There has been quite a lot of commotion around the recent Gamestop trading activity and has garnered a lot of media attention. Let us look at what happened.
Short selling is when an investor borrows stock and then sells that stock on the stock market. They do this because they take the view that the stock is overvalued and is bound to fall. Furthermore, they market this view by putting out investment thesis and marketing blurb on media to promote this view and, in doing so, hopefully cause traders (punters) to sell the stock in droves. This then causes the stock to fall and for the shorts to be “in the money” and hugely profitable. They then purchase the stock back at depressed prices and return the stock to the original holder/lender and pocket the difference.
The original holder of the stock lends it for a ‘premium’ which is essentially rent. Given the prevailing low interest rates globally, short selling has become very popular and affordable as the ‘premium’ is low compared to historical standards. They simply have a contract to have the same number of stocks returned based on the contracted time frame. The stock lender does not care at what price the stock is returned back as they just require the same number to be returned.
Unfortunately for the short sellers, a group of day traders got together and decided to implement a short squeeze —this is where people buy shares targeted by short sellers to bid up the price. The more the price goes up, the more the short sellers have to purchase to cover their position as, remember, they have to return the same number of stocks to the lender in due course. This causes a spiral where the price keeps getting bid up and the short covering has to keep purchasing stock at a higher and higher price.
The twist in this scenario was the online trading platform Robinhood, which offers trades for free but makes most of its money from the market maker. In this case, the market maker was Citadel Securities. Citadel Securities had US$2Billion invested in Melvin Capital which had placed the shorts on Gamestop and was losing money big and fast due to the short squeeze. This is why, it is suspected, that Robinhood put limits on the short squeeze from retail investors to try and plug the bleed in Melvin Capital.
Now, let us look at fundamentals of equity markets and the prevailing views.
I attended a couple of virtual investment briefings by both PIMCO as well as Schroders last week. These are both highly reputable and significant firms with a breath of investment expertise second to none. The ‘mood’ generally for equity market returns for 2021 seems positive. The weight of money supply has prompted some analysts to question the risk of inflation which may cause equity market revaluation. However, according to Joachim Fels, Chief Economist for PIMCO, there is no automatic relationship between money supply and inflation. He believes inflation will remain subdued for a number of years yet. Our own Reserve Bank also recently stated that they do not expect rates to move up until 2024 and their inflation targets remain subdued as well.
We are expecting a jump in global growth in 2021 following successful vaccinations globally, and especially in the US and Europe, and off course China. Since the Biden win, the daily target for vaccinations in the US has been exceeded and targets revised up. Despite news on certain vaccines not having strong efficacy rates, the impact has been of alleviating the need for hospitalization and the significant decrease in deaths from covid post vaccination. This is a very positive outcome and should fuel an increase in global demand and trade, and a return to normality in due course. Furthermore, the Biden government’s focus on climate change and the US re-joining the climate accord bodes well for ‘green deal’ in the US which bodes well for infrastructure and further focus on ESG (Ethical, Social, and Governance) issues.
On a macro view, we see global GDP and employment improving and these are a positive for risk assets (such as equities, property, etc.) and underpin a reasonable outcome for growth. Therefore, global output and demand is likely to rebound.
Off course, there are risks. These would be issues with the vaccination not going to plan; fiscal fatigue (where the balance sheet cannot keep rising and keeping pace with the increasing debt burden); inflation (although less likely); and China (in terms of trade and becoming increasingly belligerent and antagonist with the US, Europe, and Australia).
Whilst the overall theme is positive and leads us to believe that we should now deploy cash and increase equity exposures, volatility remains elevated and the principles of diversification and liquidity will remain important in our investment thesis in 2021 and beyond.