Markets

It's likely going to take a constant stream of excited buyers to keep the GameStop, AMC rally going

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Key Points
  • The David-vs.-Goliath premise in the GameStop saga is somewhat flawed as neither hedge funds nor short sellers have ruled the Wall Street playground by any stretch in recent years.
  • With stocks like AMC and GameStop up huge and volumes enormous in recent days, it will likely require a constant stream of excited buyers to support these shares.
  • While clearly a factor driving the S&P 500's 3% decline last week, the risk of a broader market contagion from the short-squeeze stampedes likely remains low.
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The vivid popular storyline in the markets last week portrayed the masses of small-fry investors getting the better of Wall Street's bullies, with frenzied buying of heavily shorted cast-off stocks dealing massive losses to smug hedge-fund managers who had had used bearish bets to abuse the likes of GameStop and AMC Entertainment.

There's truth in this as far as it goes – but it goes only so far as to cover perhaps a few-dozen stocks with extremely high short interest, and does not imply the broad market is ripe for these short-squeeze stampedes to be a strong or lasting driver of the investment outlook.

A couple of flawed premises are at work in the simple David-vs.-Goliath angle. For one thing, neither hedge funds nor short sellers have ruled the Wall Street playground by any stretch in recent years. Quite the opposite, in fact.

And the current market has an unusually low short base relative to overall market value, which if anything implies less of a cushion of entrenched bearishness to fuel index gains from here.

Annual returns for equity long-short hedge funds over the last five years have ranged from negative 3% to a gain of 9%, according to BarclayHedge. Over that same period the S&P 500 has returned 15% annualized. If hedge funds were market bullies able to have their way with stocks they pile into, why would they have limited themselves to such meager rewards?

While academic research has shown heavily shorted stocks have underperformed over the long-term, this factor is not consistent over all periods. JP Morgan strategists last week showed that crowded-short stocks have performed roughly in line with the market as a group in the past few years, before beginning to outperform strongly in recent months as the "squeeze event" got rolling.

Short selling is expensive and risky, given that it's often costly to borrow shares, losses are theoretically limitless as stocks can rise indefinitely, and the preponderance of incentives among corporate executives, analysts, bankers and long-term investors is to push stock prices higher.

This is not to solicit sympathy for the poor short seller or deny that shorts way overplayed their hand in targeting the cluster of stocks now surging on social-media-emboldened squeezes. It's simply to point out these were never all-powerful predators who were able to profit from self-fulfilling short bets. 

In fact, the days-long binge on the shares and, especially, the call options of the handful of favorite back-from-the-dead stocks raises the question of whether the squeezers are the ones possibly overplaying their hand now.

Constant stream of buyers needed

This data from Barclays shows the precipitous surge in options buying on short-squeeze names this year, both including and excluding GameStop, the squeeziest of the squeeze stocks.

The massive exposure to these stocks through options in retail-client accounts is what forced Robinhood and other brokerage firms to restrict trading in some tickers, because of the heavy cost of posting collateral in the clearing-and-settlement process that occurs over two days after a trade is made.

With these stocks up huge and volumes enormous in recent days, it will likely require a constant stream of excited buyers to support these shares.

As an illustration of rising stakes, AMC shares went from just over $5 at Tuesday's close to finish Friday at $13.26. Yet the average price paid by all investors in the stock over those three days was over $14, given how much time the shares spent between $13 and $16. A stock up huge but with latecomer investors underwater, and in this case a company that has repeatedly issued new shares to shore up its balance sheet.

There surely remains substantial short interest in many of these names even after the bears' bloodletting. While official data come only every two weeks and with a lag, short-sale analytics firm S3 Partners calculated Friday that as of Thursday there remained well more than 50 million shares in GameStop short – down from some 70 million two weeks ago but still a heavy bearish position.

 (Note the GameStop short position has routinely been described as far exceeding the entire share float. For practical purposes, this is not true: When a share is sold short, a new long position is created and added to the float. The same share is effectively owned by the original owner and the one who bought it from the short seller who borrowed it.)

Broader market contagion?

So, in these names, perhaps the squeezes have more to go. But this must remain a pretty localized affair because the amount of short exposure across the market is at a 12-plus-year low relative to total equity market value.

For sure, the aggregate dollar loses being absorbed on the short side of the market are not trivial in the short term. Data analysis firm Ortex calculates the net loss this month exceeds $50 billion – a big chunk gouged out of the long-short investing cohort.

And the losses along with the searing volatility from the relentless squeeze buying destabilized portfolios enough to cause selling down of crowded long positions, a factor clearly driving part of the 3.3% drop in the S&P 500 last week. Analyst Richard Repetto of Piper Sandler notes the group of wild squeeze stocks "have made up 4.6%-7.6% of total U.S. consolidated equity volumes, which compares to the mere ~0.5% of volumes the group comprised prior to the Reddit hysteria." And these names' intraday volatility over the past five trading days "has averaged 72.2% compared to that of the S&P 500's 1.5%."

Barclays strategist Maneesh Deshpande says, "The key question is whether the stresses from the short squeeze will cause a broader contagion as the shorts are forced to de-lever. The bottom line is that while the pain could continue in the short term, the risk of a full-fledged contagion remains low."

The total market capitalization of the stocks with a short-to-float ratio above 20% is only about $40 billion. That's one-tenth of 1% of total US market cap approaching $40 trillion.

And assuming the squeeze-and-chase game continues until the shorts vacate the playground, it would result in a market with even less of a short cushion, which is a headwind for stocks from a contrarian perspective.

We're not there yet. And the current 4% pullback could surely be simply a needed shakeout in an over-long, over-loved market that had run up 18% in about ten weeks.

But a depleted short base is another unexpected factor to ponder, along with a new market rhythm – no longer the passive-index and quant-algorithm dominated tape that prevailed in recent years, and a more emotional, energetic, undisciplined and populist flow coming from legions of small fries.