Retail money is having more of an influence on stock market trading these days, because there is so much of it. Out of all the cash created by QE and high savings rates, some of it has inevitably funded speculative trading in markets. The battle between retail longs and short-sellers is an interesting sideshow on the whole, but there is a chance it could have some systemic fall-out. Whenever there is a lot of leverage and volatility together, things can go badly wrong. We might just be seeing the broader implications with equity volatility measures jumping this week. I prefer to focus on the longer-term fundamentals. We have earnings growth and we have negative real yields. Perhaps we will get an opportunity to buy low(er) soon?
Forever blowing bubbles
There is a lot of talk about bubbles. This week the drama has been around a certain cohort of retail investors forcing a squeeze in the price of stocks that had been subject to unusually high levels of short-interest. The price movements have been dramatic. The activity is speculative, combative and, according to some, illustrative of market excesses. A couple of weeks ago Bitcoin hit new price highs and has since been very volatile. There have been reports of a huge amount of money pouring into SPACs (Special Purpose Acquisition Companies). Seasoned investors and commentators have described the stock market as being in a classic bubble and many continue to struggle with the concept of high levels of equity return and valuation in a world still ravaged by the COVID-19 pandemic. The narrative is “it doesn’t make sense; investor activity and market valuations are out of touch with economic reality; and something bad will come of all this.”
I doubt many mainstream investors are involved in ramping up prices of low cost stocks or running massively leveraged short positions through the options market. There is a temptation to be dismissive of the sort of “casino capitalism” on show on Wall Street at the moment. After all, buyers coming together on a social media site to “teach hedge funds” a lesson is not behaviour characteristic of long-term investors focussed on structural economic trends, value and earnings growth. It’s more like game theory, pushing those on the wrong side of a trade as far as they can tolerate losses without capitulating. Price moves can and have been dramatic as a result. The temptation is to think it is a passing fad and that it should not impact on the long-term performance of the broader market. However, there is a risk, albeit small at this stage, of today’s side-show having more meaningful implications for markets ahead.
For one thing there could be some behavioural implications of more focus on the wild gyrations of certain stocks. The more the media focusses on it, the more the idea that the whole market is in a bubble takes hold. The psychological impact could drive investors to take profits on their equity portfolios or hold back cash in case there is a market correction. Fear of “something going wrong” or a policy response to the speculative activity may be somewhat self-fulfilling in terms of some adverse market reactions. There is no end to commentators on US financial television warning that retail investors are going to lose all their money.
While the short squeeze activity appears to be fairly concentrated, mostly in small-cap stocks, there could be contagion to other parts of the market. Mainstream investors will have exposure to some of these stocks through dedicated or multi-cap strategies. Increased volatility could impact on how portfolios are managed with higher volatility bringing about attempts to reduce risk exposures. Capital might be allocated away from parts of the market that are believed to be subject to increased volatility. At the very least, increased price volatility could impact on performance in a way that is not consistent with the stated investment philosophy of the strategy.
Leverage, it's always leverage
Perhaps more difficult to get a handle on is the systemic risk. It seems that many of the stocks in the news in recent days have attracted a huge amount of leveraged money positioned for price declines, usually executed through the options market. While leverage takes many forms, the idea that net short positions have been more than 100% of a stock’s market capitalisation is a cause for some concern. Leverage and volatility are a toxic combination because someone, somewhere, needs to underwrite the inevitable losses. The risk is that short-sellers have to close their positions and fund losses, potentially by liquidating other assets to raise cash. At the extreme there could be some huge realised losses at a hedge funds. Credit lines from banks are likely to be drawn and there are already reports that this has happened in relation to one of the larger retail trading platforms. Margins calls have apparently been increased. Leverage is a constant in the analysis of any past market blow-up.
Cash, apps and boredom
The other aspect of the retail phenomena is that it probably reflects the huge amount of cash around. As a result of quantitative easing, fiscal stimulus and a lack of spending opportunities that has resulted in higher savings balances, money has flowed into equities. Some through 401Ks, some through purchases of mutual funds and also some through direct retail purchases. A subset of these appear to be of a very speculative nature and may even be driven by motives other than making a quick buck. It’s a side effect of liquidity, yet it is not a true reflection of the underlying fundamentals. The development of technology and the abundance of liquidity has allowed retail speculative activity in the stock market to emerge to an extent that is surprising. It will cause damage, financial and reputational, and will solicit some political reaction. However, taking liquidity away is not the answer. I suspect there will eventually be more of a Darwinian end to what we are seeing at the moment – the opportunities for squeezing short sellers will shrink as short-sellers fear the squeeze, which means less opportunities for the social media-driven retail longs. Some will win out of it, others will lose. On the whole, the activity has very little to do with macro or corporate fundamentals.
The cyclical picture
I am not sure any of this is enough to hail an imminent bear market. Monetary policy support (illustrated by real interest rates remaining very low) and expectations of economic recovery remain the key drivers of equity market performance and the lack of volatility in the fixed income markets. I would be more worried about entering a new market regime if real rates started to rise in response to concerns about the growth in global debt levels, or if earnings growth forecasts underwent a significant downgrade on a re-think of the cyclical outlook for the next 12-18 months. We are still in the grips of a global pandemic. The consensus view is that vaccines will pave the way to better economic conditions which is a supportive view for earnings and market performance.
It's another risk
Of course there are risks to this consensus view. It is evident that the roll-out of vaccinations is disappointing in many countries and supply and logistical problems that have been discussed, are showing up in reality. There are also the epidemiological concerns about the infectiousness and deadliness of new strains of the coronavirus. This in turn leads to potentially longer periods of economic activity being below capacity and scarring from a year of rolling lockdowns and businesses being shuttered being worse than we might have thought. The last thing the Fed and ECB and other authorities want, when they are focussed on supporting the recovery, is a financial shock coming from the antics of anti-establishment retail stock investors pitting their wits, and money, against short-sellers. Note that Jerome Powell gave nothing to those looking for the Fed to start talking about tapering. If the going gets tough again, the central banks will ramp up support. Nevertheless, the current environment is a tricky one for investors and analysts alike.
Real yields still low
Supporting the thesis that we are not out of the woods yet and thus it would be foolish to think the authorities would step away, is the fact that 10-year yields retreated over the last week. The US Treasury 10-year yield is back at just above 1.0% after toying with moving above 1.2% in mid-month. Not a big move but it has been in the opposite direction to that suggested by some a few weeks ago. This is even after the market has been coming to terms with more borrowing to support Joe Biden’s “build back better” economic stimulus programmes. The real 10-year yield in the US is 15bps lower than its recent high on 12th January. It has rarely been lower than the current -1.06%.
At the same time the message from the Q4 earnings season has been encouraging. What started with the banks reporting good numbers, has continued with big-tech also demonstrating that it can continue to grow earnings. From the S&P500 technology sector, revenues for Q4 have so far surprised by 7.3% while earnings beat expectations by 20% (of the 22 out of 59 companies reporting so far). Even with high price to earnings ratios for technology stocks, the earnings yield remains more attractive than for bonds and earnings growth is solid. As long as bond yields remain low, these valuations can be sustained and growth stocks will continue to reward. Q4 looks like being the third consecutive quarter for the S&P500 in which earnings surprises have been positive by at least 18%. Of course, it is not all upside surprises, some companies will miss out and some of the guidance might be cautious. Analysts might be too optimistic on Q1 and Q2 given the prolongation of economic lockdowns. Yet growth in aggregate earnings has been encouraging, the economy is expected to expand strongly in the second half, real rates remain low and investor sentiment will likely be buoyed when more countries get to the position that Israel is in today (more than half the population vaccinated and evidence that infection rates are falling quickly).
Talk about expensive
I tried to search on the internet about how many times the word “bubble” is published in articles. One piece I found said that its usage had reached levels that were worrying, just as had been the case in 1999 and again in 2007. Unfortunately, the article was dated July 29, 2014. The S&P went on to deliver another 5.4% total return that year and a 13.5% total return for the year as a whole. There will always be bubbles somewhere and the stock market obsessed might want to consider the German government bond market or 10-year plus maturity, A-rated European corporate bonds with a yield to maturity of just 0.52%. One thing is for sure, if the “bubble” in equities bursts, the “bubble” in bonds will get even more inflated!
I suspect we haven’t seen the end of this “casino-capitalism” story just yet. January’s gains in equity markets have been largely wiped out. We could even get a significant correction in stock markets if the bubble obsession generates panic. I remain of the view, however, that beyond short-term volatility, the fundamentals of low real rates and earnings growth remain powerful. There is cash waiting to be invested and a buy-on-dips response would be my expectation if bond yields and equity prices see further downward moves in the days and weeks ahead.