In a week when the Dow crossed the 40,000 barrier, a lot of attention turned not to the 30 giants that make up the Dow Industrials but to the so-called meme stocks, names like GameStop and AMC, whose most relevant investment characteristic was probably their elevated short positions. We’ve seen this act before during a more speculative phase back in 2021 at the same time the word SPAC entered our lexicon. Last week saw a mini-version repeat. But just as in the movies, sequels rarely live up to the original.
The concept of shorting stocks with lousy prospects is obvious. But shorting stocks, even those with the worst fundamentals, can be dangerous. To short a stock, one has to borrow shares to deliver to the buyer. Attached is a cost to the borrower. Moreover, the lender can always recall the borrowed shares if, for instance, he or she wants to unload the stock themselves. And, of course, short selling potentially leads to unlimited losses. If you buy a stock at $20, you can only lose $20. If you sell a stock short at $20, there is no limit to one’s potential loss.
The biggest fear of short sellers is a squeeze. When too many short a single stock at the same time, they become exposed if for any reason a surge of buyers emerge. That pushes the price up. Some of the borrowed shares used by sellers get recalled. They have to scramble to find replacement shares to borrow. Meanwhile, as prices go higher, some choose to mitigate losses. They join the buyers and the price escalates further.
In a game of cat-and-mouse, traders look for unusually high short positions in a stock with limited float. That’s the set up for a short squeeze. So, when one prominent investor who was behind the original surge in GameStop and AMC said now was the time to buy the two again, all the ingredients fell into place for another short squeeze. History never repeats itself but often rhymes. Last week’s romance with the meme stocks was more a side show than a full-fledged repeat of 2021. And there was no accompanying chorus of SPAC offerings. But that doesn’t mean the action had no meaning. Speculative fever hasn’t been suppressed. It keeps reappearing in various forms. It’s fair to say that much of the speculation has occurred outside the mainstream of serious investors. The meme stocks appear to have attracted unsophisticated investors more likely to follow Reddit than CNBC. Last week, as the big institutional investors reported their holdings as of March 31, you didn’t see anyone gobbling up bitcoin much less the meme stocks.
Therein lies the real tale. If one simply looks at the economic world today it actually looks rather good. GDP is growing at a normal sustainable rate of 2-3%. Inflation is still higher than most would like, but it is moving in the right direction albeit a little slower than central bankers would hope. Unemployment remains below 4%. Immigration is stoking growth in the workforce even as more and more baby boomers retire. In simple terms, Americans do seem worried. And if they aren’t worried with money coming in every week, they spend. Most of the excess savings built up during Covid has been spent. But as long as workers have their jobs and don’t fear losing them, they will continue to spend.
That doesn’t mean all is perfect. Without the excess savings, they can’t spend at the pace they were spending last year. Or so it would seem. But airplanes are full, cruises are experiencing record bookings, and Taylor Swift is still out there performing. Yet, there are cracks. Housing prices are teetering. In some markets, they are starting to fall. Housing starts are OK, but existing home sales are not. Auto sales have been OK as well but dealer lots are filling up and the appetite for new electric vehicles is slowing down. Many retailers and restaurant chains report slower traffic. Even in technology we are seeing some pause. Those providing AI services, like the cloud companies and the semiconductor companies feeding the cloud are still doing well. But corporations are slowing their growth in spending as they assimilate the benefits AI is offering in real time. In English, the time to make a major commitment to AI investments is taking a bit longer as corporations stretch the decision making cycle.
There are other trouble spots as well. While Congress passed a huge infrastructure spending bill a couple of years ago, spending hasn’t accelerated as many have hoped, as the permitting process continues to be measured in years, sometimes even a decade or more. You would think defense spending would be taking off given the wars in the Middle East and Ukraine and the need to upgrade our capabilities across the defense spectrum. But, again, red tape and delayed decisions get in the way.
Finally, there is red tape. If government is involved at all, companies have to answer whether planned initiatives are green energy compliant, whether enough components were produced in the U.S., whether employment was properly diversified, or whether any steps were anti-competitive. Additional reviews and regulation have added time and cost to many projects.
We face a big election this fall. Markets have risen both during the Trump and Biden administrations. The message would seem to be that investors are indifferent. In all likelihood, central bank actions and other factors are more important to corporate performance than who is President. But Presidential election years are not often great years for the market. So far, 2024 is an exception. My guess is that investors prefer Donald Trump based on an expectation of lower taxes and less red tape. Yes, I get all of Trump’s baggage and, before you yell, I am taking no sides here. I am only talking the market. While polls favor Trump slightly, the election is too close and too far away still to have major impact on markets. Corrections are born out of some fear including stubborn inflation, a confirmed growth slowdown, or international tensions with major economic implications.
Without major headwinds, good companies find ways to make money in most environments. If the rules of engagement change, they adapt. For most, the external environment may be important but what happens inside is far more relevant. How does one react to competition? How does one offset rising costs? What new opportunities come from innovation? How well can one execute?
There are times, in deep recession or during pandemic induced quarantine, when the externals simply overwhelm most companies. But those times are rare, and now is clearly not one of those times. Thus, while red tape, a slower economy and inflation can create some headwinds, managements simply need to deal with them and find ways to move ahead. When times are tough great companies virtually always gain market share. McDonald’s and Wal-Mart have been doing it for 50 years!
The only thing to really fear at the moment as an equity investor is valuation. Too many bulls and not enough skepticism. That will self-correct over time. When, is an unanswerable question. I am not talking about the need for a major bear market. If you own the right stock, it might not even matter. This isn’t a market to be feared. But it isn’t one to be chased. Be patient, pick you opportunities, and enjoy the ride.
In a world where we all have choices of what to do with our money, we ultimately choose the option with the most favorable risk-reward ratio. The Federal Reserve has made it clear that it wants to start cutting interest rates. While the questions of “when” and “how quickly” remain open, the specter of lower rates emboldens investors to take more risk. Clearly that favors stocks. On the other hand, equities sell at more than 20 times expected earnings, 10-20% above historic norms, while at the same time, fixed income instruments sell closer to historic norms. Reversion to the mean is inevitable over time.
Besides valuation, what are the real risks today? There are probably two. One is that the economic slowdown morphs into a recession. The odds of that happening keep coming down but they are still elevated compared to history. The second is when the massive debt levels accumulated by sovereign nations, led by the United States, will have a deleterious economic impact. No one knows. But as the world witnessed a dozen years ago in Europe, too much debt can cause serious harm. Neither Democrats nor Republicans show any signs that they want to restrain spending. Both candidates have declared entitlements untouchable. Each would spend in different ways but both have shown no spending restraint while in office. This is not likely to be a 2024 concern for markets.
Few expected a depression in 1928. Few anticipated a financial crisis in 2007. The seeds were there. Most were even acknowledged. Subprime mortgage lenders started going bankrupt in early 2007. Right now, investors are focusing on the promises of artificial intelligence, the thoughts that AI will increase productivity at a pace that hasn’t been seen since the inventions of the car and passenger plane. But too much optimism isn’t a good thing. Just think back to the Internet bubble of the late 1990s. Indeed, the Internet was bound to change our lives. But the path forward was a lot rockier than perceived in 1998. Too much skepticism leads to bad decisions. But a healthy dose of skepticism avoids big mistakes. As the Dow crosses 40,000, enjoy the ride. Just recognize it isn’t a one-way road. The world is complicated. Focus on what might happen. Don’t dwell on the negatives, but don’t ignore them either.
Today, Cher is 78.
James M. Meyer, CFA 610-260-2220