Goldman Warns If The Short Squeeze Continues, The Entire Market Could Crash

Last Friday (Jan, 22) we advised readers who thought they had missed the move in GameStop (they hadn't), to position appropriately in the most shorted Russell 3000 names which included such tickers as FIZZ, DDS, BBBY, AMCX, GOGO and a handful of other names, as it was likely that the short-squeeze was only just starting.

We were right and all of the stocks listed above - and others - exploded higher the coming Monday, and all other days of the week, with results - encapsulated by the WallStreetTips vs Wall Street feud - that has become the top conversation piece across America, while on WSB the only topic is the phenomenal gains generated by going long said most shorted stocks. To wit, the basket of top shorts we compiled on Jan 22 has tripled in the past week.

And while some are quick to blame last week's fireworks on the "dopamine rush" of traders at r/wallstreetbets who seek an outlet to being "copped up with little else to do during the pandemic" (as Bloomberg has done), the reality is that at the end of the day the strategy unleashed by the subreddit is merely an extension of the bubble dynamics that were made possible by the Federal Reserve (of which Bloomberg is also a very staunch fan) pumping trillions and trillions of shot-gunned liquidity into a financial system where there are now bubble visible anywhere one looks. In short, main street finally learned that it too can profit from the lunacy of the money printers at the Eccles building, and some are very unhappy about that (yes, it will end in tears, but - newsflash - $300 trillion in debt and $120BN in liquidity injections monthly will also end in tears). That aside, one week later, Goldman has finally caught up with what Zero Hedge readers knew one week ago, and all the way down to a chart showing a basket of the most-shorted Russell 3000 stocks...

Goldman's David Kostin has published a post-mortem of what happened last week, writing that "the most heavily-shorted stocks have risen by 98% in the past three months, outstripping major short squeezes in 2000 and 2009."

He then points out something we discussed in "Hedge Funds Are Puking Longs To Cover Short-Squeeze Losses", noting that while aggregate short interest levels are remarkably low (imagine what would have happened has shorting been far more aggressive marketwide) "the -4% weekly return of our Hedge Fund VIP list of the most popular hedge fund long positions (GSTHHVIP) showed how excess in one small part of the market can create contagion."

Hedge funds were forced to cover (as well as paying for margin calls), and as part of the broader degrossing they also had to sell some of the favorite hedge fund names across the industry, in this case represented by the Goldman Hedge Fund VIP basket.

Yet what may come as a surprise to some, even as hedge funds deleveraged aggressively and actively cut risk this week, gross and net exposures "remain close to the highest levels on record" (something which may come as a huge surprise to Marko Kolanovic who has been erroneously claiming the opposite), suggesting that if the squeeze continues, hedge funds are set for much more pain.

According to Goldman Sachs Prime Services, this week "represented the largest active hedge fund de-grossing since February 2009. Funds in their coverage sold long positions and covered shorts in every sector" and yet "despite this active deleveraging, hedge fund net and gross exposures on a mark-to-market basis both remain close to the highest levels on record, indicating ongoing risk of positioning-driven sell-offs." With that in mind, here are Kostin's big picture thoughts: It was a placid week in the US stock market – provided one was a long-only mutual fund manager. US equity mutual funds and ETFs had $2 billion of net inflows last week (+$10 billion YTD). Although the typical large-cap core mutual fund fell by 2% this week, it has generated a return of +1.3% YTD vs. S&P 500 down -1.1%. However, life was very different last week if one managed a hedge fund. The typical US equity long/short fund returned -7% this week and has returned -6% YTD. With the average WSB portfolio up double digits this past week, one can see why hedge funds are upset. Anyway, moving on: The past 25 years have witnessed a number of sharp short squeezes in the US equity market, but none as extreme as has occurred recently. In the last three months, a basket containing the 50 Russell 3000 stocks with market caps above $1 billion and the largest short interest as a share of float (GSCBMSAL) has rallied by 98%. This exceeded the 77% return of highly-shorted stocks during 2Q 2020, a 56% rally in mid-2009, and two distinct 72% rallies during the Tech Bubble in 1999 and 2000. This week the basket’s trailing 5-, 10-, and 21-day returns registered as the largest on record.

Thanks Goldman, and yes, your "brisk assessment" would have been more useful to your clients if it had come before the event (like, for example, this) instead of after. Kostin then goes on to point out that the "mooning" in the most shorted stocks took place even though aggregate short interest was near a record low (imagine what would have happened had short interest been higher), which is odd because historically, "major short squeezes have typically taken place as aggregate short interest declined from elevated levels. In contrast, the recent short squeeze has been driven by concentrated short positions in smaller companies, many of which had lagged dramatically and were perceived by most investors to be in secular decline" to wit: Unusually, the rally of the most heavily-shorted stocks has taken place against a backdrop of very low levels of aggregate short interest. At the start of this year, the median S&P 500 stock had short interest equating to just 1.5% of market cap, matching mid-2000 as the lowest share in at least the last 25 years. In the past, major short squeezes have typically taken place as aggregate short interest declined from elevated levels. In contrast, the recent short squeeze has been driven by concentrated short positions in smaller companies, many of which had lagged dramatically and were perceived by most investors to be in secular decline. Of course, there is nothing "historical" about what happened last week, because - as we all know - the biggest difference between the typical short squeeze of the past and the recent rally in heavily-shorted stocks "was the degree of involvement of retail traders, who also appear to have catalyzed sharp moves in other parts of the market." Why thank you WSB, but that's ok - you will be handsomely rewarded. Last week we discussed the surging trading activity and share prices of penny stocks, firms with negative earnings, and extremely high-growth, high-multiple stocks. These trends have all accompanied a large increase in online broker trading activity. A basket of retail favorites (ticker: GSXURFAV) has returned +17% YTD and +179% since the March 2020 low, outperforming both the S&P 500 (+72%) and our Hedge Fund VIP list of the most popular hedge fund long positions (GSTHHVIP, +106%).

So why does this matter? One simple reason: contrary to the bizarrely nonchalant optimism spouted earlier this week by JPMorgan's Marko Kolanovic who said "any market pullback, such as one driven by repositioning by a segment of the long-short community (and related to stocks of insignificant size), is a buying opportunity, in our view," Goldman has a far more dismal take on recent events, and writes that "this week demonstrated that unsustainable excess in one small part of the market has the potential to tip a row of dominoes and create broader turmoil."

He then picks up on what he said last weekend when responding to Goldman client concerns about a stock bubble, which we summarized in "Goldman's Clients Are Freaking Out About A Stock Bubble: Here Is The Bank's Response", and which turned out to be 100% warranted, and writes that "most of the bubble-like dynamics we highlighted last week have taken place in stocks constituting very small portions of total US equity market cap. Indeed, many of the shorts dominating headlines this week were (prior to this week) small-cap stocks. But large short squeezes led investors short these stocks to cover their positions and also reduce long positions, leading other holders of common positions to cut exposures in turn." As a result, Goldman's Hedge Fund VIP list declined by 4%. Which is a problem because as Kostin concludes, "in recent years elevated crowding, low turnover, and high concentration have been consistent patterns, boosting the risk that one fund’s unwind could snowball through the market." Translation: if WSB continues to push the most shorted stocks higher, the entire market could crash. And since Kostin admits that "the retail trading boom can continue" as "an abundance of US household cash should continue to fuel the trading boom" with more than 50% of the $5 trillion in money market mutual funds owned by households and is $1 trillion greater than before the pandemic, what happens in the coming week - i.e., if the short squeeze persists - could have profound implications for the future of capital markets.

I certainly hope this leads to true market reform, but I am doubtful it will happen. I have yet to read a single article that discusses what needs to be done to permanently solve this problem. In the meantime, keep sticking it to Wall Street, Big Banks and Hedge Funds.

With that said, I do have some concrete ideas about how to correct the problem. I trade for a living and my success comes from avoiding certain things. I wish it did not have to be that way, but my avoidance is necessary so that I don't get stomped by institutional traders.

I won't go into the specifics of how I trade because that will take too long and most will not understand. But I will say I only trade derivatives. I utilize leverage. I trade long and short. And I hedge my positions. All of these have existed in markets in some form or another since markets have existed. There is nothing inherently wrong with any of these practices on an equal playing field.

That is the origin of the problem - an equal playing field for small investors and institutional investors. The biggest advantage institutional investors have is information. I'm not talking about information on a company's fundamentals or what is classically called insider information. Sure, some of that exists and there will always be insider trading. There are laws and regulations against that and there is little more that can be done other than enforcing those laws.

I write of a different type of information. Institutional traders have access to market data that small investors do not. Institutional traders know the disposition of all trades. They know who is long and who is short. They know where people have their stop losses. This occurs because Big Banks are also brokers. They get that information from the brokerage side of the business. The larger the brokerage business the better information they have because they have a larger sampling of retail and small investor trades. That sampling aligns to what is happening overall in the market. I am writing of information that is of better quality and detail than any small investor can get from level II quotes.

The banking side of the business uses that information and their vast amount of money to move price where they want without regards to fundamentals. They take out small investors' stop loses, accumulating positions and then executing an about face taking the price in the complete opposite direction that may or may not be based on fundamentals. It most certainly is based on what is profitable to institutional investors. That is just one example of many tactics and strategies employed by institutional investors. All their methods utilize information that small investors do not have.

The only way a small guy can defend himself is avoiding the most precarious financial instruments because of manipulation. That is basically saying, trade things the Big Banks have little interest in manipulating, or trade things that you can survive some manipulation and still profit. By the way, if you trade on your own, it is best you fully understand this if you want to continue to trade. As the rules stand today it is critical to survival.

There are many things that can be done to correct markets and protecting the little guy. However, it should not deny the little guy access to certain financial instruments. It should not require the little guy to limit the number of trades he can make in a week because his brokerage account is small. It should not limit the types of transactions the little guy can make, short or long, hedging or not. It should not limit the little guy the use of leverage as long as it is within the little guy's means to cover losses. None of these limits protect the little guy. In fact, it dooms his success. It is also the same type of regulation included in past legislation such and Dodd-Frank.

What is needed is a democratization of market data so the little guy knows the same information as institutional investors. This can be achieved in two steps. 1.) The banking side and brokerage side of businesses need to be completely separate. That means broken up and separated, without any transfer of market information through any on-going agreements. 2.) All market data, including price, number of shares/contracts, trade types, stop losses, etc. needs to be instantly and uniformly available to all investors regardless of size. This information should be available for free or at cost. It is technically achievable, because the information is already there. It just is not shared with small investors.

These are not some draconian regulations that are askew with free market capitalism and competition. In fact, in economic terms, "perfect information" is one of the pillars of pure competition. It was recognized in the past that perfect information was not possible because it just wasn't possible to convey that information to everyone in a market. Today it is very feasible to convey more perfect information because it does exist and it does get used; but only by a select few. That is the crux of the problem. Solving it does not create a perfect market, but it is step in the right direction.

Taking away small investors ability to trade in the same way as institutional investors does not fix the market. The only difference between large and small investors is how much capital they have to work with. That is an inequity that will always exist and is a fact of life. The little guy should be offered a chance to operate on a mostly equal playing field so he too can become on of the big guys one day.

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