The retail mafia has done it again. GameStop (GME) shares have climbed 633% since the end of October and 308% since the beginning of the year. Michael Burry’s Scion Capital Management (you may remember Dr. Burry from his character in The Big Short as the hedge fund manager that shorted the housing market) had encouraged the firm back in 2019 to buy back stock given its cash on hand and the outsized trading of its shares given its market cap. This seems to be when one intrepid trader took an aggressive $50K call position on the stock that has now reportedly netted him over $11 million. The recent rally however, has reached a frenzy more recently when activist investor RC Ventures managed to get 3 board seats including one for Chewy founder Ryan Cohen. This touched off a stampede into the stock by the r/wallstreetbets community in a concerted effort to squeeze the institutional short sellers in the stock. The fallout has been dramatic for both short sellers and long punters alike. Shares rallied as much as 100% within an hour of the opening bell on Monday January 25, before falling more than 50% back down to $70 a share. This compares with the $20 per share price just last week.
There’s no value in GME shares. The firm is a dinosaur physical retailer that has been in secular decline for years now. It hasn’t generated an annual profit since 2017. Yet fundamentals don’t matter for what I call “the retail mafia”, only momentum.
What This Means
Market commentators rushed in to label this incident as the starkest sign of the top of the bubble in stocks. The P/E of the S&P 500 is at nearly 39. It’s only touched valuations this high during the dot com bubble and when S&P 500 earnings went briefly negative during the financial crisis.
Those with this view tend to look at the current state of the market like dot com 2.0. The surge in valuations for anything tech, SPAC’s and worthless retail stocks indicate that the market is poised for a downturn. This is a simplistic view, and let’s be honest, sometimes simplistic views are correct, but it doesn’t mean it’s right. Remember that fear sells, and financial media as well as the mainstream media taps into our survival instincts that help us avoid danger. Fear has helped humans survive for hundreds of thousands of years and its hardwired into us to pay more attention to the fears of others. Because of this, it’s important to keep in mind that media stories will often have their root in fear, be it fear of losing it all in the market or fear of missing out on all those gains others are getting and you aren’t.
Those who fear a correction or a downturn do have a point in the sense that valuations are high in the US and there is a nonsensical rally in many segments of the US market. But it’s just that, this is a rally in the US market and specifically the US growth sector. Many other sectors are reasonably priced or even a deal right now. In addition, the global economy looks very different than it did in 1929 or 2000 for that matter. So I wanted to point out a few factors that may not necessarily point to a drop, but rather reason to believe we may not see many more pops in the US market in the coming years.
- Rallies Can Last for Years – In 1998, many institutional investors knew the market was in bubble territory, yet many hedge funds lost their shirts trying to short stocks. The retail mania pushed things ever higher. Just like in 2020, there was a correction due to the Asian financial crisis in 1998, but US stocks recovered and resumed their rally. The Nasdaq started 1999 moving past 2,000 and by early year 2000, had a moonshot rally to 5,000. The market can remain wrong longer than many can remain solvent. Very few will call the top and those that do will likely have done so out of luck.
- Others Can Pick Up the Slack – In 2001, US GDP accounted for 26.7% of global GDP. That figure as of 2018 was 20.8%. Meanwhile, China’s share of global GDP has risen from around 5% at that time to almost 17% in 2018. The market cap of stocks in China has followed suit. Emerging market stocks including China and India, made up 11% of global market cap in 2003 whereas these firms accounted for 24% in 2018. If US returns sag, there is now a much more significant presence of foreign markets which can pick up where the US has left off. (See below)
- Low Growth Doesn’t Mean a Drop – The real rally is being fueled by big tech, which actually earns money. The dot com bubble saw a rally in anything tech as well as things that were perceived as tech, like GE. I can’t see anything in the near future that is going to tank Apple stock. Yes valuations may come down but that doesn’t mean earnings have to take a big hit. The same goes for the other big tech companies. There hasn’t been much of a rally outside of tech for the past few years, the performance of stocks ex-tech, which has been lackluster, may be an alternative preview of what is to come. Rather than a drop, a slow decline or a flat market which allows earnings to catch up with valuations until they become more reasonable is another alternative scenario. Although some have called this an “everything rally” there are still reasonably valued shares outside of tech. Tech valuations could slowly deflate while the rest of the market remains flat. You can see how this played out previously in 2000 when you overlay the Dow, S&P 500 and the Nasdaq over each other. You will notice that the Dow remained relatively flat, there weren’t tech companies in it at the time. Other than a 25% drop which took about 2 years from peak to trough, shares bounced back and remained flat until about mid 2006. Given rates are so low, rather then a sudden drop, I find this a more likely scenario for the US market in the medium term.
Could the Retail Mafia Move Overseas?
The SPAC’s rally is sure to die out, same with the tech IPO rally, but now that retail traders have discovered options, I don’t think they are going anywhere soon, even in a flat market. This is in contrast to 2000, when retail traders quickly dropped out of the market. What we may witness is they they turn their attention away from bankrupt US companies and then start to pivot towards emerging market and foreign stocks, especially those that are listed as ADR’s on the US exchanges. This has some precedent as well.
When emerging markets saw their boom in the early 2000’s, late in the rally, everything China became hot. Firms that were both energy or commodities producers as well as China based were snapped up quickly by many retail investors. Names like CNOOC (CEO) and Petro China (PTR) saw their shares spike between May and October of 2007.
Another scenario is that the “influencers” of subreddit Wallstreetbets could come under some heat themselves, especially if they have made some big winnings at the expense of those that lost big bets. With price swings of 100% in a matter of hours and with the financial media’s attention fixated on this, it’s only a matter of time before the SEC launches an investigation into who knew, and who traded what. Those institutional short sellers also have other means to get the price back down to where they can profit: the specter of calling up law enforcement.
Even if this happens though, as we have seen with internet gambling, pirating movies, and music, if there is a devoted following for wealth plays and the SEC doesn’t like it, someone can simply set up a server in Russia and keep the party going. Whether those influencers will still be able to trade is another question.
Update: the retail traders are actively picking up the most shorted stocks. There seems to be a speculative value rally going on. The ten most shorted stocks in the Russell 3000 have gained 33% year to date. There may be more than madness to this method than we realize.
How to Hedge the Madness
Those of us who have been in the market for a while know that things will eventually move on from this silliness. It doesn’t hurt to ride the rally though. For those rough waters or the lost growth decade that may be in the cards for US investors though, some old and boring sectors may find life in a flat US tech market in the coming years. Sector bets like the Vanguard Russell 2000 Value ETF (VTWV) or the Vanguard Small Cap Value ETF (VBR) have a place, even if it’s a small one, in your overall portfolio. I think emerging markets, led by Asia, will continue to match and even outperform the S&P 500 through a weakening dollar and slower growth in the US. WisdomTree offers an interesting diversified ETF (meaning not too Tencent or Alibaba heavy) which is the Emerging Markets ex-State Owned Enterprises Fund (XSOE) which avoids any company with more than 20% state ownership. I particularly don’t like state ownership as I feel it opens up the taps for corruption and political risk. The government usually uses these state enterprises as cash cows and will always have the national interest above shareholder interests. Government is not normally the most friendly backer for shareholders, even if it helps these companies secure cheaper debt in the short term.
Both value and emerging markets still offer attractive valuations compared to the US right now. The discount for emerging markets to the US market is sitting at one of the widest margins in history. This time however, US investors can’t rush back into bonds that yield 6% for protection, the low rates will push them to take more risk in sectors like these and maybe even help them see the “value” in value.
