Investors fear broader stock bubble after Reddit storms GameStop and silver

Oscar Williams-Grut
·Senior City Correspondent, Yahoo Finance UK
·6-min read
Reddit users and other social media groups take on Wall Street. Photo: STRF/Star Max/IPX/AP
Reddit users and other social media groups take on Wall Street. Photo: STRF/Star Max/IPX/AP

Reddit’s storming of the stock market has sparked jitters among professional investors about the fundamental strength of the market, with bubble talk spiking over the last week.

Reddit users from the r/WallStreetBets forum last week masterminded a short squeeze on professional investors that were betting against stocks like GameStop (GME) and AMC (AMC), forcing several hedge funds to swallow billions in losses. The action moved to the silver (SI=F) market on Monday.

The events have spiked anxiety among professional investors, with concerns that the stress could spread to the broader market. Some investors were already convinced that a bubble had formed and think this new band of retail warriors could pop it.

“Market commentators point to increasing signs of froth as evidence that the equity market is in the late stage of a bubble, which is set to burst soon,” Bank of America’s European equity strategy team wrote in a recent note.

Echoes of dotcom bubble

After slumping in March as the pandemic first struck, US stock markets surged to record highs last year despite a collapse in global growth.

“The US stock market has only been this highly valued twice before: during the Dot Com Bubble in the late 1990s and before the 1929 market crash signalling the beginning of the Great Depression,” said William Ryder, an equity analyst at Hargreaves Lansdown. He cited the cyclically adjusted price-to-earnings ratio, a closely watched metric of valuation.

Bulls argue sky-high valuations reflect the bumper growth potential for the US economy once the worst of the pandemic passes. The IMF expects the US to grow by 5.1% this year. Earnings growth that should follow would justify today’s valuations.

MPI
GameStop's stock has soared to unbelievable heights after Reddit forum users banded together to drive the price from $17.25 a share to over $325 a share. Photo: MediaPunch/IPX/AP

Not everyone is convinced. Veteran investor Jeremy Grantham, the cofounder of $64bn (£47bn) asset manager GMO, wrote at the start of last month: “The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble.”

“I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000,” he wrote, decrying “extreme overvaluation” and “hysterically speculative investor behavior.” This was before r/WallStreetBets started pushing up prices of loss making, old school businesses like GameStop and AMC.

GameStop's wild ride. Chart: Yahoo Finance
GameStop's wild ride. Chart: Yahoo Finance

Sceptics like Grantham argue that cheap money from central banks and low interest rates have combined to inflated a huge bubble in the stock market. The problem has only been exacerbated by stimulus checks and furlough payments made to people stuck at home with little to spend money on.

“For me, there is little doubt that huge central bank liquidity and government stimulus cheques in the hands of the underemployed/furloughed (through no fault of their own) retail investors will be a big part of this bubble story,” Deutsche Bank strategist Jim Reid wrote.

GameStop has had a wild ride on Wall Street as the stock has been heavily traded - some say manipulated - by hedge fund managers short-selling shares while Redditors (registered users of the website Reddit) have utilized social media to artificially inflate the value of the stock. Photo: STRF/STAR MAX/IPx 2020/AP
GameStop has had a wild ride on Wall Street as the stock has been heavily traded - some say manipulated - by hedge fund managers short-selling shares while Redditors (registered users of the website Reddit) have utilized social media to artificially inflate the value of the stock. Photo: STRF/STAR MAX/IPx 2020/AP

Research in the UK by Boscobel & Partners and FindOutNow estimated that 400,000 new investors joined the market in Britain last year, investing an estimated £20bn between them. Most were young men who were more likely to be furloughed than traditional investors. The newer crowd were also more likely to get their investment ideas from social media than more traditional sources.

‘A warning’

Some fear this wave of retail money could bring the stock market crashing down. Traditional investors, spooked by the anarchistic tendencies of the Redditors, may flee to safer corners like the bond market. Hedge funds hit by losses may be forced to liquidate profitable positions to cover their losses, feeding into the selling. And, when Redditors get bored and move on, many stocks will come crashing back to earth.

“Retail exuberance is a warning,” Barclays’ head of European equity strategy Emmanuel Cau wrote in a note last week.

If prices do start to turn, the mechanics of the rally mean it could unravel fast.

Dow Jones slump and then recovery to record highs. Chart: Yahoo Finance
Dow Jones slump and then recovery to record highs. Chart: Yahoo Finance

“Derivative markets continue to mushroom and so does the use of margin debt – the latter once more stands near record-highs according to data from the New York Stock Exchange,” said Russ Mould, investment director at stockbroker AJ Bell.

Margin debt is money borrowed from a broker to buy securities. The use of borrowed money means that people could be forced to sell out quickly to cover themselves once the market starts to turn, rather than hold losing positions in the hope that they can ride out the volatility.

“History shows that confidence soon evaporates if the market stumbles and you could argue that the liquidation (forced or voluntary) of positions bought on margin accentuates any subsequent market decline,” Mould said.

“It is here that the greatest dangers may lie today, in these over-the-counter, lightly regulated, trillion-dollar markets, which are funded by leverage.”

WATCH: Silver swept up by GameStop retail frenzy

For now, most analysts see a large scale stock market collapse as a relatively small risk. Despite raising the bubble question, both Barclays and Bank of America said r/WallStreetBets was unlikely to tank the market.

“The recent run-up in equity prices is not so much a bubble, but rather the pre-pricing of the extremely strong growth conditions that are likely to materialize this year,” Bank of America said.

Deutsche Bank’s Reid said: “My personal view is that when the history books of this pandemic and its impact on financial markets will be written, they will have a significant chapter but more as a story of the bubble-like tendencies in certain parts of the market, rather than the main market event.”

However, Wall Street and the City should start paying more attention to the retail market even if the events of the past few days are largely a sideshow.

r/WallStreetBets has attracted millions of new followers over the last week, suggesting the movement’s momentum is unlikely to fade soon. And, more broadly, retail money has played a fundamental role in pushing up the price of bigger name stocks such as Tesla (TSLA), which rose over 700% last year. Tesla, now part of the S&P 500 (^GSPC), is much more systematically important than the “memestocks” targeted by Reddit last week.

Tesla's vertigo-inducing 2020 rally. Chart: Yahoo Finance
Tesla's vertigo-inducing 2020 rally. Chart: Yahoo Finance

“I think this movement does create some systemic risks but it is perhaps a smaller version of the risks associated with some of the eye watering valuations elsewhere in large corners of the technology sector,” Reid said.

“Retail has in many parts driven such valuations in the last 10 months. If this pops the wider market will have bigger issues than last week.”