Market risks are extremely hard to identify. Known risks are rarely the catalyst for a market sell-off, as they are reflected in everyday prices. Rather, it’s unknown risks that pop up out of nowhere that often cause the most disruption. Last year was a perfect example of that: Covid was an unknown, and it crushed stocks in March. Talk of a Biden victory hurting stocks, a known risk, proved to be totally unfounded. The S&P 500 rose 10% following his victory. So it should be no surprise that the biggest risk to the market now is something no one saw coming: A short squeeze in GameStop stock and the subsequent ramifications.
Reddit vs The Street
First, let’s clear up a few things that have been bothering us in the media coverage surrounding these events. GameStop stock will have traded over $100 billion worth of stock this week. $100 billion! This has been a short squeeze of epic proportions fueled by algorithms controlling hundreds of millions of dollars. To think that it’s only Reddit squeezing the hedge funds ignores an obvious fact: there is massive amounts of institutional money involved here.
Secondly, can we please stop labeling Reddit traders (or any trader) as “amateurs” or “rookies” as shown in this CNBC article:
A day trader buys and sells in the same day. By most accounts, Reddit traders bought and held on tight (and are still holding). A number of them are also clearly educated enough to understand the complex mechanics that go into a short squeeze. If we’re calling them rookies then we should hand out Rookie of the Year awards, because some of them made more money in a week than most people make in a year. Aside from the labels being disrespectful and unnecessary, it would also appear that they’re incorrect. Now, onto the important stuff…
Three new risks in the market
The end result of the GameStop short squeeze is not yet clear, but there are strong signs that there are going to be unintended consequences. Among them:
- The threat of increased regulation in the market
- Decreased retail trading sentiment
- Reduced margin debt
The GameStop short squeeze, and subsequent broker actions across the industry restricting trading in the stock, is immediately being met with calls for increased regulation. Senator Elizabeth Warren appeared on CNBC and called for a more proactive SEC. Congresswomen Alexandria Ocasio-Cortez tweeted out calls for an investigation, and appears to have the support of Senator Ted Cruz and Elon Musk! It’s not hard to read the tea leaves here and see that increasing regulation is going to be a big political talking point from here. We don’t know what these regulations might be, or if they will even come to fruition, but talk of them alone could be enough to frustrate markets in the near-term.
A cool off in sentiment
Speaking of frustrations, can you imagine not being able to sell stock you owned? Or how about if your broker forced you out of a profitable trade at its lowest price point? That was the unfortunate reality for many Robinhood customers today. Stories like this one are making the rounds and it’s leading to a retail trading uprising of sorts. These types of stories could dampen retail trading sentiment in the near-term. While that could be bullish long term and allow market sentiment to reset from exuberant levels, it’s likely to coincide with short-term pain. Like them or not, retail traders have been a source of demand in the market. If that demand decreases it could help put downward pressure on the market.
The margin problem
An obvious casualty of the GameStock short squeeze are those who trade on margin, which just means borrowed money. Margin can help fuel market rallies but also intensify market sell-offs when it’s unwound. The total amount of margin being used in the market place is tracked by FINRA and recorded as Margin Debt. The chart below, from Merrill Lynch, shows an expansion in margin debt is associated with a rising market. Meanwhile, a decline in margin debt coincides with a falling market. Margin debt is a leading indicator for the market in the same way credit card spending is a leading indicator for the economy:
It’s too early to know if there’s been a contraction in margin debt recently, but there are widespread reports of high profile margin calls as a result of the GameStop short squeeze. We know there’s been collateral damage here, we just don’t know how much and if it will snowball into something bigger. However, consider these recent events a potential warning shot to the market.
Broad pullbacks are difficult to predict because the catalysts are often impossible to see coming. Raise your hand if you had Reddit message board vs Wall Street Hedge Funds as the biggest risk to the market to start the new year. In reality, that could prove to be the catalyst that sparks a sell-off. Why? Because of the ramifications. The situation is leading to immediate calls for increased regulation in the market. It’s possible that retail traders, fed up with the actions taken by popular brokers like Robinhood, may pare back their exposure to the market. Most importantly, keep an eye on margin debt, if it turns lower that would be a warning signal for the stock market. All of this presents potential risks that were not apparent just one week ago.
Don’t want to miss anything?
Subscribe to our monthly newsletter for market insights.