The small investor uprising fueled by free trading platforms like Robinhood has been billed as David versus Goliath, with retail investors combining their strength in an effort to beat Wall Street hedge funds at their own game. Over the past month the message board–fueled mob disrupted the short-selling niche of the stock market, long dominated by hedge funds and large institutions.
These small investors focused a large volume of trades in companies like GameStop to cause losses for the large investors who had bet that the stock prices would fall. The small investor took home the initial victory in this trading brawl, as a few large players lost money and were forced to exit many of their trades. Prices of the affected stocks have declined considerably since the euphoria peaked, however, and the ultimate victor in this skirmish remains uncertain.
In the past, periods of severe stress have revealed shortcomings in market functions that may not be evident during times of low volatility. But what was on full display during the recent trading frenzy was that the financial market plumbing that is in place works very well during times of market strife.
Financial system regulations, such as capital requirements for brokerage firms, strict margin account trip wires, and temporary trading halts, have been put in place over the decades based on painful lessons learned in prior market crises. And this structure worked admirably over the past few weeks to ensure the efficiency and integrity of the financial markets.
The massive trading volume and gains and losses in stocks like GameStop were certainly entertaining to watch. However, some investors worried that these tussles would spill over to cause extreme volatility or a correction in the overall market.
But we do not yet see this type of intense trading sideshow as detrimental to the market, mainly because there are two types of dislocations that can affect the financial system: systemic and nonsystemic. Systemic dislocations are usually the result of an overuse of leverage. The large market decline arising from the financial crisis in 2008 was a clear example of a systemic dislocation.
Investment losses by themselves are part of a free market system. However, when players utilize large amounts of leverage in speculation—as banks and brokers did during the financial crisis—the whole financial system may become infected with huge losses if those bets go bad. When a few investors lose money—whether small traders or large players—the system generally remains unaffected. But when investment losses cause large banks or broker institutions to fail also, that dislocation may cause large declines in the financial markets.
The current volatility in a few small stocks—a result of extreme speculation—has so far not been fueled by excessive leverage. As such, it is much more benign to the overall financial system. The financial markets can operate around this skirmish between large and small investors without being unduly affected.
Gains and losses for investors are as old as the financial markets themselves. The only difference is that these days, with the wonders of technology, reversals of fortune can happen far more quickly and can take place on the phone in an investor’s pocket.
So far, the effects of the recent Robinhood trading headlines are just a temporary disruption in a small corner of the financial markets. Normal market volatility should be expected after two very strong years for stocks and with valuations stretched relative to near-term earnings prospects.
At the same time, the yield on the U.S. 10-year Treasury bond has remained steady recently, and both crude oil and corporate credit conditions have been stable. As a result, this Robinhood trading tumult or any similar short squeezes are unlikely to affect the general economic recovery that is clearly in its early stages. Interest rates remain low, business confidence is high, and coronavirus vaccine distribution is ramping up. These positive factors are not affected by the speculation of small investors or the comeuppance of large market players.
Investors should follow stories of temporary market dislocations with interest, but not with fear or trepidation. Long-term investors should utilize portfolios and asset allocations that are constructed to meet their needs over decades, not for quick gains in an individual month.
C.J. MacDonald is the client portfolio manager at GuideStone Funds. The views expressed herein are the author’s alone.
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