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Five metallic balls of a Newton's cradle, with the first ball in motion to strike the second. In the background are various graphs and numbers.
Five metallic balls of a Newton's cradle, with the first ball in motion to strike the second. In the background are various graphs and numbers.
Financial Health
February 2, 2021

An object in motion …

What the unprecedented volatility of the late January “short squeeze” says about the future of investing.

Editor’s note: Darrell Cronk is Wealth & Investment Management’s chief investment officer as well as the president of Wells Fargo Investment Institute, which is focused on delivering the highest quality investment expertise and advice to help investors manage risk and succeed financially. Cronk leads global investment strategy and research, including equity, fixed income, real assets, and alternative investments. He offers the following context following a week of unprecedented volatility involving stocks with high short interest ratios.

It would be nice to believe that markets are always steadily efficient, acting appropriately as a discounting mechanism. The purpose of markets is to allow prices to be discovered, and that requires a large pool of buyers and sellers to participate. At various stages of an economic cycle, different shifts of human behavior occur that can lead to prices fluctuating well above and below their fair value. Equally, there are no set rules that determine which group of investors – institutional, foreign, retail etc. – should dominate the setting of prices at any time.

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What happened

Darrell Cronk
Darrell Cronk

In an almost David-versus-Goliath-type battle this past week, retail investors — supported by liquidity and social media — swarmed popular hedge fund short positions, creating what Wall Street calls a “short squeeze” on a number of stocks with high short interest ratios, inducing unprecedented volatility. Last week witnessed a 62% spike in the CBOE Volatility Index (VIX), a commonly followed measure of stock market volatility, the second largest single day spike in a decade. This appears to be a vocal army of retail traders bringing a populist fight to the markets through targeted buying in selective single names, forcing prices to inconceivable levels relative to their fundamental outlook. As a result, some of the most heavily shorted and levered names have sharply risen — the common thread for these names is both consumer brand awareness and intuitive understanding of the product by retail investors.

Retail participation has been on the rise steadily over the past several years with the acceleration of secular trends, declines in online trading fees/commissions, better technology creating retail ease of use for trading platforms, and demographic shifts as Millennials enter their prime earning years. New internet platforms are facilitating the education and recruitment of new investors. Social media is spreading new trade ideas with higher velocity in chat rooms and trending news sites are flagging abnormal trading activity, high volume, or extreme single-day price moves.

A U.S dollar bill and seven pennies are shown with an overlay of a white outline of an upward arrow.

Why this happened

So why did this trend explode onto the scene in late January with a few select stocks as the battlefront? Frankly, this phenomenon has been growing for some time below the surface, as this democratization of information has purposeful traders sparking popular sentiment against short sellers betting that financially struggling companies stocks will falter. Younger retail cohorts appear more comfortable wielding leverage, owning single stocks versus passive products like exchange-traded funds (ETFs) and mutual funds, and using capital to take moral stands supporting companies deemed under attack. Elevated New York Stock Exchange (NYSE) margin balances, strong retail derivatives purchase levels, and recent social media posts confirm these trends.

It is important to note that like many other themes, COVID-19 intensified and accelerated this underlying retail investment trend. Multiple rounds of stimulus, excess savings, low consumer debt service ratios, and rising home equity levels are all contributing factors, and the scarcity of substitutes to spend cash on has resulted in higher-than-usual retail stock market participation. The latest U.S. savings rate remains at an elevated 13%, down from its March 2020 all-time record of 34%. The pandemic’s unusual influence has discretionary spending by consumers down 30%-50% year over year on transportation services, recreational services, food services, and gasoline/energy spending. This additional disposable income, along with extra time as people work from home, is a key catalyst in rising retail stock market participation.

Various U.S. bills and coins are falling against a black background.

The future

History has proven time and again that while irrational market behavior can persist for short periods of time, over the intermediate to long run, markets have returned to rationality and fundamentals. That said, it would be wrong to ignore this changing trend in democratization of financial markets, where the power of social media platforms creates both opportunity and risk. 

This latest trend has its roots in an outcry — or dare we say even a demand — for an equitable ecosystem between Wall Street and Main Street. We wrote about this theme of convergence in our 2021 Outlook, even if we weren’t fully able to predict the tool set used to pressure this gap. Often, ground-shaking events like a global pandemic have rippling repercussions. This latest trend, backed by the power of social media, will require investors to expand their investment toolkit to include fundamentals, market insight, and community sentiment.


Disclosures

Published by Corporate Communications.

Risk considerations: Past performance is no guarantee of future results. All investing involves risk, including the loss of principal. Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors.

Definitions: CBOE Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

An index is unmanaged and not available for direct investment.

General disclosures: Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability or best interest analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. The material contained herein has been prepared from sources and data we believe to be reliable but we make no guarantee to its accuracy or completeness.

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