GameStop (GME) shares traded at an average price of $13 during 2018. The stock fell precipitously between mid-2019 and mid-2020, hovering around $5 per share. At the end of 2020, a sharp rally pushed the shares to $19 by year-end. But that was nothing. By mid-January the stock hit $30 and then jumped to $65 by January 22. The progression during the five days from January 25 to January 29 was something to behold: $78, $148, $348, $193, and the stock ended the month at $325, up 1,600% since the start of the year. And predictably, recently the shares have plunged by 85%.
GameStop wasn’t alone. Stocks with an extremely high short interest were stampeded by a group of social media-inspired investors (note: short interest is a measure of shares sold against shares outstanding; selling shares short is a way to capitalize on share prices moving down no period here should be after). A record amount of call options supercharged the stock price and forced those investors who were short to cover at increasingly higher share prices. The situation was compounded because orders were placed with broker-dealers who suspended trading in order to meet the minimum capital requirements of the Depository Trust & Clearing Corp (DTCC).
For those of us who were managing money during the dot-com era, the story had a familiar ring to it. The last stock market bubble formed when a new generation embraced equity trading as a cultural phenomenon. Are we seeing history repeat itself, as younger cohorts live vicariously through online risk-taking brought on by the pandemic? Is this a sign of the top, or much ado about nothing? The answer, of course, is not a simple “yes” or “no.” Yes, the disorderly sequence of events has implications for market structure and oversight. But, more importantly, no, we do not? believe investors should adjust their financial plans based on fortunes made, and lost, in GameStop. Quite simply, there are more important forces at work.
For those who have been following our weekly market updates (click here to see the videos), you will be familiar with several of our key concerns and opportunities. Since the beginning of the pandemic we stated that the retrenchment in economic activity, while necessary, is self-inflicted, not structural, and prone to snapping back as re-opening resumes or vaccines enter the narrative (see The Road Back, Resilient, or Delusional?, Escape Velocity, Navigating the K-Shaped Recovery, Election Vexation, Back To Basics, Inoculating The Unprecedented and New Year, New Leadership? here).
We also wrote last month that despite the volatility it is important to maintain a disciplined approach to investing. A new year brings with it promise of normalization in many facets of the capital markets, several of which are materializing with pronounced sector and industry rotation. We noted that investors are continuing to discount what a backdrop may look like six-to-twelve months from now. We expressed confidence a vaccine can take us from pandemic to panacea, towards normalcy and away from some of the uncertainty.
January was a mixed month. The S&P 500 closed in negative territory, but other indices, including small-cap and international markets, closed higher. Former laggards continued to pick up relative strength (e.g. materials, financials, economically sensitive groups like energy, etc.) as the recovery broadened. Recently, investors have begun to question the outlooks for key drivers of positioning (e.g. low interest rates, low inflation and economic growth, the extraordinary success of the technology sector vs. ongoing headwinds in the financial and commodity sectors, etc.). We noted last month that there is ample room for rotations within the market to continue. We are sticking with that view.
At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases from the equation and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental and macro analyses indicate. Currently, our short-term metrics are in a neutral position. Long-term trends, influenced by our recessionary and bear market views, are? increasingly painting a more optimistic picture (positive).
For us, the macro discussion centers around policy. The world’s central banks (e.g. the Fed, the ECB, etc.) have provided the monetary fuel to help boost the recovery. Low interest rates, a series of government support packages and a commitment by the Fed to highly accommodative policies have buffeted the pandemic shutdowns and laid the groundwork for the recovery. They will continue to be tailwinds well into 2021. While the Fed is anchoring short-term interest rates, longer-term rates are sniffing out a recovery and are pushing higher.
Inflation expectations have increased as signs of a global economic recovery increase. Consensus forecasts for global GDP growth in 2021 is almost 6%, the highest in many decades. Inflation has been relatively non-existent since the Global Financial Crisis (arguably for 40 years), and is worth watching in 2021. Many macro indicators are adjusting (e.g. the yield curve steepened last month to the widest level in three years, TIPS inflation readings broke out to seven-year high, Brent oil touched $60, etc.), but we feel broad measures of inflation look contained.
We welcome any narrative shift from deflation to inflation as we? feel the market can handle higher interest rates. After all, Treasury yields have been in a bull market for nearly 40 years since peaking at 16% in 1981. We are encouraged by the prospects of an economic ‘reopening.’ Vaccination trends are promising, and hospitalizations are declining faster than projections.
The current technical backdrop remains in good shape, although many of the short-term metrics we monitor are a bit stretched (e.g. put-call ratios are low, the percentage of stocks trading above key moving averages is high, etc.). Encouragingly, market breadth is expanding, and the highly concentrated market of 2020 continues to ease. A broad market is a healthier market, so we welcome this development.
Despite the move back to all-time highs, we still don’t think investor sentiment is euphoric. We sense healthy skepticism. There are still trillions of dollars in money market funds and, despite the advance, flows into equities are far below those of bonds and cash. The strong price moves of late increase the odds of a technical consolidation, but we feel pullbacks present opportunities to deploy capital for the long-term.
Fundamentally, we are focusing on the trend in corporate profits and credit metrics. Earnings estimates continue to be revised higher and we suspect 2021 will end with profit levels at record highs. Valuations are stretched in some pockets of the market, but only slightly above long-term averages in others. Valuation dispersion is at record levels with a big gap between “haves” and “have-nots.” During the recent rotation, it’s the “have-nots” that have benefited most. It is worth noting that historically low interest rates make the earnings yield offered by stocks attractive relative to bonds and provides a strong counter-point to any valuation concern.
The credit backdrop has improved with both investment-grade and high-yield spreads vs. Treasuries back to pre-pandemic levels. Because continued tightening here is consistent with a rally in stocks, it has been encouraging to see. Dividend reinstatements (or increases) are now running well ahead of dividend cuts. As corporations’ confidence in their outlook continue to improve, we expect share buybacks to follow.
The disorderly trading of GameStop and other highly-shorted stocks has revealed market structure vulnerabilities that are sure to be reviewed. The sequence of events is a reminder that investing is often not the study of finance. It’s the study of how people behave, and sometimes that behavior is astonishing. Disruptive innovation also played a role here, as free trading apps and social media have empowered a new sort of trader. Add in the pandemic (and shut-ins), and the recipe for non-linear outcomes increased. While we are mindful, we see isolated risks with little if any systemic follow-through.
Our investment philosophy is based on a dual mandate of growing, and protecting, client assets. With our cash positions now residual in nature, we are focusing on strategy positioning vs. our respective benchmarks to control risk. We have championed a ‘barbell’ approach by investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a recovery. Should our base case hold, we plan to maintain our steady positioning. Of course, should the backdrop start to de-stabilize, we will take a more defensive stance.
Given the volatile and ever-changing backdrop, we believe a strategy that combines disciplined fundamental, technical and macro analyses has the best chance of generating superior risk-adjusted returns. While our forecasts are subject to revision, our commitment to client service is rock solid. Should you have any questions, please reach out to us. We are happy to share our thoughts in greater detail and welcome your questions or comments.