GameStop short nightmare shows few signs of becoming a contagion

GameStop’s surge has struck fear into anyone caught on the wrong side of its ascent. But those bearish positions probably aren’t big enough to lay low the larger universe of investment funds.

That’s the view of Barclays strategists led by Maneesh Deshpande. By plotting the value of bearish equity bets versus the whole market’s capitalisation, they found that short sales have actually dwindled during the past year to the lowest level since at least 2008. Moreover, those most-heavily shorted companies targeted by day traders this year had bearish wagers amounting to less than 0.001 per cent of the $43 trillion market.

Whether losses being suffered by hedge funds and other money pools will be large enough to ignite a full-blown contagion was a concern that arose several times during last week’s selling — the worst in the S&P 500 since October. For now, while Reddit-fueled stock jocks may have drowned out every other narrative, they’re unlikely to completely subsume the bull market.

“We’re witnessing a nearly unprecedented amount of speculative activity. But on the other hand, we are talking about a very narrow group of stocks that don’t have an outsize influence,” said Marshall Front, chief investment officer at Front Barnett Associates. “The underlying fundamentals of the economy are strong. A very aggressive and accommodative policy by the Federal Reserve is still intact. Together, they help the stock market on the way up.”

Burned by short sales going against them, hedge funds have yanked money from the market at one of the fastest rates on record. The most-shorted stocks rallied 14 per cent last week as a group, dealing the biggest blow to short sellers since last April, a Goldman Sachs Group Inc. basket shows.

While the S&P 500 dropped more than 3 per cent last week, traders described the broad market as orderly. To JPMorgan Chase & Co.’s strategists including Dubravko Lakos-Bujas, the retreat is likely a “short-lived technical tumble.” With earnings improving and US consumers strengthening, this pullback is another opportunity to add stocks, particularly those geared toward an economic recovery, the strategists wrote in a Friday note.

To be sure, day traders are targeting companies favored by bearish investors, trying to spur squeezes. In 2021, the top quintile of the Russell 3000 stocks with the highest short sales as a percentage of their float is up 20 per cent, compared with a loss of 0.8 per cent for the bottom 600, according to data compiled by Bloomberg. But those returns are also consistent with a contour that was already taking shape as investor risk appetite increased: gains in companies with shakier finances, which had trailed during 2020’s pandemic market.

“Although the short squeeze started with GME, it appears to be spreading to a wider range of stocks,” Deshpande at Barclays wrote in a note Friday, referring to GameStop’s ticker. “While we expect some more deleveraging, ultimately the scale of the problem appears quite limited.”

By Barclays’s tally, short sales totaled $800 billion, or roughly 2% of the total market value of American equities, a sign that short sellers have not extended themselves. The heavily shorted companies — those with interest making up more than 20 per cent of their share float — saw $40 billion of their stock sold short, or per cent of the total pool of bearish bets.

“We remain optimistic that it is likely to remain localised,” Deshpande said. “The bottom line is that while the pain could continue in the short term, the risk of a full-fledged contagion remains low.”