sold it at $300, and that’s great. But for every winner, there’s a loser. Every investor who bought GameStop last Friday, and there were over 50 million shares purchased, paid at least $250 a share – some as much as $414. It’s currently at $57. If someone paid more than $114 and bought it on margin, they are wiped out. Plus, they owe the broker a bunch of money. In the weeks to come, we will see news stories about those who lost significant portions of their wealth on these stocks. As a society, we’ll remember them – until the next bubble.
* Source of returns and prices are Morningstar, Inc., and Yahoo Finance. Past performance is not indicative of future results.
** Source: S&P Dow Jones Indices
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