Superior investors make more money in good times than they give back in bad times. – Howard Marks
Although the good news far outweighed the bad news last week, it was speculative trading by retail investors in Gamestop and a few other heavily shorted stocks that caused massive losses at a few hedge funds and resulted in losses for the major stock averages as well. It was collectively the worst week for stocks since way back on October 30th as all three benchmarks were down. After a weekly loss of 1.4%, the S&P 500 Index finished the month of January slightly in the red. What unnerved the market was fear that day-trading of shorted stocks by investors could ripple through financial markets and cause huge losses at brokers such as Robinhood and hedge funds that were overleveraged. The speculative trading behavior also might have been a sign that the market was overvalued and due for a pullback. But there was plenty of good news last week, too, as fourth quarter earnings continued to be strong, economic data was encouraging, the Federal Reserve reiterated its easy monetary policy and two new vaccine candidates were announced. Novavax, a biotech firm, said that its coronavirus vaccine was more than 89% effective in protecting against Covid-19 in phase three trials in the United Kingdom and Johnson & Johnson’s one-dose vaccine proved to be 72% effective in trials in the U.S. Although there had been hope that its efficacy rate would have been 80% or higher, its vaccine does offer protection against Covid-related hospitalizations and is 100% effective in preventing deaths. The Federal Reserve also had reassuring words for investors last week. At its meeting last week, the Fed kept interest rates unchanged as expected and said that it will keep buying at least $120 billion of bonds each month. While it acknowledged that the path of the economy will largely depend on the course of the virus and progress on vaccinations, the Fed also stressed that it won’t raise interest rates in anticipation of inflation but will tolerate higher prices to ensure an economic recovery. Finally, quarterly earnings continued to be a bright spot as more than 80% of S&P 500 companies that have reported so far have beaten analysts’ estimates. Technology-heavyweights Microsoft, Facebook and Apple easily topped revenue and earnings expectations last week with Apple reporting its biggest quarter for revenue ever at $111.4 billion.
Fourth quarter gross domestic product (GDP) grew at a 4% annualized rate, slightly below estimates. GDP for the full year in 2020 declined by 3.5%, the worst year for the U.S. since at least the end of World War II. Weekly jobless claims were 847,000, which was less than 875,000 forecast by economists. Durable goods orders in December rose modestly and were down significantly from the two prior months as there was a big decline in aircraft orders. The manufacturing sector continues to fare well, however, despite rising Covid-19 cases but could see slower growth in both business investment and equipment spending. The consumer confidence index rose in January from its level in December and was better than expected.
The International Monetary Fund (IMF) raised its forecast for global economic growth in 2021 but warned that there is much uncertainty about the outlook.
For the week, the Dow Jones Industrial Average lost 3.3% to close at 29,982 while the S&P 500 Index also fell 3.3% to close at 3,714. The Nasdaq Composite Index declined 3.5% to close at 13,070.
The January employment report is expected to show that 100,000 new jobs were created and that the unemployment rate remained unchanged at 6.7%. ADP also releases its National Employment Report for January and it is projected to show a gain of 100,000 private sector jobs. Both construction spending and factory orders in December are expected to increase modestly but by less than in the prior month. The ISM Manufacturing and Services Purchasing Managers’ Indexes (PMI) are forecast to be solidly in expansion territory above the 50 threshold, a positive sign for the economy.
The most notable companies scheduled to report quarterly earnings this week include Alphabet (Google), Amazon, Qualcomm, eBay, Amgen, Pfizer, AbbVie, GlaxoSmithKline, Bristol Myers Squibb, Merck, Cigna, BP, Exxon Mobil, Royal Dutch Shell, Ford Motor, Illinois Tool Works, United Parcel Service, MetLife, Philip Morris International and Unilever.
Turnabout is fair play and last week’s revelation that retail investors had piled into some heavily shorted stocks like Gamestop and AMC Entertainment was proof that they had used one of hedge funds’ popular investment strategies against them. Although individual investors can also short stocks, it is considered a very risky strategy that is usually only employed by hedge funds. Generally, stocks are purchased with the belief that they will rise in price and a profit is made when the stocks are sold. With short-selling, the profit motive still exists but investors believe that a stock is overvalued and that it will decline in price. Selling a stock short by an investor begins by borrowing shares from a brokerage firm and then immediately selling those shares at the current market price, which the investor thinks will drop. If the decline occurs, the investor purchases the shares at the lower price and returns them to the lender to complete the transaction. The difference between his initial sales price and his subsequent purchase price is his profit. However, if the price of the stock rises instead of falls, an investor has to buy the stock to repay the brokerage firm, resulting in a loss. With so many retail investors banding together on Reddit to buy shares of Gamestop, short sellers in hedge funds also had to buy the stock to cover their position and minimize their losses. This created what is called a “short squeeze” which can lead to the price of a stock going higher and higher. While trading could be choppy in the weeks ahead, the impact on the broad market should be minimal as there are very few stocks that are heavily shorted.