Could forced selling spark long-awaited correction?

Battle over previously unloved stocks shows dangers of investor complacency

Could forced selling spark long-awaited correction?

This year has once again proved that nothing is as risky for investors as getting complacent and thinking they're invincible. No sooner had we entered 2021, witnessed political regime change in the U.S. and settled in for a calmer ride, then Reddit chat rooms sparked some unforeseen volatility.

Greg Taylor, CIO at Purpose Investments, believes that although the scars from last year are still fresh, positive sentiment among investors remains high despite the short-selling saga. Optimism stems from the widely held belief that we are near the end of the global pandemic and entering a calmer political era.

However, he said the last week in the January has changed the landscape and wondered whether forced selling around crowded trades could be the trigger for a long-awaited correction.

He said: “Equity markets have been exhibiting signs of excess over the past few months but lacked a trigger to cause any selling. From the SPAC boom to the impressive returns of technology IPOs to the Bitcoin boom, excess capital from the stimulus had found its way into increasingly risky parts of the market. No one seemed to think the next phase of this mania would involve a flurry of buying in near-bankrupt companies.”

Upon reflection, Taylor called the Reddit investors’ move “brilliant” and a fitting riposte to years of hedge funds aggressively touting their short positions and ganging up with other firms to prey on the weak.

Taylor said that while covering these positions isn’t a new strategy, the use of options on margin exacerbated the move to new extremes and that there were many companies involved at the same time, not just the headline-grabbing GameStop.

“Shares of GameStop have been under pressure for years,” he said. “Few mall-based retailers have been able to successfully adapt to the new online world. As such, GameStop became a favourite short target for hedge funds. Many of these funds run what are called market-neutral strategies, in which short positions are paired up with longs. What we saw to end January was the largest de-grossing - taking down exposure - in years.

“As the short positions skyrocketed, hedge funds were forced to buy them back and to pay for this they had to sell their winners or favourite names. In an already extended market, could forced selling around crowded trades be the trigger for the long-awaited correction?”

The good news, according to Taylor, is that central banks will not let markets crash during a pandemic but that a short-term correction is probably due given the run equity markets have been on over the past 10 months.

He added: “While it won’t kill the bull market, it does highlight the risk investors take when everyone is too complacent and thinks they’re invincible.

“No one expected the strongest performing equities for January would be the worst-positioned companies. But these hedge funds are relearning the old adage that the market can stay irrational longer than you can stay solvent. It appears volatility is going to be with us once again in 2021.”