The Big Squeeze
It’s only when the tide rolls out that you discover whose been swimming naked. A popular Buffet adage once aptly applied to Enron, and as of recent also applied to Melvin Capital—the hedge fund that had heavily shorted Gamestop. The proverbial shorts are somewhere on the beach and Melvin Capital chose a poor year to go skinny dipping. In all likelihood this Gamestop story will be the financial front runner for the rest of the year. So what happened? Gamestop along with a laundry list of other publicly traded and highly shorted companies had come to the notice of internet traders across stock trading forums. Many of these companies have experienced what is known as a stock short. But what exactly does it mean to short a stock? It is actually a relatively simple concept that could be explained as the betting—by an individual investor or financial entity—that a stocks price will fall because the bettor thinks the company’s current stock price is higher than it should be(overvalued). When the price does fall over the period this bettor predicted it would he will achieve a profit.
To flesh out the mechanics of a stock short a bit more, the bettors profit occurs through a process of selling a stock that he borrowed from someone who actually owns shares in the company. The bettor then sells that stock at a current market price that he deems it over valued. Then the bettor waits for the price to drop before buying that same amount of borrowed stock back to which he now returns it to the original lender while keeping the difference in price he payed vs price he borrowed as his profit. The person or organization who lent their stock is usually an investment group or bank who will take a fee or some other transaction cost in order to collect their own version of profit. Sometimes the bets are correct and sometimes they are incorrect. If prices fall drastically short sellers can make a great deal of money.
In the current case it appears many regular stock traders on internet forums noticed that Gamestop along with a number of other companies were being shorted by large investment firms such as Melvin Capital. These firms bet heavily that companies like Gamestop are over valued and as a result indicated to the market that these companies are in some way unsound business models going into the future. In the short term this heavy interest against Gamestop drives their stock price lower as other investors in the market see someone betting against its value. Think of the Kentucky Derby where you walk up to a bookie and ask to see the odds. Chances are if you see no one believes in Flying Irish, the race horse that reportedly has a bunch of money betting it will come in near dead last, you won’t place your bet on the horse. In an investment sense one can see how this type of stock shorting may put off investors who see such shorting taking place. They see someone telling the market, often publicly, that they have information dictating to them this company will fail.
In reality, Gamestop is a company that has a quite sound business model that spans multiple regions and consistently sees revenue in the billions of dollars. It is established, well known, and has its ups and downs as such. Yet the business itself is far from a failure despite being bet against year after year. So why bet would a hedge fund against it? Well it seems that Melvin Capital simply made a poor bet and had strung out this bet over a period by over leveraging their firm to avoid paying up. The real problem became the size of this bet. Often times it can appear that modern investment firms due to sheer purchasing power can manipulate certain stocks to achieve their betting goals. In doing so they often place bets that are far outside what would normally be placed given, and in the case of a naked short they are actually shorting stocks without borrowing any stocks at all. They are betting with no skin in the game. If it pays off, they win big and they up till now usually could manipulate the price enough to avoid losing big bets. In the current case some internet stock traders noticed this over extension and Melvin Capitals badly placed bet against Gamestop. They also noticed this company had consistently been undervalued in terms of stock price as a result of this short over a number of years. The surge in buys of Gamestop shares saw the price soar—as a result increased demand—exponentially past what it had been under the Melvin Capital short. So what about this short squeeze?
A short squeeze is what occurs when the price of a stock sharply increases while the short bettor who thought the stocks price would fall is on the hook to rebuy the stock and return it to their lender. As a result of being on the hook to pay up, the investor who shorted the stock must sustain massive losses as they buy back what they had been lent and sold into the market at a far higher price. If a large investor who has access to immense amounts purchasing power—such as Melvin Capital—made this stock short with money around the hundreds of millions any observer can see how this had this potential to become serious trouble when it came time to buy back all those shares. Especially when in the case of Gamestop these shares are worth almost 100 times what was originally shorted. Currently on the year Melvin Capital is reported to have lost 53% of its investments in January alone. Perhaps this historical financial event will be a word of caution to any future large hedge funds who recklessly short sound and successful businesses. That is of course if they don’t get bailed out by the government. The age of decentralized finance may even gain more of a foot hold in the years to come. - TP
A Renewed Union: The Relationship Between Yellen and Powell
When Jerome Powell succeeded Janet Yellen as the Federal Reserve Chief three years ago, Powell threw a farewell dinner party for Yellen at his residence in Maryland. Unbeknownst to the now two leading monetary and financial policy figures at the time, this would not be Yellen and Powell’s final instance working together. Thus, when Yellen was confirmed by the Senate as Treasury Secretary under President Biden on January 25, 2021, the relationship between the two was solidified in their respective positions, marking a virtually never-before-seen marriage between fiscal and monetary policy.
Prior to Yellen’s confirmation, Powell and the Federal Reserve have spent 2020 battling the current pandemic, employing various strategies to prevent the economy from entering a full-blown recession. To do this, Powell slashed the Federal Funds rate to its lower bound, partook in unprecedented bond spending, and initiated a multitude of emergency lending programs. While these methods have proven effective in relieving some of the monetary pressure on American citizens and businesses, a lack of fiscal policy to complement Powell and the Fed’s work contributed to the high number of jobless claims present during the health crisis. However, with Yellen now confirmed, Powell has essentially passed the stimulus baton over to her. Yellen hopes to oversee a period of high fiscal spending aimed at reducing unemployment and preventing and fixing issues of inequality.
During Yellen and Powell’s shared time at the Fed from 2012 to 2018, they developed a close bond, even having adjacent offices next to one another at one point. This common experience working in monetary policy and with one another has now set the stage for the closest relationship between fiscal and monetary policy since the Great Recession in 2008. Economically, this relationship will likely lead to decreased interest rates for extended periods of time and a quicker economic recovery. Additionally, Yellen will play a crucial role in helping President Biden decide whether to offer Powell a second term, as the chairman enters his final year of his first term in the position. The stakes surrounding this decision are higher than Powell’s initial initiation into the position, with the economic effects of the Pandemic a primary concern among government officials.
Many economists agree that Powell and the Fed’s swift and aggressive monetary response to COVID-19 helped stop the health crisis from morphing into a financial one simultaneously. While these circumstances led to unseen cooperation between the Federal Reserve and the Treasury Department, the events also spurred friction between the two entities, especially over their view on the length and size and emergency lending programs. With Yellen now in office, however, this friction is expected to decrease substantially given Powell and Yellen’s relationship.
One key concern about the relationship between Powell and Yellen lies in the two’s stance on inflation. Given the Fed’s promise of decreased rates till 2024 and Yellen’s goal of increased fiscal spending, economists warn the two institution’s high utilization of stimulus may overstimulate the economy, triggering a financial bubble or inflation. However, Powell and Yellen appear unworried about these factors, citing that if an excess of these policies leads to evidence of a bubble or increased rates, they will adjust it at that time.
Right now, both Yellen and Powell’s primary concern is spurring an economic recovery from the coronavirus pandemic. To do this, the Federal Reserve will maintain low rates for at least the next three years, and Yellen will push for major stimulus spending. Together, the two hope to heal the labor market so fractured by COVID-19, as well as examine our relationship with a multitude of economic variables, including inflation, unemployment, and the Phillip’s Curve. - CS
Increasing Power of Retail Traders
The turmoil of financial markets in the past two weeks – most notably the meteoric rise of stocks such as GameStop, AMC, and Koss – have demonstrated a newfound power of retail investors in a world traditionally dominated by institutional money. The unprecedented performance of shares of generally poorly performing companies is largely explained through a technical trading situation known as a short squeeze (discussed in more detail in an earlier post). However, an important precondition for the rise in certain stock values has been the increasing interest and significance of retail investors. The pandemic induced lockdowns beginning in the early months of 2020 coupled with substantial and direct fiscal stimulus added fuel to a personal investment craze that had already gained significant momentum due to a host of other factors – both within the market itself as well as within the financial technology industry.
Most notable among the market forces influencing the uptick in consumer investing was the low-interest rate environment that has existed since the onset of the financial crisis almost fifteen years ago. While the federal funds rate had been steadily increasing prior to the onset of the pandemic, the average interest rate on a U.S. savings account only topped out at 0.10% during that time. That number has since been halved as the Federal Reserve once again moved its benchmark interest rate to zero percent. The lack of any real returns in a savings or money market account created one condition that pushed an increasing number of amateur investors into the market. Coupled with these forces was the ease of access to the stock market through online brokers such as Robinhood and Charles Schwab and their adoption of commission-free trading – leading to the creation of over ten million new accounts in 2020.
As it became much easier for the average individual to trade, the onset of the COVID-19 pandemic provided both time and money to accompany the existing opportunity for a significant uptick in retail investor activity. During the early stages of the pandemic in the United States, widespread lockdowns prevailed as one of the most prominent methods to blunt the spread of the disease. Remote work, school, and socializing became the “new normal” and as a result individuals experienced a newfound abundance of time that was previously unavailable to them. Simultaneously, those who were able to keep their jobs found themselves with increased disposable income as many opportunities to spend money outside of the home were reduced or eliminated (the rate of personal savings skyrocketed nearly 50% following the onset of the pandemic in Q2 of 2020). Further fiscal stimulus in the form of direct payments to certain individuals and enhanced unemployment benefits increased the cash available to many Americans. All of these factors combined to create a perfect storm of speculative market activity with origins in the Reddit investment community r/WallStreetBets.
This formerly niche Reddit forum, a place for potential investors to share tips or strategies, has grown to include almost eight million members, 75 percent of which have joined in the past two weeks. This group of investors has attracted significant attention in the past month due to its demonstrated market power following its successful strategies regarding rapid increases in the prices of stocks such as GameStop, AMC, and Blackberry among others. The noteworthy aspect of this forum as opposed to other similar offerings is simply the propensity for its members to congregate around certain equities and create a hype that sweeps over the broader market. This unique situation whereby a horde of individual investors fervently bid up the stock price of a struggling company in opposition to the Wall Street consensus exemplifies the type of market power that retail traders possess in today’s economy.
Trading activity from individuals made up an average of twenty percent of the overall market in 2020, a number that is more than double the amount from the previous year. While retail traders continue to remain in the minority, their influence constitutes a significant factor in market behavior as their financial interests are substantial and their ability to coordinate and rally around specific assets creates outsized impact. As the world attempts to return to normal, it is more than likely that this increase in consumer investing becomes a permanent fixture of the financial world. - JR
Sources
A Renewed Union: The Relationship Between Yellen and Powell
https://cnn.it/3tg1ZDb
https://on.wsj.com/3cF7ipI
Increasing Power of Retail Traders
https://bit.ly/39ElUnx
https://bit.ly/3j6tHxH
https://on.wsj.com/3cF7HZg