Feb 24, 2021 FAS Monthly Market Update February 2021
Posted By FAS Team
The U.S. economy grew at an annual rate of 4% in the fourth quarter of 2020, according to the advance estimate released by the U.S. Department of Commerce. Despite strong growth in Q4, preceded by record growth of 33.4% in Q3 2020, it still was not enough growth to book a positive year as the U.S. economy shrank by 3.5% in 2020 – the largest decline in GDP growth in post-WWII history and the first negative year since the Global Financial Crisis.
Despite the negative year for the economy, things look to be still heading in the right direction as vaccines continue to be distributed and as another stimulus plan in the ballpark of $1.9T is expected to be rolled out by Congress. While there are still signs of weakness in the economy such as jobless claims remaining above pre-pandemic levels and ticking up over the last several weeks, consumption remains relatively strong. Retail sales, after slowing in Q4, picked up at the start of the year with help from the second round of stimulus checks and manufacturing output is nearing its pre-pandemic levels.
Economic data overall appears to be trending in the right direction, however, even with the encouraging numbers we have seen over the last several months, there is still plenty of pain being felt by many. About 4.5 million workers are collecting unemployment benefits through state programs, and while that number is significantly lower than its pandemic highs, it is still more than double the level from the year prior.
Very few could have imagined back in March 2020 the markets coming out on the other side and posting positive returns for the year, let alone double digit returns virtually across the board. However, the market proved its resilience last year and didn’t let up, at least at first, to start the year. The S&P 500 again hit several new all time highs before peaking in late-January and giving back all of its 2021 gains and then some. The index ended the month down 1.4% to start the year. The same went for the Dow Jones Industrial average as it was down 1.1%.
Much of the volatility in the markets was arguably driven by the fallout from the infamous GameStop saga, which ultimately caused the selloff due to the markets worrying if the impact from GameStop and other heavily shorted names would lead to broader market selling from hedge funds and institutional managers to cover shorts and raise cash to meet margin requirements. Volatility spiked, not only in the Reddit stocks, but also across the entire market. At the end of the day, one small name stock such as GME, despite the media frenzy around the story, does not have the power to lead to a contagion through the entire market and volatility quickly stabilized after realizing the growth prospects for the broader market had not been effected by the chaos within a handful of small names in the market.
The Real GameStop Saga
It is likely that if you hadn’t heard of GameStop before January this year, you almost certainly know the name today, even if not having an understanding of their business model. After becoming a widely discussed name in financial news outlets in mid-January, rising over 100% in a matter of days, the gains did not slow down from there. Within less than two weeks the stock had risen another 200% and kept rising. By the time the mainstream media got a hold of the story, investors had maybe one day to capitalize on any further gains before the price began to come back down to earth. At its highs the stock was up over 1,700% year-to-date before crashing over 88% and settling in the $40-$50 range where it stands today. So what exactly happened and what caused GameStop and a few other names to sky rocket in a matter of days?
In brief, what happened with these names is known as a short squeeze. When an individual or institution wants to short a stock what they are really doing is borrowing the stock from someone else who owns it, selling that stock and taking the cash in anticipation of it going down, then hopefully buying it back at a lower price on a later date and returning the stock to the original owner while pocketing the cash they made for selling high and buying low. One of the biggest risks in shorting a stock is that unlike buying a stock, your losses could be infinite. If you short a stock at say, $50, it could theoretically run up forever and your losses will continue to pile. What happens when a known shorted stock begins to increase rapidly is called a short squeeze – essentially the stock is being bought by other market participants, driving the price up and therefore the losses up for anyone short the stock. After a while, those shorts will need to cover their losses and buy the stock back for more than they sold it for in order to return the borrowed shares. That in turn continues to drive the shares up even more.
Short squeezes are nothing new in markets. However a group of individuals in a subreddit community buying shares and call options in order to drive the price up in a stock in an attempt to short squeeze a hedge fund is very new and unprecedented. As the price continued its path “to the moon,” as members of the WallStreetBets subreddit call it, the hedge fund Melvin Capital, ran by a former SAC Capital portfolio manager, required a liquidity injection to the tune of $2.75B from Citadel and Point72, two other Wall Street hedge funds; the latter ran by the portfolio manager’s former boss, Steve Cohen. The stories reported in the media about individual investors’ revolution against Wall Street and nearly bringing down a hedge fund are only about half right, however. While they did cause a successful hedge fund to turn to the street for additional liquidity, Wall Street as a whole still came out on top because the house always wins. This is the real underlying story not being as widely covered as the GME price itself.
The wave of free trading, which became the new industry standard in late 2019, benefited retail traders who could now trade equities for free with no commissions. This leap in the industry lead retail’s share of trading volume nearly doubling by the end of 2020. With trades now being free and with technology making price discovery more efficient, it’s a win-win for the trading industry and retail traders. Enter “payment for order flow”. Payment for order flow is when market makers pay brokers to route trades to them. Market makers such as Two Sigma, Susquehanna and the aforementioned Citdel are some of the big players in this sector. Brokerages like Robinhood, who may not have the infrastructure to route thousands of orders coming in throughout the day to different exchanges, may have agreements with market makers to route trades to them for a set fee – often fractions of a penny per share. The agreement is that these market makers are required to meet certain best execution obligations. If a stock is trading at a bid (what a potential buyer is willing to pay to purchase the stock) of say $25.00 and an ask (what a seller is willing to sell for) of $25.50, the market maker may come in and offer a buyer of a stock $25.15. Under this agreement the broker gets paid to route orders, the market maker profits on the bid-ask spread, buying from sellers and selling to buyers, and the trader is probably getting a better price than they otherwise would without efficient order flow and price discovery provided by the market makers. Again, for the most part a win-win-win.
When a massive trade like GameStop enters the market and volume skyrockets, the volatility will tend to make price discovery more difficult – is the price going up for a reason? Was there good news? Is this a one-off? All of these unknowns cause that bid-ask spread to widen out. So that $25.25 stock, instead of having a $0.50 spread, may widen out to a bid of $24.75 and an ask of $25.75. Buyers and sellers are still getting matched and still arguably receiving best execution, however with the spreads now widening out, market makers’ profits are now increasing as well. All of this leads to the question of whether payment for order flow is a good thing for retail investing. Critics claim it causes a conflict of interest between best execution for their clients and maximizing profits and revenues for their shareholders. Some even went as far as calling the markets rigged. These critiques, along with the epic rise and fall of GameStop’s price in a matter of days and the halting of certain names on several brokers’ platforms, were what ultimately lead to the congressional hearings in late February.
The bottom line is that this, like most political disputes today, is not a black and white issue. Yes, market makers are profiting off of paying for order flow, however they are also providing a great deal of transparency and price discovery in the markets as well, ensuring traders are getting better pricing than they otherwise would if their brokers were to route trades to exchanges themselves without the appropriate infrastructure in place. Citadel claims market makers returned $3.7B to traders in the form of price improvement in 2020 – far more than they paid for their order flows. Retail traders want free trading and the best price execution, which they assume is provided to them by their brokers. Brokers like Schwab, E-Trade and Robinhood need revenues in order to provide the platforms for their customers to trade. Market makers provide a service to find the best available price for brokers’ customers, which is also a service, while all at the same time providing more price transparency in the market. The market is not rigged and as a matter of fact, it is extremely efficient.
If we really think about it, nothing is truly free in life. If you want to ensure you receive the best price when selling or purchasing a home, you hire a real estate agent. If you want to plan a trip with little effort and ensure you get everything you want at the best price possible, you hire a travel agent. This is really no different. Retail traders want “free trading,” however they also most likely don’t want to manually seek out the best price on an exchange every time they place a trade. Especially when in that time the market could move against them. They want the best price at that moment when they click the “Trade” button. There is a lot going on behind the scenes to ensure they are getting the best price at that moment. However brokers and market makers aren’t going to provide it out of the goodness of their hearts. Win-win-win.
Disclosures & Index Definitions
Under style performance boxes, indexes referenced in the equities section for large, mid and small reference the Russell 1000, Russell MidCap and Russell 2000 stock indices, respectively. The Barclays US Government, Barclays Credit and Barclays High Yield fixed income indices refer to Gov’t, Corp, and HY, respectively. Short, Intermediate and Long refer to the time frame of the investments and their positions on the yield curve.
The information and opinions stated in this presentation are not intended to be utilized as an overall guide to investing; nor should they be taken as recommendations to buy, sell or hold any particular investment. This presentation is not an offer to sell or a solicitation of any investment products or other financial product or service, an official confirmation of any transaction, or an official statement of presenter. The opinions and views conveyed are for informational purposes and make no recommendations in regards to how a client’s portfolio should be managed, as that involves inquiring, in depth, of a client’s or prospective client’s risk tolerance, investment objectives, time frame for investing and any other details pertinent to said client’s or prospective client’s financial situation. The presentation may not be suitable to be relied on for accounting, legal or tax advice.
Past performance is not indicative of future returns. Prices and values of investment vehicles will rise and fall as broad market conditions change. Investors’ portfolios may fluctuate, to varying degrees, in tandem with market conditions. Diversification neither guarantees returns nor does it eliminate the risk of a portfolio decreasing in value. Equity securities tend to be more volatile than bond/fixed income products and carry greater risk factors than that of fixed income products. Smaller capitalization equities (i.e. mid and small caps) typically involve more risk than that of larger capitalization stocks. Political, economic, and currency risk are all risks subsumed under the additional risk factors of investments in international securities, to include those in both developed and emerging markets. In addition, political conditions in emerging markets can tend to be more volatile than in those of developed markets.
Investments in bonds will be subject to credit risk, market risk and interest rate risk. Interest rates will have an inverse effect on prices of bonds. Bonds of lower credit ratings, also known as High Yield bonds which hold a rating of less than investment grade (BB+ and below), will have greater risks attached than will those of investment grade bonds and will experience greater volatility.
All dates are as of January 29, 2021, unless stated otherwise.
Presentation prepared by Financial Advisory Service, Inc., an SEC Registered Investment Adviser. Securities offered through FAS Corp., an affiliated insurance agency and broker/dealer.
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The S&P 500 Index is based on the market capitalizations of 500 large companies whose stocks are listed on the NYSE and NASDAQ. This is widely regarded as the single best gauge of large cap US Equities.
The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks, primarily industrials. It is used as a barometer of how shares if the largest US companies are performing.
The NASDAQ is a market capitalization weighted index of the more than 3000 common equities listed on the NASDAQ Stock Exchange. These securities include American Depository Receipts, common stocks, real estate investment trusts, and tracking stocks.
The MSCI EAFE (Europe, Australasia, Far East) Net Index is recognized as the pre-eminent benchmark in the US to measure international equity performance. It comprises the MSCI country indices that represent developed markets outside of North America, Europe, Australia, and the Far East.
The MSCI Emerging Markets Index captures large and mid cap representation across 23 Emerging Markets (EM) countries. With 822 countries, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The Barclays US Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS, ABS, and CMBS.
All index information has been gathered from public sources who are assumed to be reliable, although we cannot guarantee the accuracy or completeness of those public sources.