Last week’s extraordinary surge in brick-and-mortar videogame retailer GameStop came to an abrupt halt this week. By Thursday’s close, the stock had lost nearly 90% of its January gains.
The rally initially started as an act of rebellion by average-Joe day traders against hedge fund short-sellers. However, herd behaviour soon took hold, with individuals tripping over themselves to get their cards in the game. The highly sensationalized reporting of the story by major news outlets undoubtedly amplified a fear of missing out – a common attribute in effervescent markets. The relative few speculators boasting enormous initial gains further fueled the participation fire (at increasingly egregious prices). With nothing but human psychology backing the stock price, individuals soon scrambled just as quickly to minimize their losses. The appeal was never in any underlying fundamentals. The appeal was in the game itself.
“Beware taking financial cues from people playing a different game than you are.” – Morgan Housel
In his book, The Psychology of Money, Housel dedicates an entire chapter to how bubbles form, why it is important to determine which game you are playing, and the importance of not deviating – regardless of the noise around you. He suggests that investors are prone to unknowingly taking cues from other investors that may be playing a very different game than their own – for example, when long-term investors shift to playing a short-term investors’ game, like we witnessed last week. Bubbles can then form as the momentum from people chasing short-term returns increases.
It’s important to note that short-term traders are governed by different rules; valuation is ignored because it is not relevant to their game. Those who locked in profits early on may have had success in their brief GameStop stint, but the damage for other late entrants – left with an overvalued stock and no one who wants to buy it at that price – may be severe. Housel points out that no one wants to believe that they own an overvalued asset, which is exactly what can lead to even frothier markets.
As fascinating as the events over the past couple of weeks have been, these heavily shorted stocks, even at their peak, represent a mere drop in the bucket that is the $42 trillion US stock market. The Wall Street Journal reported that by January 27th, the most shorted stocks only accounted for 0.17% of the S&P 500. The more meaningful outcome may have been the trickle-on effects for some of the S&P 500’s top constituents, such as Apple and Microsoft. As hedge funds scrambled for liquidity, they opted to sell some of these mega cap stocks, resulting in a temporary year-to-date loss for the S&P 500 (which has since been recovered). This speaks to heightened volatility and highlights how vulnerable the broader markets are right now, particularly for passive investors. It is fair to expect this type of behaviour to continue.
Despite these troubling signs of weakness, we take comfort in knowing that our disciplined, risk managed approach to investing keeps us from jumping into the wrong game. We are confident in the positioning of our funds relative to the overheated broader market. Not only do our funds represent better underlying value, but we believe the tailwinds are in our favour for attractive future returns. That is a game worth playing.