What Does the Buzz Mean for Markets

Article originally posted here by Ronald Blue Trust

by Ron Blue

The meteoric rise and fall of stocks like GameStop and other favorites on Reddit captured everyone's attention earlier this year. No one imagined that mostly amateur investors could drive a beleaguered retailer's stock price up more than 1,000% in a week, without any notable reason for renewed optimism in the company's prospects. The stock soared as large crowds of mostly individual investors rallied around the idea of fighting back against Wall Street by purchasing stocks that hedge funds had placed large bearish bets on. Incredibly, these individuals succeeded in causing some hedge funds to exit their bearish positions at large losses, which fueled the rally further. (This event is known as a short squeeze.)

As GameStop surged, the S&P 500 sold off while hedge funds de-risked their portfolios and concern grew that this manic investor behavior might indicate a broader stock market bubble. However, within a couple of days GameStop's stock price retreated, almost as quickly as it rose, and the stock market rebounded.

While the speed and size of the speculative rally that GameStop (and other stocks) briefly enjoyed were unprecedented, we do not believe this or other "micro bubbles" should concern long-term investors. More specifically, we don't believe the surge in speculative trading activity by individuals pose a systemic risk to the financial system. Instead, we believe the GameStop scenario is symptomatic of two things: the current macroeconomic environment and technological innovation.

The macro backdrop is characterized by high debt levels, which are restraining economic growth. Slower growth has driven interest rates down, and lower interest rates have caused valuations of financial assets (like stocks and bonds) to increase. Consequently, the future returns for almost every asset class are below long-term averages. Additionally, because ownership of financial assets is uneven, wealth inequality was exacerbated by the surge in asset prices. This combination of lower prospective future returns and wealth inequality set the stage for opportunistic risk-taking.

When the virus came along it made matters worse by shutting down businesses and spreading the economic pain in a more acute and uneven way. As the government distributed relief checks, consumer savings actually increased--something we've not seen before in a recession. Fiscal stimulus has helped stocks go higher, lending credibility to the belief that stocks (or "stonks" as many jest) only go up. Although we know that is a flawed perspective, it is the fuel driving participation of some investing crowds today.

At the same time, technology has increasingly equalized access to financial markets. Trading fees have gone to zero, in many cases, removing one of the hurdles to frequent trading. Fractional share trading has given even the smallest traders access to expensive investments. Trading apps like Robinhood have socialized day trading and empowered the masses to feel comfortable making investment decisions. Social forums like Reddit, where the GameStop narrative germinated, serve as breeding grounds for pile-on investors.

The powerful combination of this technological and macro environment created the opportunity that culminated in the dramatic rise and fall of GameStop. There's no doubt that pockets of irrational exuberance will continue to exist in the market and play out in unpredictable ways. However, we don't believe these events threaten the larger market structure.

In the days ahead, investors will face many opportunities to abandon their well-reasoned investment plans in favor of speculative reward. We believe investors should remain vigilant and focused on a disciplined investing approach that is time-tested and reflects their own financial goals. Suitable investment opportunities remain for those who pay heed to valuations, diversify for various economic outcomes, and maintain an appropriate level of market exposure.

[ Photo by energepic.com from Pexels ]