These Shorts Are Uncomfortable
If you have been following along Wall Street’s latest wall of worry you have learned the a “short squeeze” has nothing to do with how comfortable your Fruit of The Looms are. Millions of small retail and mostly new investors have been getting the better of Wall Street hedge funds, with synchronized social media buying of heavily shorted stocks dealing massive losses for those betting against certain companies. These investors have targeted those who have taken bearish bets on failed business models and COVID causality companies like GameStop (brick and mortar video games sales) and AMC (movie theaters) respectively.
Let’s first look at “shorting” a stock to better understand how investors can get squeezed.
Along with buying a stock because you think the company will grow, investors can bet against a stock because they think the company’s stock price will go down. This is called shorting the stock. Shorts borrow shares of stocks they expect to fall, with the expectation that they’ll be able to buy them back at a lower price and return them to the lender at a later date. But when stocks start to rise, short sellers are under extreme pressure to buy, because they need to cover their positions and they don’t want to have to buy at even-higher prices. As short sellers panic, the buying pressure grows and the stock soars.
Short selling is expensive and risky, given that it’s often costly to borrow shares, losses are theoretically limitless as stocks can rise indefinitely. And the idea that the Hedge fund bullies have ruled the markets with this tactic is actually not accurate. Annual returns for equity long-short hedge funds over the last five years have ranged from negative 3% to a gain of 9%, according to BarclayHedge. Over that same period the S&P 500 has returned 15% annualized.
The synchronized buying through millions of small investors from social media sites like Reddit and on platform such as Robinhood have push select failing companies stocks far beyond fundamental value and thus forces the short sellers to contribute to the buying of shares in order to “cover their shorts”. For those buying these companies the trick is to leave the rocket before it runs out of fuel and comes crashing back to earth fast and furiously.
Currently the vulnerable are just a few dozen stocks with extremely high short interest due to their individual company or sector circumstances. While it makes good headlines, the broader market is not vulnerable to these hijackings.
So how long can these short squeezes prop up these struggling businesses? Well for one thing it will require a constant surge of new buyers to support this ongoing squeeze. As investors lose interest, take profits and move on, the shorts (those left breathing) will eventually prevail. One would think that the shorts on these stocks would evaporate but the actual short interest on GameStop has just about maintained pre frenzy levels. There are still billions of dollars’ worth of shorts that do not think a GameStop with a one-year price target of $13.44 should be trading at $281.
Because short squeeze attacks are singularly focused on companies and not markets, a broader market contagion remains low. In the meantime, the little guy wins until it hurts.
The recent market decline is healthy. The S&P 500 has not looked back since the November vaccine announcements. It is lazy reporting to associate short squeezes with the market’s recent correction. Since 1920 the S&P 500 has on average recorded a 5% correction three times a year, 10% correction every 16 months and a 20% plunge every seven years. It’s the 5% and 10% corrections that keep the plunges at bay and keep the novice investors honest with their abilities.
What has always worked long-term is to build a financial plan, then construct a portfolio based on that plan and to stay invested.
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