Here are the top market developments we have been watching in January.
Credit risk manifests itself in the plumbing of the equity market
We have highlighted credit risk factor over the last several months (here, here, here, here, here). In January, it manifested itself not where we expected, but in the plumbing of the equity market. The nexus was GME, GameStop Corporation stock. GameStop is the world’s largest video game retailer, with a footprint of over 5,000 retail stores. Recently, the company has faced investor pressure to accelerate a transition to a digital-first omni-channel retailer. Out of the blue, the stock price skyrocketed due to a short squeeze orchestrated by the Internet forum r/wallstreetbets and facilitated by the unusually high short interest in the stock.
The stock price rise and the intraday price stock volatility were breathtaking, especially during the final week of January. Over the course of the week, the stock fell as low as $70 and reached as high as $483. The stock started the month under $20 per share.
Source: Yahoo Finance.
This chart shows GME stock price from Monday January 25, 2021 to Friday January 29, 2021.
The volume of shares traded also increased enormously as shown below. At the beginning of the month, the daily amount of shares traded on the NYSE hovered between 6 million and 15 million. On January 22, the trading volume almost touched 197 million shares traded.
This chart shows the daily volume of GME shares traded on the NYSE in the month of January 2021.
Credit risk made its appearance on January 27. Much of the trading in the stock and options (calls and puts) on the stock occurred in retail brokerage accounts, most notably accounts at Robinhood, a rapidly growing retail broker-dealer popular with younger investors. On January 27, the retail brokers began to restrict trading in GME stock and options, and in other stocks, like AMC, experiencing similar, albeit smaller, increases in volatility and trading. The stated reason was regulatory requirements and contractual financial obligations, in other words, code for credit risk.
Many retail investors cried foul, asserting the brokerage firms were in cahoots with hedge funds, like Melvin Capital, which were short GME stock and suffering billions of dollars in losses as GME skyrocketed. Whether these assertions have merit is currently unknown, but what is indisputable is the brokerage firms have an obligation to manage risk so they can meet their financial obligations to clearing firms, in particular the National Securities Clearing Corporation (NSCC), owned by the Depository Trust and Clearing Corporation (DTCC).
The financial obligations and associated credit risk arise because equity trades and options trades are not settled instantaneously, but generally with a 2 day lag (T + 2). When stocks exhibit huge increases in volatility, it creates the risk brokerage clients may not have sufficient funds to settle trades or meet margin calls. If clients default, the broker-dealers are on the hook. Conversely, a broker-dealer also has to worry about clients of other broker-dealers, who may owe payments to it. Note the NSCC and DTCC are thinly capitalized clearing / settlement companies, essentially middlemen not in the business of taking credit risk.
The credit risk was amplified in the case of GME due to (1) the extensive trading of GME derivatives, namely call and put options and (2) the use of margin accounts. The intricacies of margin accounts are often not well understood. A brokerage client purchasing a stock in a margin account does not technically own the stock, the broker does (with a cash account, the client would own the stock). The client gets the benefits of ownership with a margin account. The broker has a right to loan the stock to a prime broker so a prime broker client can short the stock, by selling it someone else. In case you are keeping track, there are multiple parties involved (the brokerage client, the client’s retail broker such as Robinhood, the prime broker, prime broker’s client presumably a hedge fund, and buyer of the stock from the prime broker’s client). This so-called hypothecation of the stock creates a debit / credit relationship between the retail broker and the prime broker. Credit risk is further amplified.
In the case of Robinhood, the credit risk was material. Robinhood has a weaker balance sheet than many retail brokers, nor does it have an owner with deep pockets. The brokerage firm was forced to tap its bank credit lines to the tune of roughly $500 million and then raise another $1 billion from its existing investors. And as of this writing, it still had to impose trading restrictions, albeit less onerous ones, on some stocks. Having enraged many of its clients who joined Robinhood because of its stated mission to democratize finance for all, it will be interesting to observe whether it permanently impaired its brand and reputation by not maintaining a strong balance sheet.
2. Corporate earnings are coming in better than expected
According to Factset, with 37% of S&P 500 companies having reported 4th quarter 2020 earnings, aggregate earnings have declined 2.3%, with revenues up 1.7%, year over year. The stalwarts are the information technology and healthcare sectors. IT earnings have increased near 15%, and revenues near 10%, year over year. Healthcare sector earnings and revenues are both up approximately 10% year over year. Next month, will have more insights as over 90% of companies will have reported.
3. January continued the trend of improving emerging markets equity performance.
Yes, over the last decade, emerging markets equities have underperformed U.S. equities by a massive 170%. In the last twelve months, emerging markets have outperformed by over 9%. And January saw emerging markets outperform by 4%. We are watching this trend closely.
The graph shows the total return for the iShares Emerging Markets ETF in purple and SPDR S&P500 ETF in blue for January 2021.
