Isolated Volatility… or the Beginning of Something Worse?

The recent volatility of major averages and the “mega” volatility in small, obscure, profitless stocks has many investors concerned that this may lead to an overall and significant market decline. Is this a storm in a teacup? Or could trading shares in a small part of the market be the tipping point that causes most stocks to take a significant tumble? Our research suggests otherwise for a few important reasons.

The epic roller coaster of shares of companies like GameStop have mainly been the fodder of hedge fund vs hedge fund, or a crowd of individual investors vs. hedge funds. In the latter case, individual investors who have banded together (many through trading platforms like Robinhood) to crush hedge funds at their own game. Through group chat sites, like Reddit, individual investors discover a hedge fund’s position and purposely unify to mount a significant counter investment in hopes of forcing the hedge funds to sell at painful prices. It worked like a charm! It caused a number of hedge funds to lose large sums of money and, as always, regulators came swarming in – a bit too late.

The lessons to learn from this recent market mania is that it is sure to happen again. Groups of investors have staged these types of coups many times in history. Where vulnerability lies, capitalists shall seize the day. To our team it is a reminder to understand the investments we own on your behalf. It is also important to understand which other institutions own shares in our stocks and what potential impact that may have. In our case, we have many rules about the kind and quality of companies that we are willing to invest in on your behalf – most of which are almost the exact opposite of a target like GameStop. Unlike GameStop, we invest in companies that are selling a product or service the world wants more of, along with a strong balance sheet, significant return on equity and profitability. GameStop, and other stocks like it, became targets of this recent volatility due to the fact that there are very few buyers or sellers of their shares – what we call low liquidity and a symptom of low-quality stocks. This is an additional reminder to our team regarding our rules about liquidity – if there is not a tremendous amount of liquidity, we are just plain not interested in taking a position.

Though it is always concerning to experience market volatility, particularly of the magnitude of these illiquid stocks, as far as our team is concerned this market action is in a world far from what we do or where we invest on your behalf. The media attention can be difficult to ignore, but rest assured it should have little implication on the long-term success of your portfolio and our work.

We remain bullish about the prospect for a new “vaccine induced” business cycle and bull market. We see many of the signs that typically precede new business cycles, such as the outperformance of small and cyclical stocks as well as a slight uptick in interest rates. We look forward to these better days ahead and will continue work hard to uncover great companies that can participate along the way.

Keep in mind that normal corrections of 7-10% are a healthy part of bull markets and we haven’t had one in quite some time. So, do not be too alarmed if we see some pullbacks along the way to our new, more robust economy. Of course, should the economy falter and markets begin to fall more than normal, we stand prepared to mitigate any catastrophic losses through our Active Risk Management. This three-pronged approach allows us to be flexible with your asset allocation, sector management and our ability to employ carefully placed stop loss orders – all in an effort to mitigate downside.

We hope this update finds you well. If you have experienced any changes in your financial affairs or have any questions, please let us know.

Your Team at Main Street Research

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