January Market Update

By Ryan Gilmer, CFA, CMT Chief Investment Officer

February 1, 2021

We hope you are doing well. Here is a recap of market performance for the month of January:

 

Stocks were a mixed bag in January. US small stocks increased for the month, while US large and international stocks declined. Bonds were also down, as intermediate and long-term interest rates increased.


Over the past few weeks, the wild fluctuations in GameStop stock (GME) have taken over the financial news cycle. We will explain the particulars, but our main takeaway is this: A large, sophisticated asset manager lost enormous amounts of their client’s money because they didn’t manage risk appropriately.

As your advisor, our job is to manage your money to help achieve your financial goals. There are two basic principles we always consider when making investment decisions:

  1. Have a plan to manage risks – When we enter an investment, we always consider how much we could lose. One of the reasons we invest your money in Exchange Traded Funds (ETFs) or mutual funds is that they are diversified among many stocks and bonds. If one holding experiences large losses, it has a minimal impact on the entire fund. There are other strategies, but no matter the approach, it is imperative to plan for worst case scenarios.
  2. Understand your liquidity – Liquidity is another primary component of risk management. Simply, it means how easy it would be to turn an investment into cash if you want out. If you have to sell your investment, will you be able to do so quickly and at a reasonable price? Real estate, for example, is less liquid than Amazon stock because it takes more time to match a willing buyer and seller. With stock or bond investments, the higher percentage of one holding you own, the less liquid it could be. Also, in periods of market stress, market participants may back away, making liquidity scarce. Whenever we consider investing in a fund, we always understand what percentage of it we own. We don’t want to have to sell it all urgently at the wrong time.

With that in mind, let’s talk about what happened with GameStop stock. Here is a chart of the GME price since 2013:

Stock Terminology: Long vs. Short
Most of the time, investors buy stocks in companies and hope they go up over time, as the companies grow. This is called going long. But, when investors identify failing, mismanaged companies, they can do the opposite, which is called going short. Rather than buy the stock, they borrow it from someone else and sell it, hoping to buy it back at a lower price later as the company continues to fail. They can then return the stock to the original owner, making a profit in the process. A stock has a limit on how far it can fall: zero. It can always continue rising. Since shorting a stock is effectively the opposite, short-selling has potentially unlimited losses associated with the strategy. This means short-sellers should pay especially close attention to risk.

Some Background
GameStop buys and sells video games, consoles, and accessories through retail stores, often found in malls. As you can see above, the company has been in a long-term decline. In the 2020 market crash, GME fell to about $2.50/share. Most investors assumed GameStop would enter bankruptcy, making GME stock worthless.
Because GME has declined for so long, it was one of the most popular stocks to short on Wall Street. One group that did this is Melvin Capital, a fund which manages over $12 billion, with a history of delivering attractive returns.

So what happened?
Over the past months, GME started to rise from the ashes. This was due in part to investors like Ryan Cohen, who specialize in turning around struggling businesses. In September 2020, Cohen acquired over 10% of GME, and GME has continued to go up since then, reaching $30/share in mid-January. Despite this, many of the short-sellers continued to hold or add to their short (rather than realizing their losses and getting out).

This is where other investors started taking notice. Because hedge funds are required to disclose their holdings quarterly, a group of investors concluded that if GME continued increasing, short-sellers like Melvin Capital would be forced to cover their short positions. Because this requires buying stock back (that they previously sold), it creates increased demand for the stock, driving the price up even higher.

You’ve probably seen a nature documentary where a group of lions single out a weak antelope. This is the stock market equivalent, but in reverse: small, individual investors coordinated an attack on a large hedge fund. The antelope have been fighting the lions – and winning. Once the market realized what was happening, other large hedge funds most likely started going long aggressively, amplifying the pain on short sellers. On Wednesday, CNBC reported that Melvin Capital finally covered their short position, but not before losing a lot of money. In fact, they had to receive a $2.8 billion investment from an outside investor. GME closed at $325/share on Friday afternoon.

The tale of GME is not new – there are many examples throughout history of similar booms and busts; this kind of madness that’s totally unassociated with the companies themselves. In all of these stories, there are winners, and there are losers. In this case, investors long in GME won big, and the short-sellers lost big – so far.

These instances bring to the forefront the importance of managing risk, especially for fiduciaries of other people’s money. This event did not impact your investments at Whitcomb & Hess, and we continue to consider risk, as well as return, in all the decisions we make for your accounts. If you would like to discuss this further, please let me know.

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