Over the past several weeks, a number of high-profile individual stocks have experienced what many observers see as retail-driven, options-assisted “melt-ups.” Most of these stocks have rallied at least 25% – 50%, including one outlier that has garnered the most attention with its breathtaking run in recent weeks and a quadruple-digit year-to-date return as of this writing.
This meteoric stock rise and others have seemingly defied logic and left many institutional investors scratching their heads, concerned that we may be in for a replay of what we saw earlier this year. I think that’s unlikely.
In January 2021, a handful of “meme stocks” experienced similar upside moves, which caught many hedge fund managers by surprise, triggering widespread de-risking and a very challenging period for performance. When all was said and done, even managers who hadn’t bet against the soaring meme stocks struggled when some of their other holdings became collateral damage. Thus, some skittishness is to be expected this time, but whether it’s warranted bears further investigation.
Lessons learned since January 2021
On the surface, these recent stock surges bear a striking resemblance to the frenetic equity market activity we saw in January. However, I think there are clear differences in investor behavior and the companies themselves that suggest market participants have learned some critical lessons and are now better prepared to weather (and even capitalize on) these sorts of episodes:
- Many investors have learned to avoid so-called “crowded shorts.” That’s when a large number of market participants bet against the same stock, “selling it short” and hoping to profit from a decline in its price. When stocks like these start rising, short sellers will frequently buy shares to “cover” their short and reduce their exposure to further price increases. If enough investors are covering their short, their buying will exacerbate the upward price move and lead to even more short covering. This type of vicious cycle (“short squeeze”) can be very costly. Since January, however, investors appear to be shying away from crowded shorts.
- Over the six months since the January 2021 market debacle, as investors as a group have continued to stay away from riskier single-stock short exposures, many have begun to rely more on macro products such as exchange-traded funds (ETFs) and futures contracts (Figure 1). I think this more diversified approach on the short side is what has thus far prevented these extraordinary stock moves from metastasizing into the type of “alpha storm” for hedge funds that unfolded after certain stocks were heavily shorted back in January.
- Unlike in January, many company management teams now recognize that an elevated stock price can in fact be an opportunity to gain financial flexibility through raising capital — selling shares of their own stock to provide needed capital. Some companies have already done so or plan to. If this trend proves sustainable, it could become an important mechanism for driving more rational pricing for certain stocks.
Bottom line for recent stock surges
I think the lessons learned from prior surges of retail investor activity and the corresponding reduction in the overall use of (and crowding in) single-name shorts have helped to limit the fallout from more recent events to a narrower segment of the hedge fund population. If investors continue to heed these lessons, I see less risk of a meme-stock-induced “alpha storm” for the hedge fund industry going forward.