In what has been one of the more bizarre four-week periods in the market, the market prices of equities have been skyrocketing and volatile in companies heretofore thought to be shells of their former selves and on their ways to oblivion. What are we to make of the insanity that led to daily market volume surpassing even that of notable panic days such as the COVID-19 crash last year and the Lehman Brothers failure in 2008?
At a high level, what happened?
Many small investors began buying shares of low-priced companies that were the subject of other investors positioned for those stocks to go down (investors positioned for a stock to fall are called “short sellers,” and their position is dubbed “short the stock.”). When the price of those stocks rose substantively enough, the short sellers began to unwind their short positions via buying the stock, which caused the stocks to rocket even higher in what is commonly dubbed a “short squeeze.”
Did anything illegal occur?
No. What these investors did is legal. Moreover, what they did was not so outlandish. Buying stocks that have been the subject of heavy short selling is anything but reinventing the wheel and is not exactly an innovative strategy. Though fraught with risks, it has been utilized routinely by savvy market participants throughout market history.
Putting aside this specific episode, why does this strategy work in general?
When investors sell stocks short, they borrow shares and sell them in anticipation of the stock declining, at which point they purchase the shares and repay those shares to the lender. Think of it as “sell high, buy low” rather than the usual mantra of “buy low, sell high.” It is the same idea, but the order of buying and selling is reversed; rather than buying a stock in anticipation of it rising, at which point it is sold, the investor sells the stock in anticipation of it falling, at which point the stock is then purchased.
It seems like it is merely a matter of preference whether investors choose to “buy low, sell high” on stocks they believe will rise (i.e., buy long and then sell long) or whether they choose to “sell high, buy low” on stocks they believe will fall (i.e., sell short and then buy to cover the short). However, there is a crucial difference. When investors buy a stock on the thesis that it will rise, there is not necessarily a pent-up demand to sell the stock. In theory, if the stock price rises at a modest pace and the company continues to grow earnings, investors may decide never to sell the stock (Of course, practically speaking, herd behavior dictates that investors will pile in and pile out together, so the stock will receive differing levels of inflows and outflows throughout time). Put differently, just because investors buy a stock, such purchases do not necessitate an eventual sell.
Conversely, unlike long investors who never have to sell the purchased stock, investors who sell short must eventually purchase the shares they borrowed, lest they default on their securities loan (the one relatively rare exception is if the company goes bankrupt, in which case the investor never has to purchase the shares because the stock is worthless). As a result, if the number of shares sold short, called “short interest,” is high relative to the number of shares outstanding, then there will be a large pent-up demand to buy the stock.
If the price of the stock begins to rise as a result of investors buying the stock (these buyers could be organic buyers getting long or some short sellers beginning to cover their short positions), people in short positions may begin to panic and buy to avoid watching profits disappear or losses grow. Such buying lifts the price further, which further worries those who remain short the stock, which begets more buying, and so on and so forth. The short investors get “squeezed” as they scramble to purchase a relatively large number of shares (i.e., number of shares that need to be purchased relative to the number of shares that exist).
Is short selling good for the market?
Short sellers are an important part of the market. Firstly, they create liquidity via their sales and subsequent purchases. Secondly, they stop the market from going up too fast by selling shares they deem to be overvalued. Thirdly, they are often the buyers during decline, which helps moderate the declines. Put differently, if there were no short sellers serving as sellers in up markets and as buyers in down markets, markets would likely be more volatile as they would go up faster and down faster.
Short sellers are often correct in their theses about the prices of specific stocks being overvalued relative to fundamentals. This could be because they see the company’s financials differently or because they sense some sort of fraud. Regardless of the underlying cause for their bearish posture, short sellers are generally swimming upstream because markets tend to trend up. So, they generally have strong reasons for positioning for a stock to decline, and frequently their theses play out.
Short selling seems risky. Why would anyone do it?
There is a higher hurdle rate, or minimum rate of return, for selling short because interest and dividends have to be paid on the shares to the lender while the short seller maintains the short position. Having said that, in and of itself, short selling is generally not as risky as is made out to be. What may make short selling risky is that in some cases, short positions against a particular security can get aggressive, as defined by a high level of short interest. Higher levels of short interest translate to higher levels of eventual purchases, which presents a risk to the short sellers. Like in any form of investing, risk management is paramount. If simple long investors put all their money in one stock, this would also be extremely risky. If appropriate risk controls are in place, short selling can be fruitful.
Can we get into more specifics about what happened with GameStop and several other securities?
Firstly, we would note that short squeezes causing stocks to go up large percentages happen relatively frequently, especially on event risk like earnings reports or important announcements, where short sellers get caught flat-footed by updated information they were not expecting. We should also reiterate that these were not the first violent short squeezes in history. Squeezes of these magnitudes are relatively few and far between, but they do happen. The most famous example in recent times is perhaps Volkswagen stock in 2008, when the stock briefly became the most valuable company in the world even though it had been teetering on the brink of bankruptcy as a result of the Global Financial Crisis. Similar examples occurred with KaloBios Pharmaceuticals in 2015 and Piggly Wiggly in 1923. So, again, this is not a new phenomenon.
The short squeeze this time was a little different in terms of the dynamics that led to the squeeze, specifically:
- people bored at home and locked down,
- excess liquidity from the Federal Reserve,
- easy access to commission-free trading, and
- easy access to pervasive information.
In this case, a group of home traders congregating in a Reddit community banded together to start buying the stock to a level high enough where the panicking short sellers themselves would be forced to begin buying to stem their losses.
Of course, when the short sellers have been liquidated out of their positions, then there are not many organic buyers left. Naturally, the stock is then destined to drop precipitously, which is exactly what has happened. We have more on the role of liquidity in this incident in this follow up blog.
What does this mean for Robinhood?
To be fair, Robinhood was not the only brokerage that imposed trading restrictions; the other notable example was Interactive Brokers. But Robinhood is likely in more trouble because of the decision they made to halt all trading in the stock. They could have slowed trading by raising margin requirements, but they chose to halt all the buying, which likely leaves them subject to litigation from all sorts of parties who feel they were harmed in the situation.
Additionally, they are raising money from investors to cover margin they need on reserve with their clearing brokers. This is because if their traders cannot fund their losses in margin accounts, then Robinhood is on the hook for those losses per agreements with their clearing brokers. Interactive Brokers has a larger capital buffer to absorb potential losses, as they are a public company and are more diligent about their capital requirements. Usually, the losses in margin accounts needed to be covered by brokers is relatively de minimis because if a stock is dropping relatively slowly (or for short sellers, if a stock is rising relatively slowly), the brokerage can issue a margin call to the clients, allowing them to either put more money in their accounts or to liquidate their position in what is normally an orderly market. But in the case of a stock whose price is moving so violently in such a short period of time, Robinhood did not have time to issue these margin calls in advance of the stock reaching levels that make many of the margin accounts insolvent, both on the long side and the short side. And for those insolvent margin accounts, Robinhood is on the hook to lend out the securities in those accounts via agreements with the clearing broker as part of the lending agreements they have.
What does this mean for the equity markets?
Let us start with these individual stocks. This was just a huge market inefficiency that many were trying to exploit, both on the upside and the downside. Investors seeing a stock overly shorted see an opportunity to squeeze the short sellers. Then, after having squeezed them, with the stock having run up 20x from trough to peak in January, the buyers bail, leaving the stock to collapse 80% in four days. In the end, the stock will find its intrinsic value, and along the way, while some investors may have done well, the majority will have ended up sustaining large losses, both the short sellers on the way up and the long holders on the way down.
In terms of the overall market, right now the concerns are limited just to these stocks and there is not systemic concern. However, theoretically this could become a systemic concern if the amount of notional dollars in play became large enough. In the end, counterparty trust and associated liquidity risks become a big deal in situations like this. Think back to 2008 and Lehman Brothers - as soon as financial partners sensed there was risk to Lehman’s balance sheet and that they could not trust them as counterparties, all liquidity was pulled, and they were finished. The irony is that it is easy to access liquidity when it is not needed, but the moment you need it, it often gets pulled. That seems to have been (and perhaps continues to be) the case for Robinhood owing to overextension of their margin buffers with their clearing brokers. This seems to be isolated to them, and therefore the risk of systemic crisis is low. But, again, theoretically, if this type of activity encompassed enough securities, thus encompassing enough brokerages, then systemic risk could be on the table. But we do not see this as the case, especially with the fervor seeming to be withering as the volume and volatility of the stocks is lessening.
What does this mean for portfolios at Balentine?
This means nothing for Balentine portfolios. As always, we continue to structure portfolios to understand client goals and follow our process in doing so. Despite the disproportionate amount of press coverage this episode is receiving, all of this insanity is merely noise in the market relative to our process. Clients can sleep easy at night knowing that risk management is paramount in our process and that our portfolios will not be substantively affected by market noise such as this.