Where Are We?
Last week the media was full of the GameStop saga and there was plenty of talk about the stresses this was causing to the entire financial system. Apart from the headline grabbing reports, what happened with GameStop et al was entirely normal behaviour from the general public.
To summarise GameStop; a group of mostly younger investors decided that they would buy shares in heavily shorted stocks and try and cause a ‘short-squeeze’. This happens when people take a negative view towards a stock and they sell with the hope of buying the shares back at a lower price.
If the shares start rising, the short sellers have to buy their positions in the market and if there is enough competition, the price can zoom higher.
GameStop shares were doing nothing until the Reddit sub-group started buying. The short squeeze plus some manic buying saw the shares hit US$347 just over a week ago. A hedge fund had to close their position and it cost them US$3bn. The platform that saw most of the buying traffic, RobinHood, also had to cough up US$3bn as they had to cover their exposure to the clearing house.
When RobinHood restricted buying on GameStop and some other stocks it limited their risk. However, it also meant the retail army lost buying momentum and the selling started.
We can see from the chart below that GameStop has fallen hard just like all the financial bubbles in history. From Tulips to South Sea Company and internet stocks of the tech wreck in 2000, the end result is always the same.
The people who entered at the last stage of a market suffered the most. They suffered because they lacked knowledge about how markets worked. Given that the participants in a market rely on each other to provide liquidity and ensure a smooth process in settlements, it was no surprise that RobinHood moved to protect their own interests.
The same thing happened in the Silver market when retail investors tried to push Silver higher to start a short squeeze. Apart from the fact that the hedge funds were net long, the Chicago Mercantile Exchange quickly increased their margin requirements by almost 20% overnight.
Small players were forced to quit their positions and Silver was back to where it started in one day.
Let’s take a look at behaviour that is typical of a mania and what can you do about it.
Share Price v Earnings
Ordinarily, the market operates within a standard field of share prices and company earnings. The average Price to Earnings (PE) ratio over a long term for Australia is around 14. Currently the S&P 500 has a PE ratio of 39.2.
According to the Shiller PE ratio, which is cyclically adjusted, the only time this measure has been higher, was back in the year 2000. Note that the current ratio is only marginally lower now.
IPO activity rockets
Companies raised more than US$60bn in 2020. Only 19% of the tech stock offerings were for profitable companies. That means 1 in 5 tech-related offerings were unprofitable.
Special Purpose Acquisition Companies raised US$76bn and they don’t even have a business.
Day Traders rise again
We have already mentioned the frenzy in GameStop. The retail crowd is being enticed by easy to use trading platforms into leveraged products, especially Options.
The massive increase in Call option buying over the past 5 months by the retail sector is a mug’s game. They have been piling into 4 week Call options, predominantly on the S&P 500 index and watching their cash disappear.
Early Warning Sign
The VIX is often referred to as the fear index. It rises fast when share prices plummet and vice versa. There is also a measure of volatility that uses a ratio of volatility of the VIX itself. In other words, when markets are extremely complacent, the fear subsides and complacency results.
Take a look at the chart below. Conditions are appearing that are similar to February 2020. Whilst we can’t rely exclusively on past performance, we know that humans behave the same way under pressure.
If we are facing the same conditions as last year, it would be a sensible move to either lighten your exposure to shares or hedge positions via stock or index Puts.