However noble the cause may be, practices that create a total disconnect between a company's stock price and its underlying value raise the question of how much small investors can trust the stock market, argues Didier Saint-Georges
A Wall Street version of David against Goliath. The famous biblical struggle immediately comes to mind when you look at the stock-market battle waged in January - but with the weapons being online trading platforms and complex financial instruments instead of slingshots and stones.
Retail traders joined together on an online trading forum and succeeded in defying US hedge funds in a conflict that received huge media coverage. The stock in question was GameStop, a video game retailer with its back against the wall. This small army of retail investors seemingly got the upper hand by using the same financial instruments as hedge funds, including the most sophisticated ones, and accessing the same information as institutional investors.
The crucial issue here is what the primary purpose of investing in the stock market should be. However noble the cause may be, practices that create a total disconnect between a company’s stock price and its underlying value raise the question of how much small investors can trust the stock market."
Though the stock market saga created as much suspense as even the best of thrillers, it also raised some serious questions about the ambiguous motives people may have for investing in financial markets.
First, the January clash resulted in part from today's extremely low interest rates, which provide incentives to engage in financial leverage - i.e., to pay for an investment with funds borrowed at an interest rate that is less than the expected gain. As it turns out, the hedge funds involved in the January saga were hugely leveraged, and once the big risk they were taking was spotted, it became their Achilles' heel. This could entice lead market regulators to take a closer look at current regulations in this domain.
In addition, not all the retail investors involved came out ahead. Those who were among the first to buy GameStop stock and then offloaded it fast did make a quick buck. But the ones who joined the game later on will most likely get a raw deal, because the price they paid far exceeded the company's intrinsic value.
Such disparity between a company's stock price and its underlying value is the crux of the matter. Investors are supposed to start out by trying to estimate the value of a company by analysing and assessing its business potential. They then either buy or sell the company's stock if they see that the market price has deviated too sharply from their estimate.
For that reason, short positions (i.e., borrow-and-sell positions) are no less honourable per se than long positions (i.e., buy-and-hold positions). Both help bring share prices closer to their "real" value. But alongside this primary process, more "speculative" practices have developed - although there is no need to associate speculation with questionable moral standards. To speculate is merely to bet on which way a share price is heading, whatever the estimated value.
The purpose of investing in the stock market
The stock market tug-of-war in January was thus a confrontation between two speculative moves. The hedge funds wagered that GameStop's share price would tank, given the company's shaky condition. The retail traders were betting the opposite - irrespective of what the company's underlying value might be. They did so more for political than for economic reasons.
Leaving aside the problem of security-price manipulation, which is expressly prohibited by law, the crucial issue here is what the primary purpose of investing in the stock market should be. However noble the cause may be, practices that create a total disconnect between a company's stock price and its underlying value raise the question of how much small investors can trust the stock market.
Incidentally, much the same can be said in relation to the recent boom in passive investing. By definition, passive fund managers simply buy stocks on the basis of the stocks' weights in a given market index, without considering the intrinsic value of the companies that have issued them.
The most expensive shares - i.e., the most heavily weighted in the index - are automatically the ones that attract the most buying, which makes them even more expensive. And given the importance of passively managed funds in today's markets, they are a much greater source of risk for financial markets than any crusades by activist retail traders.
The bottom line? If you think about stock-market investing as just a game - however rough-and-tumble - or as some abstract process untethered from real economic value - however convenient - you tend to lose sight of what investing in a company's stock is all about. And that's when you start taking inordinate, poorly understood risks.
Didier Saint-Georges is a strategic investment committee member at Carmignac