Volatility returned to close out January as concerns linked to margin calls and forced liquidations by hedge fund managers became a concern, due to a coordinated effort by retail investors to drive up the prices of some of the most shorted stocks by hedge funds. We also had continued delays on a stimulus agreement. This offset continued progress in vaccinations.
We have obviously received many questions about the ongoing short squeeze by the Wall Street Boards investor activity. Therefore, we feel it is appropriate to comment on what we believe is happening.
Let us begin with discussing what shorting a stock means. When a person or institution shorts, this involves placing a bet that the price of the stock will decline. When selling a stock short, the investor opens the short position by borrowing shares of the stock they believe will decline in value. After borrowing the shares, the investor then sells the borrowed shares to others willing to buy the stock.
The investor borrowing the shares they sell is speculating that the price of the stock will significantly decline, and they can buy the stock back at a lower price to realize their potential gain.
There are some distinct risks to shorting a stock. First, the counter party who lent the stock can demand its return at any time. This can force the borrower to have to close out the position and potentially realize a loss.
More importantly, the risk of loss on a shorted (borrowed) stock in theory is unlimited because there is no limit to how high a stock can climb. Conversely, when an investor buys a stock their loss is limited to the capital invested.
We have been hearing from the news and social media non-stop how many billions have been lost by hedge funds as a group of investors has run up the prices of certain stocks to hurt those short.
This is not an isolated event as short squeezes and large losses have been occurring for well over one hundred years. What is different this time is we have a 24×7 news cycle that is inescapable if you turn on the tv, radio or look at your phone. The 24×7 news cycle that was focused on a polarized election is now focused on this issue.
In our view, this is not the end of the world as we know it or the end of the stock market. We will continue to be mindful of this situation and trend but as of today this is not causing us to change our fundamental investing strategy.
What is different is this seems to be the first well-orchestrated short squeeze by a group of individual retail investors. Additionally, the damage being inflicted to some large hedge funds has been significant and plays into the issue of the wealth disparity in our country. We mentioned in our fourth quarter commentary that income inequality is an issue in the country and that this issue will likely remain part of political discussions in the years ahead. What has been occurring in part plays into this and is certainly worthy of discussion and debate.
Four other points to mention:
First, we are going to reiterate that intra-year stock market declines are normal and should be expected.
Second, we believe most catalysts of stock market declines come from unknown events are rarely predicted by the so called “experts”. These catalysts are random and randomness by its very nature is unpredictable.
Third, this short squeeze is not just benefiting a relatively small, concentrated group of retail investors at the expense of large corporations. There are plenty of large firms taking advantage of this and potentially making large profits.
Fourth, as mentioned above this is far from the first major short squeeze. Interestingly, after the last election in 2016 there was a significant short squeeze in shipping stocks. Also, in 2008 there was a well-known short squeeze in a German auto maker you can read about here – https://moxreports.com/vw-infinity-squeeze/
Regarding the drama last week, the fallout and debate of this will likely continue for some time, but for us there are two key takeaways: First, investor complacency and investor overconfidence remain a concern. Second, we believe the market remains priced to perfection, and if there is some sort of a material disappointment from a macroeconomic standpoint, then the pullback/correction in stocks could be quick and sharp.
Finally, beyond what is occurring this week, we believe it remains important to consider the risks associated with increased regulation and tax risks for the second half of 2021 and beyond. If nothing else, what is happening with this short squeeze will likely lead to at a minimum, an attempt at more regulation.
Thanks, and enjoy the rest of your week,
Dennis P. Barba, Jr.
President & Managing Partner
Important Disclosures: Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request. Past performance is no guarantee of future results. Wells Fargo Advisors Financial Network is not a tax or legal advisor. Be sure to consult with your own tax and legal advisors before taking any action that may have tax or legal consequences. CAR-0221-00104