No Love for the Short Sellers

The past year has been a vivid reminder that the stock market often moves swiftly and dramatically in response to unexpected events. This is true both in both downturns and upturns, and it’s more true now than ever.

The emergence of the Covid-19 pandemic in early 2020 shifted from a concern to an unprecedented global crisis in a matter of weeks. The stock market reacted accordingly, with the S&P 500 plummeting more than 30% in less than a month in February and March. Small stocks plunged even further.

While unnerving, these short-term distortions in stocks work themselves out over time, as panic recedes and the proverbial “animal spirits” return to the capital markets. That’s exactly what happened beginning in late March 2020, when stocks reversed course and began an upward climb that has continued through the first part of 2021.

All of which shows why it’s so important to have a sound investment strategy and remain committed to that strategy regardless of the market’s short-term fluctuations. With the global economy so intricately connected, unexpected events such as Covid-19 can have a much faster and larger impact on the capital markets than even just a few decades ago.

Investors who panicked and fled the market a year ago have never really found a time when it felt right to get back into stocks. The news cycle for the past year has been nothing short of dreadful, and the unknowns about the virus and the potential solutions to it have been murky at best until recently. Yet stocks marched steadily higher all along the way, and investors on the sidelines never found the mythical opportunity they were looking for when the news seemed better and stocks seemed “safe” again.

This is the paralysis that comes from trying to time the market, especially in today’s rapidly changing world.

The torrid recovery in stocks has also been a testament to the benefits of effective diversification. During the first six months of the recovery, a small handful of giant technology stocks powered the market rally – especially the so-called “FAANG” group of Facebook, Amazon, Apple, Netflix and Google.

Predictably, investors rushed to load up on these stocks throughout the year, but we cautioned last fall that the rapid rise in the stock prices of these companies would require a commensurate spike in earnings to justify those valuations. We also pointed out that other segments of the market which were out-of-favor at the time were much better positioned for future growth given their very low price-to-earnings ratios – particularly small value stocks.

Interestingly, since that time, small stocks and value stocks have soared, while the majority of the FAANG stocks have trailed far behind (with Google the notable exception).Investors in well-diversified portfolios who avoided the temptation to chase performance were rewarded for their discipline. They reaped the benefits of both the early rally in large tech stocks as well as the rotation into small cap and value stocks in recent months – all without taking on the risk of trying to time the market.

In assessing the mind-boggling GameStop (GME) stock saga that has played out in recent months, the old Mark Twain quote that “history doesn’t repeat itself, but it often rhymes” comes to mind.

No doubt, there are as aspects of the GameStop saga that are new and unique. For the first time ever, millions of people worked as a collective to drive the share price of a stock into the stratosphere, with no regard to the underlying fundamentals of the company. The movement was organized in a sub-forum of the Reddit internet chat site, appropriately titled “WallStreetBets.” The stated goal of the group was to force Wall Street hedge funds with huge short positions in GameStop stock to have to cover their positions by driving up the stock price, which would result in a buying frenzy in GME stock and send the price even high.

In that regard, the Reddit insurrection could be deemed a “success” as the hedge funds that were targeted in the short squeeze suffered more than $20 billion in losses as a result. The Reddit investor group – and millions who followed their lead – drove GameStop stock up 2,903% (you read that right) from early November through late January. Last July, the total market capitalization of GameStop was about $260 million. By January 27, it was $30 billion – ranking the moribund bricks-and-mortar video game reseller, ever so briefly, ahead of Southwest Airlines, Tyson Foods and Archer Daniels Midlands.

In the midst of all this, celebrity billionaires like Mark Cuban and Elon Musk egged the frenzied masses on, encouraging it as a populist revolt against the greedy hedge funds and their short positions. Cuban and Musk have no love for the shorts who take large positions against their companies and many others.

Unfortunately, it wasn’t their money at risk; it was the tens of thousands of small investors who bore the risk and suffered the consequences. From January 27 through February 4, GME plunged 84%, and many of the small investors who got swept up in the groupthink of the Reddit forum were wiped out. Horror stories in the media abounded about inexperienced investors who chased the GME dream right over the cliff.

GME has once again moved higher in recent weeks, as some of the diehard investors inspired by the Reddit movement vow to hold the line and keep buying the stock. But the fundamentals aren’t there to support the stock price. Ultimately, this saga is nothing more than a classic pump-and-dump scheme with a modern wrapper around it.

Sadly, like every such scheme that has ever been perpetrated, it’s small investors who will once again be left holding the bag.

One of the points we made in our First Quarter 2020 client letter was that human ingenuity is vastly under-appreciated in times of crisis, and we expressed our faith that it would again pull us out of the grip of what, at that time, seemed an unsolvable dilemma.

To be sure, we are still working our way through the Covid-19 pandemic as a society. Yet the progress we’ve seen in the interim is nothing short of astonishing. Today, one year later, there are 104 million people in the United States who have received at least one dose of Covid-19 vaccine, with 59 million of those being fully vaccinated. In the first week of April, the 7-day rolling average of vaccinations administered was over 3 million, with a record 4 million people in this country vaccinated on April 3. (Source for all vaccine data: Centers for Disease Control).

It is a staggering achievement that scientists in this country developed not one, but three, vaccines that are highly effective against a virus strain previously unknown in a matter of months, not to mention the fact that 20% of the country has been fully vaccinated just over a year after it emerged. Beyond this, medical experts have developed new treatment protocols that have been highly effective for many who have contracted the virus, raising survival rates and lowering hospital admissions.

In the early days of a crisis as profound as the Covid-19 pandemic, it’s exceedingly hard for all of us to keep the faith that human ingenuity will pull us out of the abyss. It’s an intangible concept in the face of a tangible crisis.

Yet we have seen this to be the case time and again throughout the course of human history, and we have seen it again this past year.Source: Morningstar; Russell; Bloomberg; Capital Directions; Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio; Investors should talk to their financial advisor prior to making any investment decision. All expressions of opinion are subject to change. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. M & A Consulting Group, LLC, doing business as CAM Investor Solutions is an SEC registered investment adviser. As a fee-only firm, we do not receive commissions nor sell any insurance products. We provide financial planning and investment information that we believe to be useful and accurate. However, there cannot be any guarantees. This blog has been provided solely for informational purposes and does not represent investment advice or provide an opinion regarding fairness of any transaction. It does not constitute an offer, solicitation or a recommendation to buy or sell any particular security or instrument or to adopt any investment strategy. Any stated performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss. Charts and graphs provided herein are for illustrative purposes only. There are many different interpretations of investment statistics and many different ideas about how to best use them. Nothing in this presentation should be interpreted to state or imply that past results are an indication of future performance. Tax planning and investment illustrations are provided for educational purposes and should not be considered tax advice or recommendations. Investors should seek additional advice from their financial advisor or tax professional.

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