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DJ Markets Withstood the GameStop Test

· 02/04/2021 17:06
By James Mackintosh

The GameStop saga rattled a lot of people.

Hedge funds who shorted the stock were crushed as it soared 10-fold in five days. New buyers who were sucked in late by the prospect of quick profits then lost horribly, with the stock down almost 90% from its high after falling 42% on Thursday. Even those who got in early can't be happy to see so much of their newfound wealth evaporate. Trust in Wall Street, in the clearing system and in popular broker Robinhood have all been damaged, and opportunistic politicians from left and right have leapt on the moves to support their existing policy positions.

Yet, investors might reasonably be reassured by the resilience of the wider market. If that sounds odd, bear with me. Last week the broad selloff by hedge funds as they cut their leverage shook up stocks, with those heavily shorted rallying hard while the rest fell. Volatility jumped. The S&P 500 had its two worst days since October, as the effect of deleveraging was worsened by worries about the knock-on effects if a big hedge fund collapsed.

The market became highly sensitive to GameStop. Since the retailer was listed by then-owner Barnes & Noble in 2002, it has tended to move in the same direction as the S&P, with the 100-day correlation in their moves always being positive. Over the 10 days to Tuesday, the stock has moved in the same direction only twice, and the 100-day correlation is now negative. What was good for GameStop was bad for the market, and vice versa.

The reason for comfort is that stocks didn't suffer more. It isn't so much that we should be relieved that GameStop and the broader coordinated attacks by users of Reddit didn't bring down a broker or start a chain reaction of hedge-fund failures, although of course that would have been very bad. The good news is that these worries didn't trigger a significant correction.

Put simply: The GameStop shenanigans didn't prick the market bubble, and maybe that means there isn't a bubble.

My view continues to be that parts of the market are wildly overdone and in mini-bubbles, notably anything connected to electric cars or new energy. Both are clearly growth industries. But the market is throwing money at these companies as though they alone will make technological breakthroughs and have no competition nor setbacks. These assumptions are likely to prove wrong.

The case for the wider market being in a bubble is less clear. True, valuations are back at dot-com-era levels, IPOs -- and their close relative, SPACs -- are on a tear and sentiment gauges show little fear. Pretty much every measure screams excess.

But this is explained neatly by the old argument of TINA: There Is No Alternative to stocks at a time when the 10-year Treasury yields only just over 1%. Relative to bonds, stocks still look fine.

There is an important nuance to the claim that it is all about TINA. Stocks are affected by both low Treasury yields and the weak economy. The biggest winners from low yields are those with profits far in the future, notably growth stocks such as Alphabet or Microsoft that also have solid earnings, and story stocks like Tesla with negligible net income but the hope of big earnings one day. These stocks gain from low yields, but because their growth is only loosely tied to the economy, its weakness doesn't hold them back.

Contrast that with cyclical stocks where earnings are closely tied to the economic outlook, and there's little else to provide long-term growth. These stocks -- car-parts suppliers or bricks-and-mortar retailers, for example -- get far less benefit from lower bond yields and suffer more from the pain in the economy, and have lagged far behind.

The U.S. market is dominated by the TINA winners, so low yields have helped the market overall. In Europe, the big stocks tend to rely more on economic growth, so even the region's negative yields have only just been enough to offset the hit to the market from the economy's troubles.

Bubble believers can always argue that the GameStop shenanigans just weren't enough to break through the market's complacency. Reddit traders might repeat with a new target, or yet-to-be-revealed losses might still take down a financial player. And of course Treasury yields rising faster than expected would still be bad, perhaps awful, for the market even in the no-bubble scenario.

But investors should take at least a crumb of comfort that the market has so far avoided a major tumble thanks to GameStop.

Write to James Mackintosh at James.Mackintosh@wsj.com

(END) Dow Jones Newswires

February 04, 2021 17:06 ET (22:06 GMT)

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