Recent volatility in the capital markets is due at least in part to activity emanating from a small list of individual stocks. Most notably, video game retailer GameStop and theatre chain AMC Entertainment Holding’s respective stocks have been the focus in a period of abnormal trading volume and price movements. Much of this stems from activity on a trading platform known as Robinhood that allows small, individual investors to make modest-sized trades on specific stocks at a low cost. There is growing concern that activity on a “micro” level (involving a handful of modestly-sized stocks) could grow into a larger, macro problem for the markets. Here we provide some explanation of recent market activity and some of the issues that stem from it.
As a quick primer, the key players in this drama are equity hedge funds. These managers can use a variety of tools as they seek to generate investment profits. Common among these is the ability to purchase securities and leverage a transaction known as short selling (or “shorting”). This entails borrowing a security, promptly selling it, and then at some later date, buying back the security before returning it to a lender to close out the transaction. A short seller earns a profit when their short price (the price they earned selling the stock) exceeds the price at which they must buy the security back, including borrowing and other costs. This strategy is employed when an investors comes to the conclusion that a company’s poor financial performance will result in a declining stock price.
Short selling is one way an investor can try to capitalize on the opinion that a company will fall in value. Here’s how it works: An investor borrows shares of a stock (let’s say 10 shares), then sells it at the current market price (let’s say $50 per share) for a total of $500. The investor will need at some point in the future to re-purchase those 10 shares to return them to the lender. If the price of the stock has gone down to $10 per share in that time, the investor makes $100 (10 shares at $10 per share equals $100). In effect, the investor paid $400 but sold the stock for $500. Yet there is significant risk for a short seller. If the stock increases in value, the investor still must repurchase the stock. That can result in a net loss on the transaction, and since share prices have virtually unlimited upside potential, it means the risk can be dramatic. This is the scenario that occurred with GameStop and AMC Holdings.
The GameStop and AMC Holdings phenomena
Over a period of seven trading days from January 19 to January 27, at their peaks, GameStop and AMC Holdings gained 1,239 percent and 651 percent, respectively. These movements are beyond abnormal for any company or asset over such a short period of time. Investors naturally wondered how such moves were possible.
Motivation is a key consideration surrounding what happened in the runup of GameStop and AMC Holdings. Investors across several social media and social news networks have touted both companies’ stocks for a variety of reasons. Of note was that some who posted specifically targeted short sellers in general and others by name to “squeeze” and force hedge funds to cover their short sales at a potentially significant loss to them. Through a combination of crowdsourced interest and vocal posts, investors took to both the stock market and the options market to express positive views on both companies’ stocks.
The activity drew significant interest. Those motivated by profit, those making a social statement against institutional investors who short the stock, and those simply along for the ride piled into the stock market and also the options market in record volumes. Much of this activity occurred utilizing the low-cost trading platform known as Robinhood, which made it possible for thousands of smaller investors to buy shares in GameStop and AMC in an effort to drive up their prices. This put large, institutional short sellers of those stocks in a difficult position.
Because prices of these stocks began to move dramatically higher, those who had done significant short selling in those stocks had decisions to make. In addition to facing margin calls, these institutions also must consider the overall risk profile of their portfolio; if one part of their portfolio is extremely volatile and is not offset by another part of their portfolio, its risk profile will be much higher. Most long/short equity managers set expectations of how they manage risk, and experiencing portfolio volatility beyond the expectations that were outlined can result in investors choosing to exit their interest in that hedge fund.
Wednesday, January 27, reflected the biggest drop in major domestic equity indices since October as investors worried that hedge funds would be forced to “de-risk” their portfolios and sell additional positions to satisfy margin calls or moderate overall portfolio volatility. Some notable hedge funds impacted by these events sought additional funding and others signaled abnormal losses to their investors as a result of moves in GameStop, AMC, and other heavily shorted stocks. In addition to concerns about near-term spillover effects into other markets, market observers expressed conflicting views about whether it was fair for the “herd” to target short sellers and if their tactics were legal.
For its part, Robinhood also temporarily put a hold on trading activity in 50 different stocks shortly after the market’s drop. This raised further concerns about whether this sudden lack of access to purchasing specific stocks through that platform was fair to smaller investors and what impact it had on the markets as a whole. Given the rapid pace of these developments, it remains to be seen if there will be any notable ramifications from this decision.
There has been much discussion among those in the financial industry about whether it is fair for behavior to be influenced by very active social media discussions, as seems to be the case in this situation. We believe that using the distinction between positive and normative economics offers a helpful framework. It is important to note that as professional investors, we are swarmed with information and resources. Information is readily available about stocks with very high short interest (significant “short sale” positions taken by large investors) relative to all shares outstanding in that stock. While we have long investment horizons, the reality is that social media and social news investors with very short time horizons can act on this same information. Similarly, short sellers can act on other easily accessible information about stocks that have become increasingly popular with mutual and pension funds. In our opinion, it is not the specific information itself, but how investors use that information, that is the key to maintaining an orderly and fair market for all participants.
We believe steps should be taken to ensure that content posted on any website is not misleading or drives activity that can harm investors or manipulate security prices. It is important to ensure a fair and level playing field for all investors, retail and institutional. In general, it is a favorable trend to see increased participation in capital markets. Given the savings and retirement crisis in this country, having more people involved in managing their savings and financial future is needed. The tools that they use, the information they draw from, and perhaps most importantly their ability to define their own risk will be critical to helping them shape their financial futures.
We do not view recent movements in a handful of stocks (the “micro”) and Wednesday’s capital market movements as symptomatic of a broader macro issue for investors. It makes sense that there is further exploration and inquiry into the micro considerations related to GameStop, AMC and similar situations, so they do not grow into macro problems. While markets often react to headline events, it is not clear at this point that this particular situation will result in any lasting impact on the markets.
As we have shared in many past commentaries, we are constructive on the path ahead for economic acceleration due to the confluence of vaccine progress, central bank policy and corporate and consumer activity. We are privileged to work with you and appreciate the opportunity to share our thoughts, and if we can provide further information, please do not hesitate to reach out to your U.S. Bank wealth professional. Thank you for your trust.