What the short squeeze frenzy means for portfolios

In recent days, we’ve observed speculative behavior in pockets of the market. This has been most evident by the meteoric rise of small-cap, fundamentally challenged stocks, such as GameStop, which have undergone short squeezes. This happens when many investors are short a stock—positioned for it to go down—and an increasing number of short-term traders recognize the vulnerability of the short sellers to sudden price rises. These traders go long—positioning for the stock to go up—driving the price up and making the shorts scramble to close out their positions, which in turn causes the stock to rise further. Those who have bought long positions in these stocks have come from a colluding online community of retail traders aiming to take on the short sellers (primarily hedge funds). How might this affect the rest of the market? 

We don’t foresee recent investor behavior expanding into a systemic problem for markets. The short squeeze should be a temporary event, as short positions must be reduced since a short seller borrows shares from a dealer to short and typically must buy them back at a loss if the price rises. At the same time, speculators take profits and close out their long positions, and those buyers who got into the game too late may find themselves forced to sell into a vacuum at significant losses. In the end, the stocks are likely to find new equilibrium prices that may better reflect their underlying fundamentals.

In times like these, investors need to maintain discipline and resist engaging in this type of speculation. Behavioral finance studies tell us time and time again that investors’ worst enemies are often themselves. Making poor investment decisions and deviating from a financial plan can occur when there’s a fear of missing out. This often takes place in areas of the market that experience significant price increases without adequate fundamental support. We believe the value of a financial professional and a well-defined plan is more important now than ever.

While these pockets of speculative trading lack fundamental support, with their prices rising without a corresponding improvement in the underlying business, the same is not true of the broader market. The S&P 500 Index closed January at a price-to-earnings (P/E) ratio of 21.3¹; admittedly not cheap, but forward earnings estimates are climbing, providing support for higher valuations. In fact, the P/E ratio of the S&P 500 Index hasn’t budged since June, as earnings have kept up with prices. Contrast this with the late 1990’s bubble, when prices took off while earnings barely ticked higher. A healthy earnings environment gives investors cause to hold equities, albeit thoughtfully. In our view, that means avoiding speculative stocks with bubble-like valuations in favor of quality stocks with fundamental support.

Unlike the dot-com era, earnings are keeping up with stock prices

Source: FactSet, 2/1/21.

When signs of exuberance start to build in the markets, the tendency for investors to make mistakes gets amplified.  Excitement builds, overconfidence takes over, and it can become tempting to abandon longer-term goals in order to chase the next hot investment. Now is the time for investors to stay disciplined. A proven way to overcome frequent investment mistakes over time is consulting a financial professional.

1 FactSet, 2/1/21.