Tuesday 2 February 2021 1:16 pm

Analysis: How worrying is the GameStop-Reddit mania?

The second half of last week was a fascinating news cycle for financial newshounds and traders alike, as headlines were very much dominated by one story: GameStop.

Global equities fell back 3.5 to 4 per cent last week, leaving them down slightly year-to-date, even though they did recover some of these losses yesterday.

GameStop – a small troubled US games retailer – suddenly became the epicentre of a short squeeze rally which retail investors in the US managed to inflict on several heavily shorted stocks.

Implications for the market

According to City-based Rupert Thompson, chief investment officer at investment planner Kingswood in Moorgate, the GameStop saga “prompted realms of coverage because of the damage John Doe, aka Joe Bloggs, had managed to inflect on short-selling hedge funds and the significant regulatory issues raised by the whole episode. What concerns us here, by contrast, is the implications it has for the market outlook.”

“The sight of retail investors piling into particular stocks and driving prices up to levels bearing no resemblance to the fundamentals is classic bubble behaviour and brings back bad memories of the tech bubble 20 years ago,” Thompson told City A.M.

Other areas of the US market have also recently shown signs of excess, he continued, with a surge in IPOs. Generally, equity funds have seen a sharp rise in inflows in the last few months.

Stability

Andrea Barbon, assistant professor of finance at the University of St Gallen, said the behaviour of retail traders – like the ones on Reddit – may ultimately lead to hedge funds getting into serious financial difficulties, and they therefore pose somewhat of a threat to financial market stability

“Extreme volatility of GameStop may be pushed by the negative gamma of option dealers, who sold call options to retail investors. If the price of GameStop rises enough, big hedge funds may go bankrupt,” Barbon explained to City A.M.

Hedge funds are struggling due to their short positions on GameStop and they will need to raise cash to respond to margin calls and avoid bankruptcy, he continued.

“A massive sell-offs of their holdings on indices and blue chip stocks could potentially lead to a crash,” Barbon said.

So how worrying is all this?

“Certainly, if you’re a fund manager specialising in short-selling, this activity is looking a lot riskier than it was and a couple of hedge funds have already hung up their boots,” Thompson noted.

As for the army of Redditors – as users of the Reddit social media platform used to coordinate these short squeezes are called – there’s no reason to expect them to hang up their boots though.

“Flush with their recent victories and with Biden wanting to hand out to all US individuals another $1,400 on top of the $600 stimulus check they have just received, their resources will only have increased,” Thompson argued.

More generally, this is all a symptom of the liquidity sloshing around the markets which is unlikely to be withdrawn any time soon.

“There is still a mountain of cash on the side-lines, potentially available to drive markets higher,” he said.

Importantly, it does not seem like central banks plan to start scaling back their quantitative easing programs any time soon. Fed Chair Powell was at pains last week to emphasise that it would tread very cautiously on this front, not least because the economy still badly needs supporting.

Macro-outlook

The market may also take comfort in the macro outlook. Last week’s economic data was mixed but rather old news as far as the markets are concerned. Fourth quarter GDP numbers for the US, Germany and France confirmed the Eurozone is seeing a double dip in activity in contrast to the US, where growth slowed substantially but remained positive.

Much more important, a strong global recovery still looks on the cards for later this year.

“Indeed, the IMF has just revised up its forecast for global growth this year to a strong 5.5 per cent. This in turn should drive corporate earnings growth of as much as 30 per cent this year,” Thomspn said.

The current US reporting season is encouraging in this respect with US companies beating expectations substantially, he continued, pointing out that US earnings in Q4 are now forecast to fall only 1.5 per cent on a year earlier, whereas at the start of reporting, the expectation was for a 10 per cent decline.

“In short, while we are far from complacent about the latest signs of bubble-like behaviour, we believe this bull market still has some way to run,” Thompson concluded.

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