How Did it Spill Over?
So how could stocks comprising less than 0.2% of the market cap of the S&P 500 Index3 (as of January 27) wreak such havoc? The manic activity in this seemingly small slice of the market spilled over into the broader market when the hedge funds that were short these stocks and experiencing large losses were forced to trim back risk in other holdings, which had grown in size relative to their now-depleted capital.
Forced sales frequently target the biggest, most liquid long-equity holdings, which in this case were large-cap tech stocks. Since large-cap tech makes up around 25% of the S&P 500 Index, sizable sales of these companies affected the performance of the broad index. (Forced sales are a common feature of market swoons that swiftly spread from a relatively small corner of the market.)
How Unique Is This Episode?
Clearly, there are some unique aspects to the recent short squeeze, but a dramatic rise in certain stocks that appears to be divorced from underlying fundamentals is not that unusual. Today’s record-low interest rates, search for higher returns, accommodative policy, zero commissions, and plentiful market liquidity are all conditions ripe for performance spikes that may not be supported by fundamentals.
What is unique is the ability of social media to rapidly proliferate an idea to the masses and markets. Efficient markets depend on the free flow of capital to the best uses of that capital. If an argument for or against a company is promulgated on social media and sways large numbers of investors into action (i.e., trading), technicals can overwhelm fundamentals. When that behavioral dynamic is accompanied by a mismatch in liquidity (in this case, substantial volumes of smaller companies that need to be funded with bigger, more liquid companies), systemic risk can quickly become an issue (FIGURE 1).