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A Reddit subgroup with 2 million members has performed coordinated attacks on individual stocks by buying call options en masse, nearly driving a major hedge fund into bankruptcy. There is a lot of unusual market activity occurring and equity valuations on average are higher than any time since the peak of the dotcom bubble.

Lyn Alden

The S&P 500, which is tracked by the C Fund and represents over 80% of the stock market capitalization of the United States, has quietly been making fresh all-time highs:

Chart Source: YCharts

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The trend is relatively neutral, with the daily MACD trending sideways.

If we look below the calm surface of the broad index, however, there has been some highly unusual activity.

Parabolic Valuations and Massive Short Squeezes

Unprofitable tech stocks were relatively flat for a number of years, but nearly quadrupled in value over the past 10 months:

Chart Source: Bloomberg, Goldman Sachs

The leading example has been Tesla, which is now worth more than the next nine largest global automakers combined, despite selling less than 1% as many cars as them. It has a price-to-earnings ratio of 1,700. In comparison, the long-term average price-to-earnings ratio for the S&P 500 is 16.

Tesla managed to increase their number of cars delivered in 2020 by 35% compared to 2019 despite the pandemic, and for that they were rewarded with a stock that went up over 900% since last year:

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Chart Source: YCharts

If, instead of looking at growth companies, we look at struggling companies, there have been some surprising examples there as well. GameStop, the physical mall retailer that sells video games (and thus is being structurally harmed by the decay of malls and the shift towards digital downloads), went below $3 per share last year, but here in 2021 is suddenly up dramatically:

Chart Source: YCharts

The catalyst for this is retail investors on Reddit. A Reddit subgroup with 2 million members has performed coordinated attacks on individual stocks by buying call options en masse. This forces Wall Street market makers to buy shares to hedge their exposure, which drives the price up further, and then the Redditors keep piling in with more call options.

In recent weeks, this group has specifically been targeting heavily-shorted stocks, which means stocks that many hedge funds have sold short because they are bearish on the company.

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Redditors pile in and buy calls and buy the shares, forcing the price up, and after it goes up maybe 5x or more, the hedge funds that are short the stock are losing a lot of money, so the hedge funds have to “buy to cover”, meaning they have to go out and buy shares to cover their shorts. When those hedge funds start buying the stock, it creates a vicious short squeeze, which drives the stock price up exponentially as they are trying to get out of their short position. If the short squeeze is big enough, it can drive a hedge fund to bankruptcy.

Melvin Capital, the fund that has been badly caught short on GameStop, is being bailed out with $2.75 billion in investor capital from other sources. It’s literally a case of Redditors breaking a hedge fund. In response, many other heavily-shorted stocks rallied on Monday, often making gains of 10%, 20%, or more, as investors began targeting them and hedge funds wanted to get ahead of any similar problems to Melvin Capital.

Due to fiscal and monetary stimulus, the broad money supply is up more than 25% year over year, which is the largest increase since World War II. Along with super low interest rates, it has been a prime field for speculation and active trading.

Chart Source: St. Louis Fed

Investors with a longer-term view would do well to make sure they are appropriately positioned for their risk tolerance. There is a lot of unusual market activity occurring and equity valuations on average are higher than any time since the peak of the dotcom bubble.

Market Exuberance Hits a Peak
There are various threads on social media where young investors are plowing stimulus checks into call options or shares of highly-valued stocks. With little else to do during lockdowns, trading volume among retail investors is at record highs over the past year.

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Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.

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