150 North Main Street
As 2021 has begun, markets and asset prices have continued to march onward and upward. We’ve also seen some frenzied activity in certain individual stocks (i.e. GameStop and AMC) and in cryptocurrency. This has led some to question if this activity in the market periphery is something that they should be concerned about and/or participate in. The overall level of the market is also being called into question by some as we have seen great performance in equity markets in spite of COVID challenges and political unrest and division. In this month’s comments, we’ll explore the following themes and the considerations for investors:
1. Are markets in a bubble? 2. What’s going on in cryptocurrency and should I own this asset class? 3. What do I need to know about GameStop and does it impact me?
Are Markets in a Bubble?
Anytime we experience sharp and sustained increases in markets, individuals reasonably question if prices have risen too far too fast and if we are experiencing a market bubble. The implication of a bubble is that market valuations are not supported by underlying economic reality. In exploring whether or not markets are in a bubble, we need to first determine what drives stock prices. A friend and colleague has insightfully pointed out that over time, EARNINGS DRIVE STOCK PRICES. While we see short term spreads over time, in the long run, earnings drive stock prices:
Stock prices may get disconnected from reality at times (look at the late 1990s), but they inevitably revert to the mean and the mean in this case is earnings growth.
So how do stocks measure up today relative to earnings? A popular measure of how expensive or cheap markets are is price to earnings (P/E) ratio. This metric provides a multiple of how much investors are willing to pay for an equity interest in a company’s earnings stream. High multiples mean a company or index is expensive and potentially overvalued and low multiples indicate a comparative value and/or potential low-quality earnings (earnings stability and/or sustainability is in question). P/E ratios according to the Wall Street Journal stood at the following as of 2/12/2021:
We can clearly see that the tech heavy Nasdaq is trading at very lofty levels as is the S&P 500 which is increasingly dominated by large tech names. The Dow Jones Industrial average has less growth and tech focus and trades at a comparative value, but note that all three indices are trading at much higher levels that they were a year ago (the year ago figure was pre-COVID, so the figures for last year are theoretically free of COVID-related distortions).
Markets are clearly expensive right now (particularly on the growth side) but are they overvalued? Consider the following:
Conversely, there are significant causes for concern. Below are some key ones to consider:
The market is unquestionably expensive, but the question as to whether or not we’re in a bubble is more nuanced and more uncertain. The portfolio prescription for markets like these is hedging one’s bets. Don’t abandon growth, but consider adding value and international. Carry cash for liquidity and for future opportunities, but beware of opportunity cost (markets go up while you’re on the sidelines) and inflation risk (inflation outpacing the rate of return your bank will pay). Fortune favors the bold, but successful investing favors the appropriately diversified.
Cryptocurrency has elicited significant interest over the past several years and has provided a wild ride for those who’ve invested in it. It has made some overnight millionaires and devastated life savings for others. Consider the path over the past three years of Bitcoin, the most widely known cryptocurrency:
The rapid increase in value, the sharp volatility, and the novel nature of the currency has garnered the interest of the financial and popular press and we have fielded questions from clients. Many main street investors are wondering if they should be owning cryptocurrency as part of their overall portfolio of financial assets.
In order to address this question, we need to begin with a primer of what cryptocurrency is. Cryptocurrency is a decentralized, digital, fiat currency based on distributed ledger technology. This means the following:
We have talked about what cryptocurrency is, let’s cover what it is not:
Cryptocurrency’s success is predicated on broad adoption and theoretically benefits if the global currency order is upset or if traditional currencies are debased significantly. While adoption is expanding (Tesla recently indicated that they would accept Bitcoin for payment), we’d likely need to see very dystopian scenarios play out for cryptocurrencies to be a viable competitor for national currencies.
For now, cryptocurrency remains extremely speculative and represents tremendous risk. The problem lies in modelling and valuation. How does one accurately predict the path of a cryptocurrency? With a stock or a bond there are underlying earnings and financials and relevant economic data. Right now, too much of cryptocurrency’s future is based on the “greater fool” theory (i.e., there’s a greater fool out there who will take this off of my hands for a greater price). In the coming years cryptocurrencies may become a more broadly used means of payment, but how this affects the underlying price is unclear. Would you for example, pay a premium to buy Bitcoin and transact if you could simply use dollars? Early adopters may be rewarded, but for now we view cryptocurrencies as too speculative to comprise a material part of portfolios.
Financial headlines have been dominated over the past month with coverage of the rapid rise (and subsequent decline) in GameStop stock. GameStop is primarily a retail outlet that sells video games and has struggled as consumers have pivoted increasingly to online services. They have been operating at a loss for some time and as such have been a target of short sellers. Short sellers place bets that an asset will decline rather than increase in value. Influential and market moving short sellers are often large institutional investors (like hedge funds) with deep pockets and high levels of sophistication. The below graphic shows how short selling works:
In the case of GameStop, the perceived grim prospects by many led to high short interest ratios (significant short positions relative to the number of shares available). The risk of high short interest ratios is that shares become scarce in the event that short sellers need to exit their positions. Short sellers in this position are vulnerable to a short squeeze. A short squeeze occurs when the price of a heavily shorted stock is abruptly bidded up. This forces short sellers to post more collateral in short order or exit their position by buying shares (which bids up the prices even further). GameStop provided an extreme example of a short squeeze as retail investors organized online in a concerted effort to bid up the price of GameStop through coordinated purchasing. The results were catastrophic for short sellers. The below hypothetical example illustrates how the GameStop short squeeze worked in practice:
1. Hypothetical Hedge Fund A has a dim outlook for GameStop and sells 1,000,000 shares short @ $17.25 share ($17.25mm in sales proceeds)
2. Individual investors note high short ratios, (share to cover are hard to come by) and/or better prospects for GME, and/or have a desire to squeeze hedge funds and coordinate purchase activity on Reddit and place orders on platforms like Robinhood, This activity and that of the purchases of hedge funds to cover, pushes prices as high as $347.51.
3. If Hedge Fund A wasn’t able to cover short position until January 27, losses would have exceeded $330mm! Hedge Fund A would likely have been forced to sell well before then, but this extreme event highlights the steep losses that short sellers can be exposed to.
The event raises many questions and here are some of the key points that we have considered:
Does this Matter to Me as an Investor?For most, the answer is no. Most investors own diversified investments with limited single stock exposure. For speculative investors or those with concentrated positions, there is some potential concern. We DO NOT advocate short selling for individual investors.
Why is Short Selling Permitted?Short selling is controversial, but theoretically plays an important role in the market. The ability to sell short provides incentive for investors to dig deeply into companies’ books and activities. This heightened level of due diligence aids in price discovery and potentially helps uncover fraud.
Why Did Certain Firms Cut Off Trading?Certain online brokers restricted trading after the meteoric rise in price. This has elicited swift and sharp responses from some lawmakers and outrage among many individual investors. While we don’t know all the behind the scenes conversations around the rationale for these restrictions, we do know the following (see WSJ, Why Brokers Had to Restrain Trading in GameStop Shares):
1. Brokers can carry liability for the illicit activity of their customers
2. Brokers carry financial risk and potentially face huge losses if shares purchased on margin (with borrowed money) precipitously fall in value
3. Clearing firms require brokers to post large deposits that can go up intraday depending on market conditions
We do not know if any malfeasance occurred in terms of the motivations behind the trading restrictions, but there were clearly legitimate business concerns from a risk exposure perspective.
We will be watching closely to see if the trend of retail short squeezes is an isolated incident or if this becomes a more common market occurrence. This is a very nuanced topic with more questions than answers. Is this just the next natural step in the democratization of investing? Does the activity that occurred constitute market manipulation? Is there a double standard between hedge fund activity and that of retail investors? Has social media been weaponized for finance? It will be interesting to watch these developments evolve.
We look forward to meeting with you in the coming year and as always, feel free to reach out if you have questions on these or other topics.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.Diversification, asset allocation and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.Investing involves risk, including loss of principal. Supporting documentation for any claims or statistical information is available upon request.All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.Registered Investment Advisors with and advisory services are offered through Alliance Wealth Advisors, LLC, an SEC Registered Investment Advisor. The firm only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability. Alliance Wealth Advisors is not affiliated with any other named entity.