Mr. GameStop’s Wild Ride

“In the short-run, the stock market is a voting machine. Yet, in the long-run, it is a weighing machine.” — Warren Buffett[i]

While the last week in the markets has felt like being on Mr. Toad’s Wild Ride at Disneyland, Warren Buffett’s famous quote on stock market behavior seems more pertinent than ever. The recent wild moves in the shares of GameStop and a handful of other names have completely detached the firms’ market values from their underlying business fundamentals.

Buffett is saying that in the short run, stock prices can be largely driven by human reaction and emotion. A company has a finite number of shares outstanding, and if there is a massive surge in demand for those shares and no increase in supply, the price can soar and soar rapidly. Ultimately, in the long run, if the business is successful and grows its cash flows, its value (Buffett’s “weight”) aligns with the stock price. It’s not an accident that Apple and Microsoft are the most valuable businesses in the US stock market, as they also generate more profits than any other firm.[ii]

So how does a video game retailer whose sales fell 30% and had a net loss of $34 million last quarter see its market value soar twenty-fold over a matter of weeks?[iii] It’s a long story but not a new story. Betting against companies by shorting shares is complicated and risky — you sell borrowed shares in the belief that the company’s share price will drop, and you can buy them back more cheaply, pocketing the difference. While the firm’s business may be suffering, the fact that short sellers must eventually buy those shares back to repay their borrowed shares can cause an unnatural demand for those shares in the short run. If one trader has a big short position and others decide to gang up on that trader by aggressively buying those shares, they can force the short seller to buy back the shares at highly inflated levels, driving up share prices further.

This “short squeeze” game had pretty much been the domain of large hedge fund managers until now. The flow of information and access through no-cost trading platforms like Robinhood has allowed individuals to organize through message boards and become a massive force.

At Team Hewins, our mantra is to keep investing strategies simple, and we avoid hiring managers that short shares. At times like this, I am sure glad that is what we do. Shorting stocks can be very tempting. As GameStop and other similarly traded names normalize back to their business fundamentals, some short players may make huge returns, but some could still get caught in the next short squeeze. There is just so much risk in the mechanics that you can be right on the ultimate direction of shares going down but very wrong on the way there.

At some point here, the GameStop and other similar trades will stop working, and the headlines will move on. The lasting impact is mostly for individuals who have bought shares at exorbitant prices and short sellers who now must be concerned that at any time, an army of online traders may attack their short positions.

But what about my portfolio?

The rest of us can focus more on our long-term strategy, how the recovery from the pandemic is going and how policymakers in the Administration, Congress, and the Federal Reserve are responding. The Biden administration and Congress are now starting negotiations on the next round of COVID-19 relief stimulus, which will end up somewhere in the range of $600 billion-$1.9 trillion — quite the range.[iv] The Federal Reserve continues to be super accommodative and will likely not raise rates again for another couple of years. But we have likely seen peak accommodation, meaning they are not inclined to ease more, which may take some lift out of equity market valuations.

The fourth quarter earnings reports are robust, with 81% of S&P 500 companies reporting earnings ahead of analyst expectations (above the 12-quarter average of 77%). Companies are giving solid outlooks, and the expectations for earnings growth for the first quarter have grown to 15.6% from 12.6% in early January.[v] In other words, large businesses continue to impressively manage through the pandemic.

The tension in the markets is clear — business performance is very good, but are prices fully reflecting that? While the GameStop short squeeze has little to do with the earnings growth of S&P 500 companies, rank speculation has been a catalyst for market corrections in the past. Remember, stock market corrections of 10% or more have occurred on average every 16 months since World War II.[vi] The strong performance of equities in the last quarter has brought many client portfolios to the point of needing to rebalance equity down to target allocations. Our rebalancing does not mean that we are predicting a correction, but rather that we know a correction can happen at any time and want our clients to be positioned at their intended risk levels. We talk about being disciplined investors constantly, so you should expect us to act accordingly.

There is no shortage of concerns around the pandemic, from the slow rollout of the vaccines to the spread of COVID variants from across the globe. Could the global economic recovery slow down before a more sustainable and robust economic boom takes hold? Will government stimulus here and abroad be enough to bridge us until we get COVID more clearly behind us? Let us hope for better outcomes but always be prepared for some disappointments.

Our disciplined approach has allowed us to help you to successfully navigate this incredibly challenging past year and will get us all through what may lie ahead this year. We are grateful for your continued support and confidence in these extraordinary times.

John M. Bussel

Chief Investment Officer

[i] Quoteinvestigator.Com, 2021, https://quoteinvestigator.com/2020/01/09/market/. Accessed 1 Feb 2021.

[ii] Johnston, Matthew. “10 Most Profitable Companies In The World”. Investopedia, 2021, https://www.investopedia.com/the-world-s-10-most-profitable-companies-4694526. Accessed 1 Feb 2021.

[iii] 2021, https://news.gamestop.com/news-releases/news-release-details/gamestop-reports-third-quarter-results-positive-start-fourth. Accessed 2 Feb 2021.

[iv] Pramuk, Jacob. 2021, https://www.cnbc.com/2021/02/01/coronavirus-stimulus-joe-biden-to-meet-with-republican-senators-about-relief-bill.html. Accessed 2 Feb 2021.

[v] Mian, Sheraz. “Earnings Strength And Market Weakness”. Zacks Investment Research, 2021, https://www.zacks.com/commentary/1254541/earnings-strength-and-market-weakness?art_rec=home-home-earnings_analysis-ID01-txt-1254541&art_rec=home-home-earnings_analysis-ID07-txt-1254541. Accessed 1 Feb 2021.

[vi] Rapacon, Stacy. “How Often Do Stock Market Corrections Happen?”. Grow From Acorns + CNBC, 2021, https://grow.acorns.com/how-often-do-stock-market-corrections-happen/. Accessed 1 Feb 2021.

Team Hewins, LLC (“Team Hewins”) is an SEC-registered investment adviser; however, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. The information contained within this letter is for informational purposes only and should not be considered investment advice or a recommendation to buy or sell any types of securities. Past performance is not a guarantee of future returns. It should not be assumed that diversification protects a portfolio from loss or that the diversification in a portfolio will produce profitable results. The opinions stated herein are as of the date of this letter and are subject to change. The information contained within this letter is compiled from sources Team Hewins believes to be reliable, but we cannot guarantee accuracy. We provide this information with the understanding that we are not engaged in rendering legal, accounting, or tax services. We recommend that all investors seek out the services of competent professionals in any of the aforementioned areas.