GameStop is a brick-and-mortar retailer that’s facing some challenges, especially as video gaming shifts to the cloud and negates the need to purchase consoles and hard copies of new games. But throughout the week, the company found itself in the middle of a showdown between a band of small investors, many from Reddit, and short-selling hedge funds. GameStop was among a handful of stocks that made spectacular moves higher and triggered broader market volatility, all due to a technical quirk in a popular trading technique. It's since captured the attention of the investing world.

Viewed as a business in decline, hedge funds and other traders had “shorted” GameStop stock. Essentially, they set up a trade that would turn a profit as the company’s stock price fell. An investor who is “short” borrows shares from a broker and immediately sells them, aiming to buy them again later at a lower price and sell them back to the broker to earn a profit on the difference. But the strategy can backfire if the price of the stock rises unexpectedly.

When the share price increases after a short position is initiated, investors try to mitigate the damage by “covering” or buying back the shares immediately and returning them to the broker for a small loss. A rising stock price, along with a wave of short sellers trying to cover, can set up a self-feeding effect known as a “short squeeze”: A rising stock price forces short sellers to buy more shares, but the process of covering raises demand and the price for those same shares — which forces more covering.

That’s essentially what happened to GameStop and other heavily shorted stocks through the week. It caught some hedge funds in a bind, as they hadn't forecast a wave of buyers from Reddit swooping in and kicking off a “short squeeze.” As the week went on, traders tried to replicate that strategy on dozens of other heavily shorted stocks on the market like Koss, AMC or BlackBerry, sending their prices higher, as well.

WHAT LONG-TERM INVESTORS SHOULD KNOW

It’s purely a technical event. The torrid increase in the price of GameStop and other heavily shorted stocks really has nothing to do with improving prospects at these firms or their balance sheets. It’s purely a short-term, technical phenomenon that can occur when traders butt heads with short sellers. At the core of all this action is pure speculation.

“I would be really, really careful because I don’t see the fundamentals backing what we’re seeing. Whenever that happens, these things tend to be in the speculative camp, and you need to treat them like that,” says Executive Vice President and Chairman of Northwestern Mutual Investment Management Ron Joelson. “When I think about how we invest in the general account, that’s not something we would be doing. We don’t invest unless we see support in the fundamentals.”

As we’re already seeing, some stocks rising on the “big squeeze” can decline in value just as rapidly as they climbed.

It’s isolated. No doubt, these stocks are making market headlines and people are pontificating the broader social and political implications of the “Reddit Squeeze,” but this isn’t necessarily a paradigm shift. A few hedge funds may have trouble unwinding the trade they were caught in, and some investors may lose or make a lot of money on this trade. Some people may argue “markets” are looking irrational. While that may be the case for a small slice of the investable universe, it doesn't mean every investable asset is irrationally priced. Even during the dot.com boom and bust, other asset classes performed quite well.

"Sure, there's likely a Wall Street versus the average investor dynamic at play, but I think this is more emblematic of a bigger picture of people taking more risk to find every way possible to make money,” says Northwestern Mutual Chief Investment Strategist Brent Schutte. “I have said from time to time this year that some parts of the market remind me a bit of 1999, as some companies are being priced heavily off their future growth prospects and stories about what they could become. But that's not the entire market.”

That’s why, in times of irrational exuberance, active portfolio management can help filter through some of the froth and weight portfolio allocations toward asset classes with strong valuations and fundamentals.

This has happened before on markets. The “short squeeze” isn’t new. Perhaps most famously in 1923, Clarence Saunders foisted the plans of investors who were shorting Piggly Wiggly stock, the company he had founded. To take on the short sellers, Saunders borrowed millions of dollars from banks to accumulate as many shares of Piggly Wiggly as he could. He eventually bought 98 percent of the shares traded, and drove the stock up from $39 to $124, forcing short sellers to book enormous losses. Throughout history, institutions, activist investors and hedge funds have put the squeeze on shorted companies.

What’s different about this week’s events is that small investors acted as a “coalition” to buy up stock and put on the squeeze, rather than a single company founder or institution. However, the short-term market effect is the same.

Trend-following is risky. Speculation in markets is always risky, but in a well-balanced, diversified portfolio that's built for the long term, there may be room to allocate a small portion to riskier investments or strategies. But there’s a fine line between investing and speculating, and speculating isn't a long-term, wealth-building plan.

“Sure, the gains can be big but so can the losses,” says Schutte. “We always recommend having a financial plan and building broadly diversified, long-term focused portfolios. Long-term investors are building portfolios, not just collecting asset classes or taking bets. Each asset class serves a purpose in a portfolio, even for investors who want to take more risks. It means there is part of your portfolio that is able to carry you through lean times for other assets.”

The fundamentals still matter. Most importantly, nothing that happened this week changes the core tenets of long-term investing. Company fundamentals matter. Businesses with solid balance sheets, competitive advantages and reasonable valuations tend to see that reflected in their stock price over the long term. Diversification is critical. Invest with long-term time horizons. Invest for growth, but also seek long-term stability and safety.

Our 2021 economic and market outlook hasn’t changed. With speculation in some corners of the market, volatility could spread more broadly. For example, the market could correct in the short term as the after effects of this week’s activity ripple and money shifts around to adjust.

However, market conditions won’t change the broader economy’s fundamental strength. Manufacturing and services growth are accelerating, personal savings are healthy and there’s pent up demand for "back to normal" leisure and travel. There are multiple growth cylinders firing right now. We could see a correction or two during the year (but that’s possible in any given year, really). But we think any market correction would be short-lived, given the economy’s underlying strength and fiscal and monetary support.

Also, keep in mind, not all asset classes are riding a wave of speculation and may have compelling relative valuations. That’s why, when speculation rises, we like to remind that diversification across asset classes is critical to long-term portfolio construction. Sacrificing diversification to follow the latest investing trend is risky, and building wealth is about growth and risk management.

While the short squeeze in a handful of stocks may be a little different in its execution, it will likely end with the same outcome: The company fundamentals won’t be able to support an elevated stock price.

The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass, nor is past performance an indicator of future performance. This material does not constitute investment advice and is not intended as an endorsement of any investment or security. References to specific securities are intended to explain market drivers and not to be construed as investment advice. All investments carry some level of risk including loss of all money invested and no strategy can guarantee a profit or protect against loss.

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