Amid a wild week in financial markets, U.S. equities broadly tumbled lower while pockets of speculative trading mania drove significant volatility and surging prices in a narrow group of small, thinly-traded stocks. For the week, the S&P 500 and Dow Jones each lost -3.3%, taking the indexes into negative territory on the year, and the Nasdaq Compsite lost -3.5%. Meanwhile, a basket of the most heavily shorted U.S. stocks tracked by Goldman Sachs rallied 14% last week as a group.
The trading frenzy overshadowed another week of positive news on the trajectory of the economic and corporate earnings recovery. On the economic front, the first preliminary report of U.S. GDP in the fourth quarter came mostly in line with expectations as the nation’s economy grew 4.0% over the prior quarter, though output was down -2.5% compared to the final quarter of 2019. The moderating pace of economic growth showed consumers taking a bit of a breather in the final months of the year as fiscal stimulus support waned and Covid-19 cases ramped up. But the report also indicated robust business investment as corporate sentiment is improving and building toward the other side of the pandemic. Fourth quarter corporate earnings season has reinforced this optimism as reported earnings for S&P 500 constituents has beaten expectations by 13.6% to date and forward earnings guidance has been lifted well beyond expectations overall.
We’d be remiss not to discuss the volatile trading activity last week in a number of small stocks that seemed to pit a growing number of individual retail investors against larger hedge funds and institutional traders. The trading activity, which produced some eye-popping price surges well beyond what is supported by the current earnings power of the businesses themselves, was concentrated to a narrow section of the stock market, headlined by struggling retailers like GameStop (GME) and the movie-theater chain AMC Entertainment Holdings (AMC).
In a nutshell, the buying frenzy was sparked when a small group of retail investors, organized on an online message board, noticed significant short positions in these thinly-traded stocks by several hedge funds. Given the lower average daily trading volume of these stocks, it didn’t take much buying momentum to start materially pushing the stocks higher, thereby attracting more market participants (including but not limited to more retail investors) to start piling in. As the price surged, institutional traders who held short positions in the stocks were “squeezed” out of their positions as losses accumulated and forced to buy back the stock to close out short positions, once again pushing stock prices higher.
Such notable trading activity has created a lot of questions about how such speculation could spill over into the broader stock market. The direct impact of the trading activity in this narrow selection of stocks at this point seems likely to remain confined to the stocks in question as they don’t have an outsized influence in the broader market indices. Collectively, the group of heavily shorted U.S. stocks have an aggregate market capitalization of just $40B, which is less than 0.1% of the U.S. overall market cap of over $50T as of yearend. Additionally, the broader stock market remains supported by robust corporate earnings announcements and accommodative monetary policy.
However, this latest speculative episode, alongside other pockets of excessive enthusiasm that we’ve discussed like the surge of companies going public through IPOs and Special Purpose Acquisition Companies (SPACs), is yet another indication of growing risk appetite among market participants in an environment awash with excess liquidity and very low interest rates. We will continue to monitor these pockets and keep you apprised of our thoughts on the implications for the broader markets. As always, our team at First Merchants Private Wealth Advisors believes that it is crucial to remain disciplined relative to a long-term investment strategy and to be selective in the current environment with a focus on investing in companies and institutions where market prices are reasonable in regard to long-term fundamental earnings prospects.
