Just when you thought things were settling down from 2020, another volatility event snaps us back to reality – the market is truly unpredictable.
2021 has kicked off with a bang, most recently with the GameStop short squeeze that the media reports has pitted Wall Street Hedge Fund managers against a contingent of retail investors (Redditors) determined to buck the system. While this particular short squeeze is unusual in how it was manifested, there’s a very practical takeaway for advisors as they prepare to manage client portfolios through 2021 and beyond.
It begins with leverage in the system.
Margin debt is reported monthly by FINRA and reached a record high of $778 Billion in December. As security values rise or fall on any given day there are margin calls for some investors. In a margin account, a registered broker dealer will loan money against an investor’s portfolio. There is a threshold to the amount of “debt” that can be held in the account, called the maintenance margin. When the value of the portfolio falls below minimums, the broker dealer requires new cash be deposited or securities be sold within hours. This is a margin call.
But margin balances reported by broker dealers are just the tip of the iceberg, and “margin calls” can also come from other venues. There’s a lot of leverage in the system.
Hedge funds borrow securities from custodial banks to support short positions. Wealthy investors borrow money from commercial banks with their securities portfolios as collateral. Hedge funds also carry general lines of credit. Corporations issue debt to support the funding of stock buybacks. The lion’s share of leverage in the market relies on underlying security values, more than just margin balances.
What does all this mean for you and your portfolios? First, let’s breakdown the mechanics behind the GameStop short squeeze.
In a short, sellers sell securities they do not own with the objective of buying them back at a lower price. They must borrow the securities to sell short. Institutions that lend securities to short sellers require collateral be posted to secure their borrowing. They also must have the securities to lend. With GameStop, the number of shorted shares supposedly equaled 140% of available shares. The takeaway? GameStop was a heavily shorted stock. And the implications of a short squeeze can affect the entire market.
In the case of GameStop, as the price of GME started to rise, the large investors who were on the wrong side of the short trade tried to cover their positions by buying the shares (at a loss) in the open market. This buying activity drives up the price of GME further, which catches more short sellers in a bad position, and the whole thing begins to “squeeze”. To exacerbate the problem in this case, there simply aren’t enough shares available to cover all of the short positions. The next step for the hedge funds is to buy call options – contracts that will deliver shares of the stock at a time in the future, at a set price. These options introduce even more leverage into the system. And as the GME continues to rise and the share price approaches the strike price of the option contract, the market maker is forced to buy shares to cover the opposite side of the contract. This further increases the share price of the available shares…known in Wall Street terms as a “gamma squeeze”.
An investor (hedge fund) that was short 100,000 shares of GameStop, needed to post $10.2 Million with the lender for every $100 move in the stock price (and the stock price rose multiple hundreds of dollars). If the hedge fund did not have $10.2 Million of cash, they would need to borrow money or sell securities—potentially a lot of them. Selling in the broad stock market on January 27th (the largest one-day downturn since October of 2020) may be partially explained by the short sellers’ sudden need for liquidity.
The takeaway is that everything in the market is connected. Leverage in the system, built upon years of low interest rate policies, carries real implications for your portfolios. It is important to stay alert. While you can’t alter the amount of leverage in the market, you can stay ahead of the curve by actively monitoring the fundamental factors that drive it. Higher leverage typically means higher volatility. It does not necessarily portend falling markets—just more volatile markets… Something to keep in mind for conversations with your clients.
Fitful economic reports, debates about fiscal stimulus, and highly-leveraged and over-valued markets—there may be a few more bumps ahead. Click here to access an infographic that outlines factors that may impact the market throughout 2021.
The information and opinions in this report have been prepared by the investment staff of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA’s judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation would violate applicable laws or regulations.
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