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Why hedge funds are more likely to cause a market crisis than Robinhood's GameStop traders

·4 min read
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Over the past week, many people have asked me the same question: “Will the GameStop situation lead to a market crash?” The direct answer is an emphatic NO! However, it will likely lead to increased volatility over the near-term, which is why I suggest traders use lighter than normal positions until the volatility calms down.

The markets have always been dominated by the large institutions and, for the record, I absolutely love the recent surge in retail trading. Here is one side effect: When retail traders take long positions against the short positions of these big institutions, and then drive up the price of these stocks, it leads to what is called a “short squeeze.” When these institutions are forced to cover a stock, they are sometimes forced to sell their long positions (if the loss is big enough) to meet margin requirements, to reduce leverage, or to possibly raise cash for future redemptions.

This forced liquidation of long positions can lead to a quick, short-term decline in stock prices, such as the one we saw on Monday, Jan. 25 between 10:45 am.-11:05 a.m. EST, (see chart) but I don’t see it leading to a market crash.

Chart is provided by MarketSmith.
Chart is provided by MarketSmith.

Another group that could be forced to sell long positions are the market neutral hedge funds. These funds typically have the same long and short exposure but may reduce both sides if short positions continue to get targeted. Again, I’m not showing sympathy for these funds; I’m simply trying to explain the mechanics of why many funds may be selling stock.

It’s the hedge funds that are irresponsible

Many people are complaining that the subreddit group called WallStreetBets (WSB) is acting irresponsibly, but I think it’s the hedge funds that are irresponsible. When you look at the majority of market crises, over the past 25 years, they have to do with hedge fund leverage. In 1998, the Russian debt crisis took down Long Term Capital Management due to using leverage of more than 25x. It led to many financial institutions bailing them out under the supervision of the Federal Reserve.

The financial/housing crisis of 2008 had to do with large institutions such as Lehman Brothers and Bear Stearns using upwards of 33 times leverage. In October 2018, Fed Chair Jerome Powell hinted at raising interest rates 1% over the next year and it led to a 3-month, -20% decline, which was mainly due to fund deleveraging. Although I don’t see the current situation leading to a crash, we will likely see increased volatility due to, once again, leverage. There should never be a scenario where a stock’s short interest can be over 100%. Technology should exist to ensure that one share of stock is not loaned out multiple times.

Hedge funds are too powerful

The problem is they will never put leverage limits on hedge funds because, unfortunately, they are too powerful. In fact, if this GameStop/WSB situation becomes out of hand, I wouldn’t be surprised to see the regulators step in, or the hedge funds force the brokerages the change the rules. I know it sounds ridiculous and I certainly don’t agree with it, but we’ve already seen traces of this last week. This topic opens up many discussions about social inequality, censorship, etc. but I prefer to stick to the markets.

Back to the markets — all this could end up being noise and a big excuse for the stock market to have a normal 8-10% correction. As I wrote in my 2021 outlook, I am bullish for the year for two main reasons: The Fed and the strong technicals. The low interest-rate policy provided the Federal Reserve creates an equity friendly environment for stocks. Also, earnings should improve as the coronavirus numbers decrease. Of course, we will have pullbacks and normal corrections along the way, which is why it’s important to know your timeframe. If you’re a longer-term investor, stick to your plan. If you’re a shorter-term trader, keep your positions lighter than normal until the volatility calms down. Once the dust settles from all this, there will be great opportunities. The key is to practice discipline and patience until they show up.

More on GameStop:

Robinhood in a tough position as it faces a wave of lawsuits over GameStop saga

‘Spill the beans man’: Tesla’s Elon Musk grills Robinhood CEO on GameStop/Reddit trading saga

GameStop traders may inflict even more pain on Wall Street: Goldman

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