I’m nervous about the market’s performance this week. What should I do?
I’m nervous about the market’s performance this week. What should I do?
By: Stacey Nickens
Watching the stock market this week felt a little bit like sitting in the middle of a casino. There was so much noise and flashing lights, it was hard to figure out what was actually going on. Where was the money coming from? Who was driving the bets? Who was “winning”? And most importantly, what does this mean for long-term investors?
What happened with GameStop this week?
Let’s start by looking at the noise. I’m sure many of you noticed that shares in companies such as GameStop soared this week. GameStop’s stock value rose nearly 400% this week. What happened? With fiscal stimulus and the pandemic, some individuals have both extra time on their hands and extra money to spend, both of which they are using on investing apps such as Robinhood Markets.
This past week, many of these Robinhood-style investors began buying call options for companies such as GameStop, American Airlines, and Blackberry. Call options allow an investor to purchase the right, but not the obligation, to buy 100 shares in a company on a specific date at a specific price. The call-option investor is thus betting that the company stock price will rise. If the company stock does rise, the call-option investor will be able to buy the company stock at the lower call-option, or strike, price, before selling the appreciated stock for a profit.
The broker who sold the call option to the investor has simultaneously sold the obligation to sell the stock at the strike price. To hedge against the risk of the stock price rising, the broker will often buy shares in the same stock at the same time as they sell call options in that stock.
Normally, call option volumes aren’t significant enough to impact the price of the underlying stock. There aren’t enough people buying call options, so there aren’t enough brokers buying the underlying stock. Thus, there isn’t enough call option-related demand to impact the underlying stock’s price. However, this week, retail investors were communicating about their call option buys in companies like GameStop. Investors were using online forums, such as Reddit, to discuss these call option bets, creating incredibly high call option volumes that artificially inflated the price of certain stocks. On Thursday, Robinhood Markets put some restrictions on this kind of investing, and as a result, GameStop stock and other stock values began to crash again. When Robinhood Markets reversed course on Friday, some of these stocks began to rise again.
What does this mean for the broader market?
It’s unlikely that there will be long-term market consequences due to the speculative investing that artificially inflated GameStop stock. In the short-term, this call option trading did put some pressure on the broader stock market.
In part due to the above events, the major indexes posted their biggest weekly losses since the end of October. However, these losses aren’t entirely due to speculative investing. Part of these losses can be attributed to natural components of an economic cycle.
We are at the beginning of a new economic cycle. Analysts at Morgan Stanley suggested that we are likely also at the beginning of a multi-year bull run in the market. When this happens, valuations can become a bit exuberant at times, and the market will need to take a breather. Corrections happen so the excesses can ring themselves out.
While history can’t always be used to predict the future, we can look at the run-up in the S&P 500 after the 2008 recession for an example of how these corrections may look. During that cycle, the S&P 500 increased about 80% over a ten month period, similar to what we saw in the second half of 2020. Following the previous cycle’s 10-month rise, the S&P 500 then underwent around an eight-month consolidation before resuming its upward trajectory.
Again, we cannot predict the future. However, it is possible that we are at the beginning of a market breather. We may see some over-inflated stock values pull back a bit, allowing the market to return to more reasonable valuations.
What does this mean for me as an investor?
Whether the market is pulling back or spiking, stocks historically return to performing in accordance with the underlying company’s actual worth. This means that if you’re investing in healthy companies with strong long-term prospects, the company’s long-term stock performance will likely reflect the health of their balance sheet. This “reversion to the mean” theory would argue against investing in the GameStop noise, opting instead for investing according to company fundamentals.
Notably, investing in healthy companies and industries doesn’t protect you from short-term market volatility. Speculation will drive stock markets all over the map. However, long-term investors can learn the value of staying investing to and through that noise, in order to get the benefit on the other side. For example, if you pulled your money out of the market during the March 2020 stock market drop, you may have missed out on the S&P 500’s overall 16% gain from January 1, 2020 to December 31, 2020. Pulling out during stock market drops may mean you end up selling low and buying high. Selling when stock prices have dropped, missing out on recovery gains, and having to buy back in when prices have shot up.
An alternative strategy could involve, first and foremost, having confidence in the long-term health of your investments. Why did you choose those investments? What about the company or industry speaks to its long-term health? If you feel compelled to pull out of the market during a drop, perhaps step away from the news cycle for a bit. Try to manage your fear, and wait to make a decision until you’re operating from a calm headspace. When our bodies are in fight or flight mode, some of our brain function is shut down. Logical reasoning goes out the window in favor of immediate survival. Knowing this, it is rarely in your best interest to make a major decision from a place of fear.
All of that said, I hope this week’s stock market movement was not too overwhelming for you, and I hope you take the weekend to rest, recover, and get ready for another exciting week of trading.
