The Week in Review: New Worries or Just Noise?

Michael Kon, CFA

Jan 29, 2021

The Week in Review: New Worries or Just Noise? image

It was an interesting week in the market. Below are some thoughts on what transpired, what can come next, and what it all means to us and our clients.


So what happened?

Retail traders have been buying heavily shorted stocks such as GameStop and AMC. They have also been pumping up the same stocks on Reddit and Discord. The stock prices skyrocketed, and as a result, hedge funds that bet against these stocks were forced to cover their shorts. Since the short interests in these stocks were massive (over 100% in the case of GameStop), the short squeeze led to another massive spike in prices. For example, GameStop is up almost 10x over the past 10 days.

A lot of the buying by the retail investors happened through an online brokerage firm called Robinhood. This is a local firm (based in Menlo Park) that was founded 7 years ago. Robinhood has a history of controversies, but it has become very popular among young traders because it never charged trading fees. Typically, if you don’t pay for the product, you are the product, and this case isn’t different. The way Robinhood makes money is by selling its order flow to high frequency traders that fulfill its orders. Based on some media reports, the largest buyer of Robinhood orders is a Chicago-based firm called Citadel.

The surge in volume and volatility in these stocks destabilized Robinhood. The firm had to post more collateral with its clearing counterparties and had to restrict trading in certain stocks. Robinhood retail clients were enraged by these actions because they believed it favored Citadel at their expense. Social media sites were flooded with unhappy clients calling to boycott the firm. Some clients are suing.

The hedge funds on the other side of the trade suffered massive losses. Some of these funds were able to cover their shorts this week, which means they don’t have any more exposure to these stocks.

The SEC announced that it will launch a review of the matter. Congress will probably hold hearings as well.


What could happen next?

Under one scenario, nothing. The investigations could die down and the market will move on to the next thing. Robinhood raised capital this week and it is possible that it will recover from this crisis. The hedge funds involved will probably post ugly results for this year, but they also might survive, albeit with more enhanced risk management practices for their short books.

Under a more turbulent scenario, Robinhood and several large hedge funds could fail. This might remind some investors of the failure of hedge funds managed by Bear Stearns in 2007, which was followed by the collapse of Lehman Brothers in 2008. For much older investors, this scenario might bring up memories from 1998, when LTCM, a massive hedge fund with over $100B in assets, failed.

Nostalgia aside, Robinhood is nothing like Lehman, and the hedge funds involved in GameStop pale compared to the size and complexity of LTCM. If Robinhood cannot survive this debacle, the most likely scenario is that it will be easily gobbled up by a larger player. Even if Robinhood files for bankruptcy, the impact on the financial system is going to be immaterial because Robinhood is an insignificant player.

And if the impacted hedge funds are forced to close their doors, it will be painful for those who invested with them, but the impact to the financial system will be immaterial. Even the prime brokers that service these hedge funds are likely to be made whole.

None of this will have a material impact on the financial system, the economy, or any businesses owned by the impacted hedge funds or the Robinhood crowd.


What does it all mean to us and our clients?

Since the market hates uncertainty, market volatility could increase, and we might see selling pressures in individual stocks, particularly those owned by the impacted hedge funds. We may own some of these names ourselves, so we could see stock prices decline as other investors are forced to sell out of their positions.

Over time, selling pressures will abate, and eventually, stock prices will again reflect what matters the most: the long-term earnings power of the underlying business. And this story in our portfolio remains positive. Microsoft just reported a terrific quarter. Visa and MasterCard reported satisfactory results. Facebook’s growth has accelerated, BlackRock and Schwab reached record client assets, and the banks we own have performed extremely well during the pandemic. Market events can sometimes be exhilarating, but it’s the “boring” factors such as business performance, competitive advantages, and earnings growth that matter most, and that’s what we focus on.


And what if volatility continues to rise?

Bring it on! We have excess cash to deploy and we are constantly looking for new ideas. We would gladly take the other side of the trade of a hedge fund that’s forced to sell out of a great business because of a margin call.

Interested in hearing more about our thoughts on recent market conditions? Contact us today!


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Tiffany Lessler, FPQP™

Director of Talent