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Posted by Greg Taylor on Feb 3rd, 2021

The Retail Rally Holds Important Lessons

Is this the calm before the storm? Markets began 2021 with the sense of optimism that often comes with new beginnings. The scars of the previous year are still fresh, but sentiment amongst investors was near an all-time high as the calendar turned and remains largely intact now.

The optimism stems from the widely held belief that we are near the end of the global pandemic. Many hope that by the second half of the year most people will be vaccinated and the economy will be reopening to a surge of pent up consumer spending. Investors have also been looking forward to a calmer political year.

Markets hate uncertainty and it felt like we were finally able to move on from the volatility of 2020. But, with January now over, a lot of those expectations are looking to have been a little too rosy. Some may even need to be outright rethought.

By the numbers as at January 31, 2021

The surprising sweep of the Georgia senate seats by the Democrats did lead to hope of further stimulus measures, but it also has markets back to worrying about what it means for regulations on Wall Street and in Silicon Valley, not to mention what may happen with tax increases.  An attempted overthrow of the US capital by a mob who felt the US election was a fraud was grounds for further concerns.

The calm everyone was expecting with the flip of a calendar seems a long way off. But, while these events and their shocking images set the media off in a panic, markets seemed unphased. Investors seem content with the increasingly obvious fact that the greatest force in capital markets remains the central bankers and they’re not adjusting plans anytime soon.

However, the last week of January may have changed things. Equity markets have been exhibiting signs of excess over the last few months but lacked a trigger to cause any selling.  From the SPAC boom to the impressive returns of technology IPOs to the Bitcoin boom, excess capital from the stimulus had found its way into increasingly risky parts of the market. No one seemed to think the next phase of this mania would involve a flurry of buying in near-bankrupt companies.

In hindsight, what has been organized on Reddit chat rooms has been brilliant. For years, hedge funds have aggressively touted their short positions, ganging up with other firms to prey on the weak. Even rumors around new victims for the shorts could cause massive declines in the shares of target companies. But the tables have turned and at this point the knock-on effects and collateral damage on the overall market are unknown.

With many of these short positions published monthly, the new strategy used by these retail investors is to team up and aggressively purchase out-of-the-money call options to force a short squeeze. When short positions begin to gain quickly, risk managers and compliance officers rule the day and automatically force managers to cover these positions, pushing the prices even higher.

This part of the strategy isn’t new, but the use of options on margin exacerbated the move to new extremes. The example everyone will remember is GameStop, but it happened across many names at the same time.

Shares of GameStop have been under pressure for years. Few mall-based retailers have been able to successfully adapt to the new online world.  As such, GameStop became a favourite short target for hedge funds. Many of these funds run what are called market-neutral strategies, in which short positions are paired up with longs.

What we saw to end January was the largest de-grossing (taking down exposure) in years. As the short positions skyrocketed, hedge funds were forced to buy them back and to pay for this they had to sell their winners or favourite names. In an already extended market, could forced selling around crowded trades be the trigger for the long-awaited correction?

The good news remains that central banks will not let markets crash during a pandemic.  A short-term correction is probably due given the run equity markets have been on over the last 10 months.  And while it won’t kill the bull market, it does highlight the risk investors take when everyone is too complacent and thinks they’re invincible.

No one expected the strongest performing equities for January would be the worst-positioned companies. But these hedge funds are relearning the old adage that the market can stay irrational longer than you can stay solvent.

It appears volatility is going to be with us once again in 2021. In a year in which everyone is expecting (or at least hoping) things to go perfectly, the risk is reality will come back to remind us that it may not.

To get through this period, it will be important to stay active and take advantage of opportunities that may arise. The last time retail investors rose up to affect trading to this extent was 2000. Everyone remembers how that ended. This rally will last as long as the central banks allow it to. Excess speculative activity may shorten that period, but we all have to realize we are getting later in the game and need to think about positions accordingly.

— Greg Taylor, CFA is the Chief Investment Officer of Purpose Investments

All data sourced from Bloomberg unless otherwise noted.

By the numbers displays total returns for the month of January, 2021. The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

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Greg Taylor, CFA

Greg Taylor is the Chief Investment Officer of Purpose Investments. A data-driven manager with a focus on managing risk through active-trading strategies, Greg specializes in finding and exploiting pockets of volatility in the market to drive returns. He spent more than 15 years managing pension and mutual fund assets at Aurion Capital Management. He also held a role of senior portfolio manager at Front Street Capital and LOGiQ Asset Management before coming to Purpose Investments.