COMMENT:

The US sharemarket has stumbled over the past week, with the strong run that we’ve seen since the election finally losing a bit of steam.

Many would argue the market was due for a breather anyway, but the unlikely catalyst for the selling pressure has been the tug of war between some large hedge funds and a group of retail investors.

A small group of US stocks, most notably GameStop, have been at the center of this frenzy, and as a result we have seen some extreme volatility in the share prices of these companies.

The intense moves have unnerved the broader investment community and with markets having risen so strongly in recent months, they found themselves sensitive to any bad news.

GameStop is a retailer of video games, so unsurprisingly the Covid-19 pandemic and the associated lockdowns haven’t done any favours to its underlying business. The structural move to online shopping had also been taking its toll, even before last year.

This dire outlook has made the company a favourite of US hedge funds with a penchant for short selling.

Short selling is when an investor borrows stock from another owner, sells it, then buys it back cheaper and returns it to the lender.

When the short seller gets it right and the stock falls, they can do very well. It also gives these funds an opportunity to make money when markets are falling, as well as going up. That’s one of the reasons they are referred to as hedge funds.

However, it’s a risky business if things don’t go according to plan.

If an investor shorts a stock which then rises, they will lose money because they must buy it back at a higher price. Some will choose to “cover their shorts” by doing this when they see the price going up, in the hope of cutting their losses.

If they hold their nerve and stay the course but the share price keeps rising even further, there is theoretically no limit to how much they can lose.

That’s a stark contrast from going “long” on a stock, which simply means owning it in the traditional manner, in the hope that it performs well and rises over time.

In these instances, there is a limit to how much one can lose. Even if the company in question goes bankrupt and fails completely, you can’t lose any more than what you put in.

With that in mind, consider how some of those hedge funds who have shorted GameStop are faring at the moment, given the share price has rocketed up more than 1500 per cent in the last 12 trading sessions.

These huge moves have been driven by smaller retail investors, many of whom have mobilised using internet chat rooms about share trading. As the situation has attracted media attention, more small investors have jumped on the bandwagon and a speculative frenzy has developed.

It’s impossible to say how and when this situation ends, but it’s almost certain that there will be some big losers.

Shorting isn’t a common practice in this part of the world. This approach doesn’t lend itself to a small, illiquid market like New Zealand. There are a few institutional funds that pitch themselves as “long and short” managers, but I can count them all on one hand.

On its own, this sideshow isn’t something that will destabilise the broader market. While it’s interesting to watch and makes for some amusing headlines, markets are much more focused on the big issues.

The pace of the economic recovery, success of vaccine rollouts, a further round of stimulus and the quantum of the rebound in corporate earnings season will all play a much bigger role in dictating where markets go from here.

Having said that, we shouldn’t ignore the impacts that broader participation in capital markets will have. Lower fees for trading, widely available information, easy to use digital platforms and limited other investment options are likely to mean the involvement of more younger people and more DIY investors.

That’s a great thing, and it should be welcomed and encouraged. However, it also brings with it some new risks and fresh challenges for regulators.

The GameStop party might not last forever and it could be quite a narrow door if the horde wants to get out all at once.

Mark Lister is Head of Private Wealth Research at Craigs Investment Partners. This column is general in nature and should not be regarded as specific investment advice.

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