Equity markets dropped across the board last week. The pullback erased all gains seen earlier in January and resulted in a monthly loss of more than 1% for the S&P 500.
We recently discussed the possibility of earnings not meeting the lofty expectation set by the markets over the past few months. The move straight up in stock prices since the beginning of November was due for a pause (at a minimum), and a retracement in the event earnings did not really shine. The tech sector is especially vulnerable on this front and its current leadership is a threat to other sectors if it begins to crack. Thus far, 82% of companies have beaten their fourth quarter estimates and that still has not been enough to propel markets higher. This tells us that those earnings improvements were already factored into prices and it is going to take something extraordinary to move us higher right now.
In addition to the overbought technical conditions, we saw some extra volatility due to the short squeeze initiated by an aggregate of retail traders on the Robinhood platform. In a nutshell, a lot of small retail traders got together and plotted a coup against hedge funds that had shorted some weak companies. GameStop was the most notable, but others have also been involved. The idea was pretty simple – and it worked. All of these individual traders bought as much stock as possible in these heavily shorted companies. This caused the price of the stocks to rise dramatically and resulted in the hedge funds having to cover their short positions. For those of you who are unfamiliar with these terms, to short means to bet that the stock will go down. Hedge funds do this by borrowing shares of the stock from a broker at its current price and immediately selling those shares. The hedge fund then buys the shares later at a lower price to give back to the broker and makes a profit on the difference in the price at which the shares were borrowed and sold and the lower price at which they were bought and returned to the broker. During the time in between, the hedge fund must pay interest to the broker on the value of the borrowed shares. The act of buying back the shares is called covering the short position. In essence, the Robinhood traders knew that if the price rose high enough, hedge funds would have to cover their positions to prevent the potential for catastrophic losses. To cover their positions, the hedge funds had to buy the stock, which simply caused the price to go even higher. The higher it went, the greater the number of hedge funds that had to throw in the towel and cover, thus creating a vicious cycle of ever higher prices. Robinhood traders simply watched the price move higher and higher and the big money was forced to keep buying the stock. I suspect some traders made a fortune from this… and good for them. They were smart enough to see a legal opportunity and took advantage of it. I don’t fault someone for thinking outside the box and taking a chance, if they can afford to be wrong. The other indirect issue that all this buying and shorting caused is that the hedge funds who were trying to hang on and not cover their short position were forced to increase their cash positions to satisfy their margin loans with the brokers. To do this they sold their winning positions to lock in profits and raise cash. Many of the positions sold were shares of Apple, Amazon, Netflix and the like. The selling of these shares put additional pressure on the markets as these huge stocks pulled down the major indices. At the end of the week, we saw some moderate losses and got some real entertainment from a bunch of little guys winning the first round against the heavyweights. We will keep an eye on this and report back as we learn more about all the players involved and see how this shakes out over the next few weeks. Let us not forget that at the end of the day, a company is worth whatever its earnings are relative to a risk-free rate of return. All the technical and mechanical gyrations in the world will not make GameStop (or any company) worth any more or less than what its earnings say.
Despite an increase in volatility and overbought market, corporate earnings are trending in the right direction.
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