Is GameStop-Style Risk-Taking a Prelude to Instability?
(Bloomberg Opinion) -- Smaller-scale retail investors, traditionally viewed as late to the party and at the mercy of institutional investors, have been capturing stock market headlines recently, directly inflicting losses on hedge funds and influencing the market as a whole. With that comes Wednesday’s striking contrast between the price surge in the handful of stocks embraced by this new investor force and the losses incurred in the overall market — one that also raises several interesting questions for market structure and future financial stability.
Whether the stock is GameStop or AMC, the pattern is similar and played out bluntly on Wednesday morning. A group of small-scale investors communicating through electronic platforms identify and embrace small-cap and heavily shorted stocks. The resulting price volatility gives way to an enormous breakout on the upside. As more investors pile on, short sellers face higher margin calls, with some forced to cover their shorts and others going further and “degrossing” their positions — reducing both shorts and longs concurrently. In turn, this leads to the sale of more liquid stocks, putting pressure on the broader market indexes. As an illustration, this was the price configuration some 30 minutes into Wednesday’s highly volatile trading session: GameStop up 93%, AMC up 217% and the S&P 500 index down 1.7%.
For some, the recent market action reflects a fundamental power shift that gives smaller investors much greater influence on market outcomes. The key enabler is ample liquidity, de facto coordination platforms (think Reddit) and low-cost and highly accessible investing interfaces (think Robinhood). It’s a tail-wagging-the-dog phenomenon that has lasting power in terms of changes to market structure.
Others dismiss it as a short-term phenomenon that caught institutional investors by surprise. Once they regain their footing, and they will in this view, their inherent resilience and larger capital base will allow for a reversion to the previous market structure.
The third interpretation has already triggered comparisons to the 1637 tulip mania, which featured a period of remarkable price increase that gave way to a drastic collapse. It places this latest market action in the context of growing evidence of bubble-like behavior that, just two weeks ago, was playing out in Bitcoin and has now shifted to another area. Highly speculative behavior and the quest for a quick buck have replaced more cautious fundamentally driven investing.
While all three interpretations will have their adherents, it is the third one that worries me most and, I fear, is too consequential to ignore.
Long comforted by the ample and predictable injection of liquidity in markets by central banks, investors have been willing to take more and more risks. Some have ventured further and further into highly speculative strategies, causing outsized price moves that then attract others. There are reports of some recipients of U.S. government stimulus checks deploying the funds straight into these strategies, including trading cryptocurrencies. Chat rooms are full of those boasting about astronomical one-day profits.
This would be a worrisome yet natural extension of a phenomenon that initially encouraged investors to take more risks in the traditional segments of financial markets. Investors have been continuously conditioned to buy the dip, regardless of its cause. FOMO (fear of missing out) and TINA (there is no alternative to risk assets) have turbocharged this behavior. Meanwhile, companies have been encouraged to do more financial engineering, including the issuance of a record amount of bonds under the false impression that debt is always the answer to everything.
Should my worries be valid, the implications for the economy are far from reassuring. The dual possibility of large-scale financial volatility and market dysfunction would pose yet another challenge to an economic recovery that faces both short-term challenges — particularly on account of disruptions related to Covid-19 — and longer-term ones — mainly on account of scarring, in which short-term problems become embedded in the structure of the economy and harder to solve.
All this notable market action is happening on a day when the Federal Reserve is likely to feel compelled to continue its ultra-loose injection of liquidity and, with that, inadvertently fuel the risk of collateral damage and unintended consequences for both financial stability and longer-term economic and social well-being.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include "The Only Game in Town" and "When Markets Collide."
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