Online trading raises questions about market valuation


When retail investors gathered on social media Reddit last January to buy stocks in a few bearish target companies, commentators deduced that online trading could move the markets. This episode cost hedge funds who sell short millions of dollars. It has also prompted questions about the valuation of the stock markets and the generosity of central banks in their responses to the pandemic.

Until last month, the name GameStop was unknown to the general public. Without a major change in its financial position or economic outlook, shares of the Texas-based company climbed from $ 19 on Jan.1 to $ 483 on Jan.28. As of February 5, the stock was trading at $ 63.77. The title of this company, which distributes video games and refurbishes consoles in more than 5,000 physical stores, has become a target for short sellers who expected its price to drop.

The short sale consists for the investor to borrow a security and then to resell it on the market at a higher price than the one at which he will then buy it back when repaying it. This operation represents one of the most demanding exercises in trading. Partly because short positions theoretically open the door to unlimited losses if prices rise. In fact, short sellers usually do extensive research to assess business fundamentals. Short selling also plays a useful role in the markets; By betting against companies they believe to be overvalued, short sellers help eliminate weaknesses, creating liquidity and closing the gap between the stock’s price and the fundamentals of the company. Yet in GameStop’s case, short positions accounted for as much as 138% of its free float stocks, which means these securities have been borrowed more than once in short trades.

When retail investors began buying shares in thirteen companies through online brokers such as Robinhood.com, prices soared. This forced the hedge funds specializing in short selling to hedge their positions by buying stocks, which further accelerated the rise in prices.

The most traded share

On January 26, GameStop Corp. has become the most traded U.S. stock, and online brokers have suspended purchases to preserve regulatory capital requirements, with some hedge funds reporting losses of up to 50%. The losses appeared to have been concentrated on a few funds, as the HFRX Equity Hedge index fell only around 2.5% for the week, in line with the S & P500. Robinhood.com, which is on a mission to “democratize finance for all,” risks losses if customers’ accounts are damaged. According to its critics, instead of banning purchases, the broker could have increased its margin requirements, in order to make trading in the thirteen stocks in question more expensive.

The GameStop affair is significant, as it is the first time that American retail investors have coordinated collective transactions via social media. The scale of these operations, amplified by purchases by hedge funds and other index investors, allowed them to change the direction of prices. For now, the disruption appears to have been confined to the United States, where the increased use of free online brokerage, coupled with narrower spreads between bid and ask prices, has created the preconditions for price movement. .

Last week, the supervisory authorities took an official interest in this issue. Janet Yellen, Secretary of the US Treasury and former Chairman of the Federal Reserve (Fed), brought together officials from the Fed, the Securities and Exchange Commission (federal market regulator), and the Commodity Futures Trading Commission (regulatory authority). regulation of derivatives markets) to try to assess whether these transactions and practices distort prices.

Too much cash?

Is the abundance of liquidity provided by central banks to deal with the Covid-19 pandemic at the origin of this price volatility? We think not. The liquidity of the financial markets is not the primary cause of these transactions, motivated rather by the high level of individual savings accumulated during the pandemic.

US spending to support the economy during a pandemic is the highest in the developed world. As a result of the Fed’s asset purchase programs, the assets on its balance sheet represent about 40% of the gross domestic product of the United States. This is hardly excessive if we compare this figure to the 67% of the European Central Bank. At the Swiss National Bank and the Bank of Japan, this ratio is even well above 100%.

The risk is that cheap credit creates an inefficient distribution of capital and that central bank injections of liquidity fail to flow into the real economy. Instead, these measures would support financial asset prices and investors, thus exacerbating social inequalities.

The Biden administration plans to increase budget spending. If more generous fiscal support were to create inflationary pressures over time, it seems likely that the central bank could anticipate it and have sufficient leeway to respond to it. In the meantime, additional spending will continue to support risky assets.

Overvalued markets?

Are record-breaking stock market valuations deserved? It is certain that low interest rates favor their relative value proposition and that central bank liquidity is added to the financial flows allocated to these markets. While not cheap, current valuations don’t seem exaggerated either. The markets therefore have reason to be optimistic.

Once the public health concerns are resolved, we expect economies to quickly return to their pre-pandemic activity levels. The markets very quickly integrated a recovery in profits reflecting the promise of vaccines capable of ending the pandemic.

The question is whether the recent volatility of a few stocks will be enough to trigger a larger decline in risky assets. Certainly, US values ​​are trading at levels that seem historically high. However, after a market meltdown, such as in March 2020, valuations look generally high, especially in an environment of low yield and low inflation. This makes assets such as government bonds and credit relatively unattractive. In addition, valuations in non-US equity markets appear significantly less strained and could benefit from the economic recovery. Overall, investors should expect more volatility in equity markets, as well as more subdued returns.

Investor expectations for Q4 2020 earnings were modest. With the earnings season still ongoing, some three-quarters of European and US companies have beaten earnings per share estimates, reinforcing the idea that an economic recovery is on the way. Cyclical sectors in particular had some positive surprises in store, along with European financial and industrial sectors, as well as consumer discretionary, financials and commodities sectors in the United States. This suggests that there is potential in these sectors for upward earnings revision in the wake of the recovery.

Advice from a shoe shiner

Professional investors may scrutinize transactions on GameStop recalling the story of John Fitzgerald Kennedy’s father, Joe Kennedy, who, following investment advice from his shoe shiner, decided to short sell all of his stock portfolio just in time to avoid the Wall Street crash of 1929.

Nearly a century later, it has become difficult to find a shoe shiner, but anyone can easily share tips on social media and then trade freely online. Technology has changed access to real-time data and put trading tools in the hands of millions of people, creating the conditions for huge volume changes in financial markets. This development creates a new risk of volatility for equity investors. Hedge funds are likely to take additional risk management measures, for example taking into account the levels of taking short positions in a security.

We believe that with a well-diversified portfolio including hedges such as gold and the Japanese yen, market volatility offers opportunities to invest in the economic recovery. In recent months, we have maintained our overweighting in equities and alternative asset classes, while reducing our holdings in cash and quality bonds.

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