The epic battle playing out in GameStop Corp.’s (NYSE: GME) stock isn’t the David versus Goliath battle some in the media play it out to be. In fact, hedge funds are far from the “all-powerful predators” that make a killing shorting stocks to zero, according to CNBC’s Michael Santoli.
Selling short isn’t a profitable strategy
Generally speaking, shorting stocks is not only an expensive strategy because of the added costs of borrowing shares, but shorted stocks have underperformed trades on the other side, Santoli wrote for CNBC.com. Data from J.P. Morgan strategists last week found that a heavily crowded short trade performed mostly in line with the market as a whole in the past few years.
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In fact, annual returns for equity long-short hedge funds over the past five years range from minus 3% to plus 9%, data from BarclayHedge shows. Yet over the same time period, the S&P 500 index returned on average 15% annually.
“If hedge funds were market bullies able to have their way with stocks they pile into, why would they have limited themselves to such meager rewards?” he wrote.
In GameStop’s case, there is plenty of reason to believe that hedge funds merely made a costly error of overextending their hand on a short position and they were exposed and vulnerable.
$50 billion in losses
Data from Ortex point to short sellers down net $50 billion since the start of 2021. Naturally, this large number is the direct result of heavily shorted stocks experiencing a surge in buying frenzy brought on by Reddit traders.
Piper Sandler analyst Richard Repetto calculated that GameStop and other squeeze stocks that dominated media headlines in the past week accounted for anywhere from 4.6% to 7.6% of total U.S. consolidated equity volume, Santoli wrote. Put in perspective, the same group of stocks typically account for just 0.5% of normal volume.
The intraday volatility over the past week has averaged 72.2% versus the broader S&P 500’s 1.5% volatility.
No reason to panic
Investors expecting the extreme volatility seen in a handful of heavily shorted stocks to spill over to the broader market could sleep peacefully at night, Santoli continued. The total market capitalization of all stocks with a short-to-float ratio above 20% is just $40 billion, or one-tenth of 1% of the total stock market’s cummulative $40 trillion valuation.
“And assuming the squeeze-and-chase game continues until the shorts vacate the playground, it would result in a market with even less of a short cushion, which is a headwind for stocks from a contrarian perspective,” he wrote.