GameStop. Robinhood. Reddit. Short squeeze. Hedge funds.
Should investors be concerned? No, we don’t think so.
As recent events have highlighted, certain trends have come to a head and created an environment that, in our opinion, cannot be ignored.
The story of how an army of retail investors almost upset the Wall Street applecart seems to have started with technology and good intentions and, as of today, the story is still being written. How future chapters unfold could have some implications on how markets trade (at the margins) going forward.
The democratization of the markets is arguably a good thing. Over the years, stock commissions have collapsed to zero and technology has enabled many to trade from the phone in their pocket. However, add to this movement COVID down time, government stimulus checks and growing social media “third places,” and the environment was ripe for unusual trading activity to occur.
Not only are small traders more active, but it is now possible for them to trade for free and trade in partial shares. Now, get all these liberated traders onto a social media platform like Reddit – a platform with the power to bring about a sense of community, an all-for-one-and-one-for-all mentality and a sense of being part of something bigger (Psychology 101) – and you have what is arguably one big player in the market. This likely is not something ever envisioned by Wall Street or the regulators This is the collective player that targeted GameStop (ticker: GME) stock and drove it from $18/share to over $300/share, forcing hedge funds that were short the stock to lose massive amounts of capital.
Technology and trade settlement
For how much technology has changed how people can trade, the infrastructure through which these trades settle and change hands has changed very little over the years. When a stock is bought or sold at any brokerage it goes through the clearinghouse system. This is the system that makes sure cash and shares get to the correct accounts. It is dominated by a few big players, including DTCC and National Securities Clearing Corp.
Up until 2017, this process took three days to settle. In today’s day and age, it surprisingly still takes two days to settle. Herein lies the issue. Brokers are required by the clearinghouses to have reserves on hand in case a party in a stock trade cannot make good on the trade over that two-day settlement period. As certain stocks get more volatile, the clearinghouse can require that brokers increase these reserves to cover potential issues in settlement. This is where Robinhood found itself one morning last month. The clearinghouse demanded an additional $3 billion from Robinhood due to the concentration of account holders owning very volatile stocks. The brokerage, with a little help from its friends, was able to make the margin call… this time.
As to whether we see risk (read: volatility) increase in stocks, the answer for the time being is, yes. Importantly, this should be contained to specific stocks and will likely occur over short time periods.
At the end of the day, and over any reasonable length of time, corporate earnings should be what matter to holders of stock. As a reminder, a stock is an ownership interest in a business, entitling the investor to a share of profits. BSW believes that investors will always have the edge over traders. Traders are gambling on the short-term supply and demand of a stock – a tricky proposition at best!
BSW has exposure to domestic index funds that hold baskets of hundreds, if not thousands, of stocks. The potential that one of these “targeted” stocks is included cannot be dismissed. However, with most of these Robinhood-type stocks being smaller cap in nature, even large movements would have minimal effects on near-term returns. I say near-term because the likelihood of a GME stock remaining at elevated levels generally centers on earnings. Again, using GME as an example, it is currently included in the iShares Russell 2000 index fund at a weight of 0.13%. For an order of magnitude gut check, even a 50% move either way in this stock shakes out to just a 0.065% move in the iShares fund.
Within the active funds in which BSW invests, we have not seen evidence of short-term trading anomalies. Should this happen, we believe our managers would take advantage of the situation by selling at inflated prices, or visa-versa, buying at overly depressed valuations – all with a longer-term view anchored to actual company profit prospects.
What is BSW doing about it?
Noise aside, we will be monitoring the situation for signs of stress within the system. We know from experience that regulators, Treasury, and the Federal Reserve value stability in the financial system and will go to great lengths to plug any weak spots. We believe there is a high likelihood that there will be regulations coming down the pike. Let’s also hope that tech can eventually improve the settlement to same day or next day settle. Maybe a use for blockchain?
Risk has always been part of the market narrative, however it’s usually large banks, hedge funds or institutional trading desks at the heart of these worries and not traders with screen names like “RoaringKitty” or “uYungBillionaire”. BSW will stick to valuing stocks on corporate earnings and investing for the long run, thank you very much. RoaringKitty can continue to have fun… although we believe similar odds can be found in Vegas; and last I checked the drinks are free if you are gambling!
Thanks for Reading,
Craig Seidler, Director of Public Investments