Economic Monitor: High Drama on the Stock Market

BY: Mark Drachenberg

One of my favorite Disney movies is Robin Hood, and not just because it's the timeless tale of taking from the rich (who stole it in the first place) to help the poor, nor because it's arguably the funniest of Disney’s older movies. The real reason I love it so much is because one of the scenes is played out with On Wisconsin playing over the action! Who knew our favorite college fight song had made it into a Disney movie? Anyway, mention the name Robin Hood these days, and most everyone will assume you're talking about the financial services company, Robinhood.

The brokerage firm is where millions of investors have gotten their start, as it allows for the purchase of as few as one share of stock in a company, with little or no transaction fees. Because its average investor is generally thought to be younger, more tech-savvy, and more connected via social websites, Robinhood is also subject to trading activity that is perhaps less driven by fundamentals and more by a herd mentality, based on social posts. I'll discuss it further below, along with things like political change, virus/vaccine news, and heightened expectations for 2021.

The markets did not exactly start the year with a bang. The Dow Jones Industrial Average, the S&P 500, the EAFE, and the Barclays US Aggregate Bond Index all posted negative numbers in January, though all fell less than 2%. On the plus side were the S&P 400 and 600 indexes and the NASDAQ, with the small-cap 600 index gaining 6.29%. The mixed bag of results, coupled with the January Effect – which implies that, “as January goes, so goes the year” – has many wondering where or how to invest. While the economy remains fragile, especially in the travel, restaurant, and entertainment sectors, expectations for the second half of the year are improving, and we should see brighter days as winter turns to spring and summer. 

Back to Robinhood: The financial press has been enthralled with the company and the related GameStop stock story. Investment chatrooms of one sort or another have long been sources of information for investors, but now some (millions?) small investors are essentially banding together to purchase shares in companies that the so-called “pros” have decided to short. Essentially, short selling is where an investor borrows funds (key point here) to effectively sell a stock without owning it. The investor is betting that the price of the stock will go down due to poor fundamentals, etc. and then, once the price has fallen, they buy the stock to cover their short position and pocket the difference. If, however, the price of the underlying stock goes up, the investor can realize steep losses, as he or she faces growing margin calls to pay for the debt borrowed to sell the stock short. This is an especially favored practice by hedge funds and other professional (read: big) traders.

GameStop has been a favored short, due to poor fundamentals related to its brick-and-mortar presence and smaller online presence, among other reasons. As such, it would generally be considered a more aggressive or risky stock to own. But due to the huge amount of short interest in the stock, it became a target of the chatrooms. The stock got promoted as an opportunity to stick it to the big guy (read: pro) by driving the price up and effectively “hurting” those who had shorted it. People who decided to purchase the stock did so through traditional means, using margin to buy additional shares, and using options (margin is required here, too) to make even larger bets on the stock. The amount of the trading caused many firms, like Robinhood, to limit trading in stocks like GameStop, but not for all of the reasons that many thought.

Robinhood and other firms have their trades cleared, or settled, through a clearing house, which matches the trades but also takes on the risk that one side of the trade may not be able to meet their obligation. The clearing house requires funds (margin) to be held, to minimize the chance for losses to the investor or the brokerage firm involved. Because of the amount of trading involved, firms like Robinhood were being squeezed and either had to limit trading in these stocks or require additional margin, or both, as required by the clearing house. The amount of margin required, too, goes up as the amount of trading goes up, and so there were more demands on Robinhood and others, which trickled down to the investor. So, contrary to what investors, the media, and many politicians thought, there was no conspiracy to stick it to the little guy (if any “sticking” was being done, it was really the little guy trying to get the big guy.) In fact, what was going on was a normal function of free-flowing markets with margins built in for protection.

Ultimately, many large short traders got hit to the tune of billions of dollars, and many small traders made a lot of money. But the story doesn’t end there. GameStop traded for less than $20 a share in early January, traded as high as the $480s late in the month, and has come crashing back down to less than $100 a share as of this writing. Many have been caught up in this (some reports predict the stock will hit $1,000 a share soon, with no justification, fundamentally, for the prediction) and bought at the wrong time, thinking the huge gains would continue. How would you like to be the poor soul who bought at $480 last week only to see the floor fall out? There are those who think this story will play out again and again, but my guess is that things will settle back down, albeit with the occasional blip along the way.

On the political spectrum, January saw Democrats take control of Congress and the presidency. Additional stimulus is likely coming, but what form it takes remains to be seen. There are growing concerns about the amount of stimulus in the economy, and that inflation will eventually rear its ugly head. While the data has not specifically borne that out, there is some evidence it may be happening. Data for 2020 shows that prices edged up 1.4%, inclusive of several months in which prices declined. Since May, the data is somewhat troublesome, as inflation has grown at an annualized rate of 4.1%, well above the Fed’s target. This could become an issue as the economy revs its engines later this year, causing demand for goods and services to soar. The Fed may be forced to start raising interest rates, or at the very least, turn off the spigot. Either would be troublesome for equity markets. For now, though, enjoy the ride, as additional stimulus and easy-money policies tend to drive equities higher.

On the vaccine front, there is both good and bad news. The bad news is that the distribution process is not going as smoothly as hoped, though it should improve in time. The good news is that additional doses are being readied and additional vaccines may be available soon, like the one from Johnson & Johnson. Some projections show that the economy’s output (GDP) could reach the pre-pandemic level at some point this year; accordingly, many have raised growth estimates for the year. The numbers vary widely (3.5% to 4.5%) and depend upon a reopened economy. With such rosy forecasts, it is interesting that many projections show unemployment to remain above 5% this year, inflation to remain somewhat muted, and output not reaching full potential for several years. All of this should, however, hold the Fed in check – a mixed bag, for sure, but one that is laced with optimism!

We expect the first half of this year, particularly the first quarter, to see periods of heightened volatility, as news of the virus ebbs and flows. As such, we will look for opportunities to take advantage of valuation disparities, diversify, and still provide downside protection. We are here and available to discuss your portfolio or anything else you'd like to address. Please call the Wealth Management department of the State Bank of Cross Plains at (608)826-3570. We look forward to speaking with you.

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