With COVID-19 cases still rampaging through the global economy, last week many turned their attention away from the growing death cases, ongoing legal battles between the EU bloc and AstraZeneca and even the IMF 2021 Global Outlook of a 5.5% economic recovery in 2021. Instead,
this week was about a market of wit and gamble, trading fuelled purely by sentiment and an on-going tussle between retail investors and Wall Street investors, with brokerages being caught in the middle. This development is interesting as it highlights inefficiencies that are present in an efficient market and allows us to extrapolate what the implications could be if our Stock Exchange regulator were to allow short selling.
A Short Sale
Last week, a Short Squeeze was in full effect. A short squeeze refers to when investors intentionally increase the stock price when there is a large open Short Position. A short position refers to an investors position in a Short Sale (verb: Short-Selling). This is a strategy by which investors borrow a stock (at a cost), sell it immediately, intending to repurchase at a lower price at a later date. This strategy is profitable if the savvy investor gets the bet right about a stock and its price depreciates. However, if the price appreciates, they have to purchase this stock at a higher price than they would have sold it for and return it to its owner. This is unprofitable as the money they would have earned from the initial sale is now less than the price to reacquire the stock, meaning they would have to essentially borrow funds to do the purchase. So, a Short Squeeze has material ramifications, especially if the investor is unable to acquire the stock due to illiquidity, or an inability to borrow the funding necessary to repurchase the stock. An example of this would be why the hedge fund Melvin Capital, needed approximately US$2.75 billion to cover its short position last week.
Wall Street Vs Retail Investors
The strategy of short selling isn’t unique and is often deployed by Wall Street, especially in companies they believe are going to underperform. But last week, retail investors were able to perform a short squeeze, based on the short interest ratios of certain companies. The short interest ratio essentially helps an investor find out very quickly if a stock is heavily shorted or not shorted versus its average daily trading volume. If the short- interest ratio is high, they are a prime target for a short-squeeze. This in effect is what transpired last week, and it caused major indices to close down. This was because investors with short-positions would essentially sell other stocks to generate the cash to cover their short positions. Now, the force behind last week’s short squeeze that saw stocks such as AMC and GameStop increasing over 100% was retail investors essentially performing a short squeeze on these companies. This forced the hands of Wall Street fund managers to sell positions in other stocks to cover their short position. This indirectly led to the decline in equity indexes into negative territory on a year-to-date basis, as fund managers would have needed to sell large positions of their portfolios to given the short squeeze
While this short squeeze may be seen as a normal part of a freely functioning efficient market, the increase in volatility due to this activity has far- reaching implications. One such implication is the direct effect it has on pension funds and their value. Over the last decade, a large proportion of pension funds have increased their allocation to hedge funds, as hedge funds are classified as an Alternative Investment. Based on the latest report by companies such as PriceWaterhouseCooper, Ernst & Young, and Deloitte, the portfolio allocation towards hedge funds have increased significantly to approximately 6%-10% for sovereign funds and pension funds on aggregate. This implies that pensions funds and future pensioners are among the indirect victims of last week’s market volatility, to the extent their pension funds currently have exposure to hedge funds caught in this short squeeze. This has led to many fund managers seeking government and regulatory intervention as a simple market activity has far- reaching implications that indirectly impact the future livelihood of individuals. As this event is unprecedented to the extent that the source of the squeeze is from retail investors, there is no current precedent for regulators to enact to curtail the current volatility without infringing on the rights of these investors. Thus, these developments remain ongoing and act as a good case study for regulators globally.
What if the Jamaica Stock Exchange Allowed Short Selling?
The Jamaica Stock Exchange (JSE) has been recognized as a top-performing exchange globally within the last five years, but it is also one of the smallest exchanges globally. With a market capitalization of just US$12.28 million (S&P 500 market capitalization: US$33.16 trillion), liquidity is low on the JSE. This indirectly means that limited shares are outstanding for investors to gain exposure to. This also means that an event such as a short squeeze would be amplified by a material measure. Also, the implications would be just the same as overseas but materially worse. Based on the September 2020 pension fund report by the Financial Services Commission (FSC), Private Investment Arrangements (PIA) and Stocks & Shares account for 37% and 22% respectively. To compound this issue, Stocks & Shares account for 35% of PIA’s. Such a concentrated exposure to an illiquid market has far-reaching implication for Jamaica, where just 11% of our employed population actively contributing to a pension plan. These are facts that cannot be ignored and must be at the forefront of the minds of the JSE and FSC when considering allowing short-selling ion our local stock exchange.
Written by Haughton Richards, FRM, FMVA, Senior Research Analyst
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