Stocks were mixed yesterday in a relatively quiet session. Earnings season picked up with a mixture of winners and losers. But the overall market did little. The financial market headlines centered around the spectacular rise in a few heavily shorted stocks. More on that in a moment. As for the overall economy, trends seem to be improving. Covid-19 hospitalizations and the number of patients in ICUs has started to decline. While the media focuses on new virulent strains of the virus, it appears the vaccines provide protection. They are starting to roll out at a faster clip and will soon be joined by one or two one-shot vaccines that will speed the inoculation process. All good news.
The headline earnings report yesterday came after the close when Microsoft# delivered incredibly strong results, testimony to its own abilities and to the speed at which the world is going digital. We will hear from Apple#, Facebook#, and Tesla tonight. All are expected to confirm the good news we heard last evening from Microsoft. Since Labor Day, these tech leaders have seen their stocks move sideways, while more cyclical names that suffered most during the pandemic surged in hope that the pandemic would end soon. It probably will. But if all the momentum in a stock relates to the end of the pandemic and a return to normal, what happens when normal is here? What growth follows?
Not all stocks are purely cyclical without any growth thrust. If nothing else, a steady 2%+ rise in GDP provides some tailwind. But longer term, which boat would you like to sail on? One that goes 15-20% faster because it has better growth engines, or one that simply lets the current move it forward? Obviously, in the stock market, price and valuation come into play. But my point for now is that a recovery rally tied to a strong but brief economic surge can only go so far. When it winds down, investors will shift back to the boat with a sustainably superior speed. There are lots of cyclical names that will grow 40-50% or more in 2021 simply because they will be comparing quarters after the economy reopens to quarters of lockdown. But a year later, when comparisons are apples-to-apples, then what?
Now I will switch gears and talk about the short squeeze. Let me start with an old saw. The only reason one has to buy a stock is to cover a short position. Selling short means you are betting the price of the stock is going to drop. You sell first, with borrowed shares, and buy back when the price declines. At least that is your goal.
When you buy a stock, at $50 per share, you know what your loss potential is. $50. However, when you short a stock at $50, your loss potential is infinite. If the stock goes to $200, you lose $150, or 3x your investment. If you make these bets with options, you magnify your potential gains and losses. The CEO of Robin Hood, a trading platform used heavily by newer and younger investors, noted that 20 years ago owning a house was the American dream. Now its owning stocks. We all know how the first dream ended. If you read some of the favored Wall Street chat forums, you will see how old geezers like myself are being ridiculed while stocks like GameStop or AMC double literally overnight. These are heavily shorted names without a lot of public market cap and large short positions, a perfect setup for a short squeeze. Several high profile traders are engaging with these newbies spurring them on.
So much for describing what’s happening at the moment. I’ll stop there and not go into the more technical aspects of trading, borrowing stock, and market making in options, all ingredients to this story, but not particularly relevant to long-term investing. What I will note, however, is that while this speculative corner of the market is still fairly small, its impact is starting to spread. At least one hedge fund, short at least one of these stocks, has closed up shop. It won’t be the last. Investors who lose money in these trades will have to sell other assets to cover their losses. Remember, margin levels are at record highs. Thus, don’t be surprised if markets periodically have a fit and fall sharply. If you want to measure speculative fever, Bitcoin may be a measuring stick. The market in Bitcoin is much too large for these newbie traders to dominate. But the sudden rise and fall can measure the current temperature of the market. After rising sharply to $40,000 just a week or so ago, it is now down to just over $30,000. I have no clue whether the next $10,000 move is up or down. I just watch. I wish the degree of speculation would moderate. Certainly, it will when the current bubble bursts. But until then, all I can do is watch.
Of course, the other thing I can do is pay attention to the rest of the market, the parts that trade on fundamentals. That part is doing rather well. Record high prices reflect the optimism. This afternoon the Federal Reserve chimes in. It is expected to acknowledge some improvement in the economy. But it will mostly focus on the slack and the need to continue to pump money in, hoping to push inflation back above 2%. The big question for investors is whether it will offer any hint of slowing down its bond buying program within the next year or so. If not, will it give hints as to what will motivate it to slow down in the future? The answers will come around 2:30 this afternoon.
Stock futures are lower this morning, suggesting nervousness that the speculative frenzy may spill over to the larger market, or some fear the Fed might acknowledge the excess speculation with a warning that may ignite some fears. Past short-term corrections have often followed Fed meetings. So, we need to be attentive.
Today, actress Rosamund Pike is 42. NFL commentator Chris Collinsworth is 62. On this day in 1850, Edward John Smith was born. Who was he? His life ended as Captain of the Titanic.
James M. Meyer, CFA 610-260-2220