I am sending out this quick note to address the heightened stock market volatility.
First, this volatility is not related to the health and fundamentals of high-quality growth companies.
Corporate earnings have been strong to start the year, with Apple posting their highest quarterly revenue of all time at $111.4 billion.
So, what’s driving the action?
Here’s a brief rundown of the headline news surrounding stocks such as the video game retailer, GameStop.
Several hedge funds shorted a handful of distressed companies including GameStop, AMC, Koss, and others. When you short a stock, you are making a “bet” that the stock is going to go down. Mechanically, the way it works is as follows:
- You borrow shares of a company from a broker.
- You immediately sell the shares.
- In the future, you buy back the shares and return the borrowed shares to the broker.
In other words, if the stock goes down, you make money.
For example, let’s say a stock is trading at $100 a share and you decide to short one share of the stock. You borrow one share and immediately sell it for $100. If the stock drops to $50 a share and you buy the stock back and return it to the broker, you just made $50 – you sold the stock for $100 and bought it back for $50.
Therefore, when you short a stock, the most you can make is the difference between the current price of the stock and $0. In this example, the most you can make is $100.
But the amount you can lose is infinite. Using the example above, if the stock goes up to $200 and you buy it back to “close” out your short, you just lost $100. If the stock goes up to $500, you lose $400.
In the case of these distressed companies (most notably, GameStop), the hedge funds were heavily short, and a group of retail traders banded together on the chat forum Reddit to aggressively buy the shares to create positive price momentum. This, in turn, forced the hedge funds to buy back the shares at higher prices, creating more stock momentum, and massive losses for the hedge funds. This is referred to as a “short squeeze”.
So why is this impacting the broader stock market?
Because many of these hedge funds are being forced to raise cash and are selling higher quality and liquid stocks such as Apple. This is a technical selloff and does not reflect the health of high quality growth companies.
In other words, this is a lot of “noise”. For a long-term investor, this volatility holds little significance. The best thing you can do during short-term volatility is turn off the TV and ignore the news.
I understand that this may be confusing and unsettling, so please reach out with questions.