Crowd-sourcing a short squeeze
How individual investors are changing the dynamics of a well-known strategy from the institutional investor playbook.
Mentioned: American Airlines Group Inc (AAL), AMC Networks Inc (AMCX), GameStop Corp (GME), Macy's Inc (M), Macerich Co (MAC)
Short squeezes are nothing new, as institutional investors have played this game for years. What’s new are the players: Crowdsourcing among individual investors has led to a lightning-fast evolution of the traditional short-squeeze play.
With its high short-interest ratio and availability to pile on additional leverage through the options market, GameStop (GME) was a prime candidate for a short squeeze. What started on a Reddit board was then further amplified on Twitter by a few high-profile investors announcing their purchases of out-of-the-money call options. All of this activity culminated in a stock price explosion from US$19 to as high as US$380 in intraday trading over the course of two weeks.
Short investors were carried out on stretchers.
Like any other trading strategy that works in the short term, this strategy is starting to catch quickly and is spreading to other stocks with high short-interest ratios.
Make no mistake about it: During a short squeeze, the increase in the stock price has absolutely nothing to do with the long-term fundamentals of the company and everything to do with the short-term technicals. However, once a short squeeze comes to an end, look out below.
In a typical short squeeze, once all of the weak shorts are margined out of their positions and the forced buying ends, the stock price will come crashing back down to earth. And just like no one wants to try to catch a falling knife until it hits the floor, fundamental investors focused on the long term won’t re-enter the market until the stock is significantly undervalued.
While we think the market is currently broadly overvalued, this phenomenon does not change our view of the market structure for long-term investors. These situations are more of a cautionary tale of the inherent risks of shorting individual stocks, especially those that already have a high short-interest ratio.
The mechanics of the short squeeze
Prior to the stock rally, the short-interest ratio on GameStop hit 260 per cent at the end of last year. With a short-interest ratio well over 100 per cent, many of the shorts were “naked,” meaning that they sold stock that they were not able to borrow, an especially precarious position.
MORE ON THIS TOPIC: Investing shouldn't feel like a trip to the casino
As the stock price first began to rise, many of these investors were forced to buy the stock to cover their positions, which in turn sent the stock price up. As the price rose, other short-sellers began to buy as their margined positions quickly moved against them. It was a self-perpetuating cycle.
The stock price really got moving as other investors purchased out-of-the-money call options. The dealers that sold those call options then bought the stock to hedge their delta, the rate of change of options price due to change in underlying stock price.
As the stock rose even further, those dealers were forced to buy even more stock as the price neared the strike price. Our guess is that many institutional stock investors who were long the stock prior to the rally have called their trustees in order to instruct them to pull their availability to lend the shares out.
As the short squeeze rapidly expands across the markets, it appears that many hedge funds have looked to cover their shorts before they are next in line. As losses are being racked up on the short positions, some highly leveraged funds may have to sell some of their long positions to cover their margins.
Don’t confuse trading with investing
Shorting stocks helps to keep the market in balance over time as it provides a natural resistance for overvalued stocks to become even more overvalued. However, after getting burned in a short squeeze, many of these investors will become much more hesitant to short stocks in the future. This could limit that natural balance between investors' opinions on whether a stock is over- or undervalued. In addition, options dealers will look to charge higher premiums, thus greater implied volatility, on the options they sell in order to protect themselves against wild price swings.
While this trade has worked for now and is still expanding to other stocks, don’t confuse what is happening with investing. This isn’t some new riskless way for investors to make money.
Once enough of the shorts have been flushed out, there won’t be any new buyers to keep the stock price propped up, and, like a plane hitting an air pocket, the stock price will drop to levels where fundamental investors will start buying.
For those who have an interest in trading, we recommend that trading positions should be separated from and differentiated from investment positions, as the two have very different paradigms of how to manage positions.
For example, within trading positions, strict loss limits should be set and rigorously followed in order to keep from being overwhelmed if positions go against you. It is better to take a small loss today and be able to survive and trade another day than to let losses overwhelm you. If a position doesn’t move as expected when an identified catalyst occurs, don’t let trades turn into investments in the hopes that the stock will recover over time.
For investing, we adhere to the age-old strategy of investing for the long term. We view purchasing stock as buying a piece of the business. We conduct a deep dive into the company and the sector in which it operates to identify long-term structural competitive advantages, or economic moats, and build a detailed discounted cash flow model to determine our fair value estimate. We then utilise a pricing overlay based on an assigned Morningstar Uncertainty Rating to determine an appropriate margin of safety in order to assign our Morningstar Ratings, often referred to as "star ratings."
Ideas at the intersection of fundamentals and technicals
Among stocks that have large short interest positions, there are a number that we rate from a fundamental perspective. The only stock with a high short-interest that we currently view as undervalued is Macerich (MAC). Over the past few years, Macerich has successfully become an owner and operator of Class A regional malls. While malls may need to reposition themselves following the pandemic and become more experimental, we think the market is undervaluing the firm’s long-term prospects.
We rate Macy’s (M) with 3 stars, meaning we think it is fairly valued at its current price. We had rated the stock with 5 stars as recently as early December, but the stock price has been on an rising trend and is now spiking upward as the short-squeeze contagion expands. We also rate American Airlines (AAL) with 3 stars, as the stock has appreciated since last November.
Among the stocks we rate 2 stars, AMC Networks (AMCX) had been rated 4 stars as recently as one month ago, and Bed, Bath & Beyond (BBBY) had just dropped from a 3-star rating on Jan. 25. From a fundamental point of view, we think the market has gotten ahead of itself. Both stocks are overvalued and the recent price movement may provide an attractive exit point for investors.