Did you hear GameStop went viral?

Here’s a quick guide to the market frenzy you’re seeing in the headlines.

But before we dive in, please don’t lose sight of this essential fact:  all this mayhem means very little to the majority of investors. If you’re properly diversified, your 401(k) is fine and your IRA is still doing its thing.

Our clients know that their NorthStar portfolios are firewalled from craziness like this thanks to this critically important truth: We will never own enough of any one idea to make a killing in it. We will never own enough of any one idea to get killed by it.

In fact, it is our considered opinion that owning individual stocks, shorting stocks, and hedge funds are all a form of the Sirens’ song (more on that in the last section below).

Now let’s look at how we got here, and what the impact is for average investors.

Long email ahead. (Buckle up, it’s a little complicated.)

What is GameStop and why does everyone care?

GameStop is a brick-and-mortar video game chain that hit hard times in the pandemic. Like many distressed companies, it was targeted by short sellers betting that the stock’s price would go down.¹

Basically, short sellers do the opposite of most investors. They try to make money when a stock’s price falls. They borrow shares from their brokerage for a fee, immediately sell them, and plan to buy them back later at a lower price when the price falls. Shorting is a strategy used by certain types of hedge funds.

What’s a short squeeze?

Shorting stocks is risky since any positive news or interest in a company can drive the stock’s price up. When short sellers bet wrong and a stock’s price rises, they can be forced to buy shares at higher prices to cover their losses (or pony up more collateral).

A squeeze happens when short sellers scramble to buy shares to cover their positions when the stock price is rising. The more investors who buy and hold those shares, the harder it is for short sellers to find shares to buy (exposing them to potentially huge losses).

With me so far?

Where does Reddit come in?

After it became clear that short sellers were betting on GameStop’s demise, the popular company became the focus of amateur traders on the popular WallStreetBets forum on Reddit, a popular community of chatrooms and forums.

By banding together and coordinating buying activity, these small-time traders boosted the stock’s price far above what the company’s financial fundamentals support, putting pressure on the hedge funds betting the other way.²

The stock went viral.

Why?

Social media chatter + free trading apps like Robinhood + bull market + new investors with time on their hands = FRENZY

Is it illegal? That’s a stretch. These armchair traders are egging each other into speculative bets, but we don’t think it rises to the level of illegal market manipulation. However, regulators might feel differently.

Is it bad for markets? The battle between gleeful amateurs pushing prices up and hedge funds scrambling to force prices down has led to some of the highest volume trading days on record and cost short sellers billions.³

Is this David vs. Goliath?

We don’t think the GameStop bubble is just about greed or boredom or euphoria. We see a powerful narrative at play.

We think a lot of these small traders are angry at the perception that All-Powerful Wall Street is pulling strings and using their connections to hurt mom-and-pop investors. They see this as an opportunity to stick it to the big-money pros by using their own strategies against them.

It’s new school vs. old school. Rebels vs. the Empire. Bueller vs. Principal Rooney. Reddit vs. CNBC.

So, should I be investing in GameStop?

No! GameStop’s stock is massively inflated and trading has been halted multiple times because of its meteoric rise.⁴ At this point, it looks like folks are piling in just to say they were there.

When the bubble bursts, it’ll be a rush to sell and many GameStop holders will end up losing most of their investment.

(It might already be happening by the time you read this.)

We’ve seen frenzies like this many times before. Tulip mania in the 1630s, the Nifty Fifty in the 1970s, the dot-coms in the 1990s, Bitcoin’s multiple bubbles over the last decade, etc. We’ll see more in the future.

Why are people angry at Robinhood?

Amidst the buying frenzy, Robinhood and other popular brokerage platforms suddenly restricted trading on several red-hot stocks, including GameStop.⁵

Protests erupted from investors, many market pros (not the short sellers, obviously), lawmakers and more.

Did Robinhood halt trading to appease big investors at the expense of small investors? Did they do it to protect markets from manipulation and liquidity problems?

What are the implications of this frenzy?

There’s no predicting the future, obviously, but we think a few things are likely. Most bubbles end naturally when the euphoria turns to panic, folks start selling, and the price crashes.

However, it’s also possible that regulators will step in if they think there’s risk to markets (or they see too many investors getting hurt).

We think this ride’s going to end in tears for many folks caught up in it. But I’m not sure who will be crying hardest.

Finally, The Sirens

Remember the story from The Odyssey, where Ulysses and his crew have to sail past the island of the Sirens?

The Sirens, you’ll recall, sing a song so seductively sweet that no sailors can resist it: they must steer toward the song, only to be dashed upon the rocks surrounding the island.

Ulysses, being the conniver he is, looks to have it both ways: he wants somehow to hear the song while not getting shipwrecked.  So he stuffs all his crewmen’s ears with wax, and has himself lashed to his ship’s mast — ordering his mates on pain of death not to obey him if he orders them to change course.

Individual stocks (GameStop!), shorting, and hedge funds are all part of the Sirens’ song, and they are singing it to you and to millions of other investors, who are perhaps losing touch with how fatal it will be to their long-term plans if the “miracle” implodes.

In this analogy, we are the one true friend who accepts the responsibility of lashing you inextricably to the mast. And diversification is the rope.

¹_{https://www.morningstar.com/articles/1019249/what-the-heck-is-going-on-with-gamestop}
²_{https://www.marketwatch.com/story/gamestop-stock-has-another-volatile-trading-day-with-more-price-spikes-and-trading-halts-11611686411}
³_{https://www.ft.com/content/56658052-76fe-4910-8cb7-810039753f7c
https://www.reuters.com/article/us-retail-trading-shortbets-idUSKBN29X1SW?taid=6012f37e9ac87d000147d4e3&utm_source=reddit.com}
⁴_{https://www.cnbc.com/2021/01/28/robinhood-customer-sues-trading-app-over-gamestop-restrictions.html}

Does it feel like 2021 yet?

The twists and turns so far make it seem like 2020 is dragging into a second season.

As Americans, we’re shocked and worried, and we’re wondering how political disagreements turned into excuses for violence.

As a financial professionals, we know that the politics, protests, and rioting in DC are just one factor affecting markets.

We honestly don’t know what will happen over the next few weeks, but we can help you understand how it affects you as an investor.

Why did markets surge the day the Capitol was attacked?

While the world watched the violence in DC with horror, markets quietly rallied to new records the same day.¹

That’s weird, right?

Well, not really.

We think it boils down to a few things.

1. Computers and algorithms are dispassionate, executing trades regardless of the larger world.
2. Markets don’t always react to short-term ugliness. Instead, they reflect expectations about economic and business growth plus a healthy dose of investor psychology.
3. With elections officially at an end, political uncertainty has dissipated.

Overall, we think investors are looking past the immediate future and hoping that vaccines, increased economic stimulus, and economic growth paint a positive picture of the future.

The Democrats control the White House and Congress. What does that mean for investors?

If you’re like a lot of people, you might think that your party in power is good for markets and your party out of power is bad.

That makes for a stressful experience every four years, right?

Fortunately, that’s not the case at all. Markets are pretty rational with respect to politics and policy.

While businesses and investors generally dislike increased taxes and corporate regulation, the Democrats hold such slim majorities in the House and Senate that it limits their ability to pass many big policy changes.

Also, the Democrats’ immediate agenda is very likely to be focused on fighting the pandemic and passing more stimulus aid, both of which should support stock prices.

Does that mean markets will continue to rally?

No guarantees, unfortunately. With all the frothy market activity and rosy expectations about the future, bad news could knock stocks down a peg or two.

A correction is definitely possible, and some strategists think certain sectors are in a bubble.

Bottom line, expect more volatility.

Well, what comes next?

We wish we could tell you.

We’re hoping that the vicious, divisive politics will come to an end after the inauguration, and the politicians can get back to work getting us through the pandemic.

We’re optimistic that the light at the end of the tunnel is getting closer and we can start going back to normal.

We’re proud of what scientists and medical professionals have been able to accomplish in such a short amount of time.

We’re grateful for the folks around us.

We’e hopeful about the future.

How about you?

What’s your take? We’re interested to hear your thoughts.

Warmly,
The NorthStar Team

P.S. Tax laws are likely to change under the Biden presidency. We don’t know exactly when they’ll happen or what they’ll look like, but we’ll be in touch when we know more.

¹_{https://www.cnbc.com/2021/01/07/stocks-rally-to-record-highs-traders-on-whats-next-for-markets.html}

On December 31, 2019, the Standard & Poor’s 500 Stock index closed at 3,230.78. This past New Year’s Eve, it closed at 3,756.07, some 16.3% higher. With reinvested dividends, the total return of the S&P 500 was about 18.4%.

From these bare facts, you might infer that the equity market had, in 2020, quite a good year. As indeed it did. What should be so phenomenally instructive to the long-term investor is how it got there.

From a new all-time high on February 19th, the market reacted to the onset of the greatest public health crisis in a century by going down roughly a third in five weeks. The Federal Reserve and Congress responded with massive intervention, the economy learned to work around the lockdowns — and the result was that the S&P 500 regained its February high by mid-August.

The lifetime lesson here: At their most dramatic turning points, the economy can’t be forecast, and the market cannot be timed. Instead, having a long-term plan and sticking to it — acting as opposed to reacting, which is our clients’ and our firm’s investment policy in a nutshell — once again demonstrated its enduring value.

(Two corollary lessons are worth noting in this regard. (1) The velocity and trajectory of the equity market recovery essentially mirrored the violence of the February/March decline. (2) The market went into new high ground in midsummer, even as the pandemic and its economic devastations were still raging. Both outcomes were consistent with historical norms. “Waiting for the pullback” once a market recovery gets under way, and/or waiting for the economic picture to clear before investing, turned out to be formulas for significant underperformance, as is most often the case.)

The American economy — and its leading companies — continued to demonstrate its fundamental resilience through the balance of the year, such that all three major stock indexes made multiple new highs. Even cash dividends appear on track to exceed those paid in 2019, which was the previous record year.

Meanwhile, at least two vaccines were developed and approved in record time, and were going into distribution as the year ended. There seems to be good hope that the most vulnerable segments of the population could get the vaccines by spring, and that everyone who wants to be vaccinated can do so by the end of the year, if not sooner.

The second great lifetime lesson of this hugely educational year had to do with the presidential election cycle. To say that it was the most hyper-partisan in living memory wouldn’t adequately express it: adherents to both candidates were genuinely convinced that the other would, if elected/reelected, precipitate the end of American democracy.

In the event, everyone who exited the market in anticipation of the election got thoroughly (and almost immediately) skunked. The enduring historical lesson: never get your politics mixed up with your investment policy.

Still, as we look ahead to 2021, there remains far more than enough uncertainty to go around. Is it possible that the economic recovery — and that of corporate earnings — have been largely discounted in soaring stock prices, particularly those of the largest growth companies? If so, might the coming year be a lackluster or even a somewhat declining year for the equity market, even as earnings surge?

Yes, of course it’s possible. Now, how do you and we — as long-term, goal-focused investors — make investment policy out of that possibility? Our answer: we don’t, because one can’t. Our strategy, as 2021 dawns, is entirely driven by the same steadfast principles as it was a year ago — and will be a year from now.

We have been assured by the Federal Reserve that it is prepared to hold interest rates near current levels until such time as the economy is functioning at something close to full capacity — perhaps as long as two or three more years.

For investors like us, this makes it difficult to see how we can pursue our long-term goals with fixed income investments. Equities, with their potential for long-term growth of capital — and especially their long-term growth of dividends — seem to us the more rational approach. We therefore tune out “volatility.” We act; we do not react. This was the most effective approach to the vicissitudes of 2020. We believe it always will be.

As always, we’re here to talk any and all of these issues through with you.

We wish you a happy, healthy, prosperous and fulfilling 2021.