What else would we write about this month? GameStop (NYSE: GME) and its ensuing short squeeze has been the culmination of so many factors over the past six months. Fundamentally, it’s a quintessential casualty of our current digital transformation, a changing and difficult retail real estate landscape, and over the past month or so, “sticking it to the MAN”.
How could a company that was 1/1000th the size of Apple at the beginning of January send shock waves through the entire financial system? Well, let’s see how we got here and perhaps give a bit of guidance as to where we might go next.
First, what is short selling? When you purchase a stock, you have hopes that at some point down the road you can sell it for more. Short selling is simply the opposite. You sell shares first (which you’ve borrowed from someone else, but we will get to that later) with the hope you can buy them back at a lower price and thus keep the difference from where you initially sold (high) and bought back (low). Seems odd to think that you’re allowed to sell a stock without actually owning it first, but that’s exactly what happens.
Second, why do you sell short? Shorting a stock usually occurs when you feel the fundamentals of a company are deteriorating and the value of that company will be much lower in the future than it is today. In today’s market environment, the most heavily shorted companies are those hit hardest by COVID; victims of an increasingly digital society, like GameStop, AMC Theatres, Kodak, Blackberry, and Bed Bath & Beyond.
Typically, short sellers are large institutions searching for excess returns for their clients (above index fund returns). Oftentimes, these firms will amass a large short position in a company and then publish negative “analysis” enlightening readers of the stock’s inevitable decline. A practice that will likely come under well warranted scrutiny from regulators in the near future.
Finally, what happened? Institutional short sellers borrowed 140% of GameStop’s outstanding shares. Then, many traditional buyers entered the market (rallied together by the WallStreetBets crowd on Reddit) and bought shares of GameStop. Because there were so few shares for sale in the market (remember all the shares have been “lent” to the short sellers) the buying pressure causes the price to jump quickly. Short sellers then scramble to “cover” by buying their shares back. This, in turn, increases the buying pressure, causing the price to rise even further. These are the conditions for the prototypical short squeeze.
What’s the takeaway? The practice of allowing institutions to use excessive amounts of debt (shorting in itself is quite healthy and a great source of stabilization in declining market) will, no doubt, be the subject of future congressional hearings and further regulation on the financial markets. Anytime the internal plumbing of the financial markets is threatened, new laws are passed to attempt to shore up cracks in the pipes. In 2008, it was Dodd-Frank. In 2000, it was Sarbanes-Oxley. In 1987 it was the invention of circuit breakers, and even going back almost 100 years, in 1929 it was the SEC itself.
Given the number of political agendas that have hijacked this market quirk, I very much doubt this time will be any different. In our experience, during market dislocations, there are very few individual investors that make money and to be honest, most lose it (sometimes with very sad consequences, like this). We understand why people feel the urge to play in this space, but without any long-term underpinning (fundamentals), these are pure gambles and should be avoided. The number of incredible businesses borne out of COVID should be more than enough to scratch the itch of great investors, if they are willing to buy and hold.
Overlooked during the market frenzy has been some of the best corporate earnings in the history of the stock market. Apple made more than $100B in a quarter for the first time ever. In 2020, Walmart had revenue of $16,614….per second. Amazon grew revenues 44% year-over-year for their 77th consecutive quarter of double digit revenue growth. The fundamentals on main street appear stronger than ever and with optimism regarding reopening and stimulus, combined with some light at the end of the tunnel, it doesn’t seem so far-fetched to see the market continuing to run. Why shouldn’t it with these types of numbers?
Here’s the rub. “The market is currently caught in a stand-off between strong momentum & and excessive sentiment & speculative fever.” (h/t David Steets). Combine that with my favorite Charles Bukowski quote and we get to where we are today. He said, “the problem with the world is that the intelligent people are full of doubt, while the stupid people are full of confidence.”
Our overall view of the market remains solidly bullish for 2021, and while we anticipate MAJOR pockets of turbulence, we believe looking back and staying with current equity allocations makes the most sense…for now.
– Adam