Julian Koski, Co-Founder and Chief Investment Officer, New Age Alpha Jan 29, 2021 2:40:43 PM 6 min read Opinions

Let GameStop Ruin Someone Else’s Portfolio

Options—they’re all the rage now. A short squeeze frenzy in stocks such as GameStop (NYSE: GME), AMC Entertainment Holdings, Inc. (AMC), and others, caused some to double or triple in value overnight. This resultant explosion fueled further activity in the stocks’ options and drove prices ever-higher. It marked a reversion largely unseen in the market previously and turned such otherwise stodgy investment concepts into headline news; the stockholders had captured the market and there was nothing the shorts or option holders could do.

Traditionally, hedge funds might short a stock, publicly announce these activities and a self-fulfilling prophecy would drag the stock lower as the market followed suit. Proof of this phenomenon was so prevalent that a strategy tracking the “most shorted” stocks was believed to produce considerable alpha. Recently, however, a motley group of investors organized in Reddit forums and decided to test these hedge funds' mettle by actively buying these most shorted stocks. In combination with a record high volume of call options, they drove prices higher, causing the hedge funds to cover their shorts at exorbitant prices, and this “melt-up” ensued.

The hedge funds never had any other goal than to make money yet, under the auspices of fighting Wall Street, it’s hard to see how all of the Redditors’ goals are materially different. Picking a winner between the two camps feels like an impossible task. In fact, there is no use in trying to figure out which side is right in this fight. Those guided by emotion will continue down their set path. However, those who want a mathematical number to truly measure this risk can do so through use of the Human Factor.

The Human Factor is New Age Alpha’s probability that measures if a company will fail to deliver the growth implied by the stock price. Using this probability, investors can better understand the risk they are taking before joining the next rally. And, when the dust settles, we believe the companies with lower Human Factor scores will outperform those with high Human Factor scores. Let’s examine some recent scores:

Capture-1

Looking closer at GameStop, we believe there is a 100% probability GME will fail to deliver the growth implied by the stock price. In other words, the stock is so incredibly overpriced almost all investors are assured to lose in the long run. But when will that be?

When a stock’s price is so divorced from the company’s ability to deliver growth—and divorced from reality—we believe you should simply stay away. Avoid the losers. GME will be a loser. Don’t short it, don’t buy, just avoid it altogether.

Picking Investment Winners is a Fool’s Option

Importantly, this isn’t exactly the first time something like this has happened. As Twain’s famous saying goes, “History doesn't repeat itself, but it often rhymes.” Typically, previous melt-ups in stocks have corrected quickly as prices reverted to the norm once the dust settled. Though it didn’t occur at the scale of GME’s preposterous run-up, a sort of “dry run” of this crowd-sourced market irrationality occurred in relation to the bankrupt company, Hertz. Beginning in June of 2020, the company experienced an unprecedented run-up in its stock price, largely resulting from retail investors expecting some form of government bailout. From a low of approximately 50 cents in late May, it shot up to approximately $5.50 on June 8th despite full transparency regarding its bankruptcy and likely cancellation of the stock. The stock has yet to come close to that level. Compare this to GME currently and it almost feels as if a warning is taking shape:

Graph

Source: Yahoo Finance

The point remains: once these events involving overheated short selling and options run their course, a comparatively small handful of individuals often make a killing while everyone else is left holding the bag.

A Different Way to Save Your Portfolio

This discussion has centered on options with a, so-called, capital ‘O’. But what about ‘options’ with a lower case ‘o’? As in…alternatives, choices. Because sometimes the choice to avoid a purchase might be the best choice of all. For example, if one is concerned about the concentration of mega-cap in the S&P 500, there are complements to it that might provide similar levels of performance but with significantly less overlap in those Enormous-Cap names.

Similarly, one could choose to avoid investing in losers altogether. Losers are stocks we believe to be overpriced which occurs when humans price vague or ambiguous information into stock prices in a systematically incorrect way. This creates a mispricing risk that we believe causes a stock to underperform. Investors may be unaware of this risk, which erodes performance, and are typically not rewarded for taking it. There is no benefit from accepting human behavior, only cost. And we believe the only way an investor can avoid a loser is by knowing its Human Factor.

Register HERE for our H-Factor System and find an investment option that won’t ruin your portfolio the way GameStop might.

About Us

New Age Alpha is a global leader in building actuarial based asset management solutions that aim to inure investor portfolios against an idiosyncratic risk caused by human behavior. Investors are unaware of this risk that leads to loss, cannot be diversified away, and don’t get rewarded for taking it. Unlike firm specific risk, that can often be diversified away, this risk affects stock prices specifically and we believe is caused by human behavior. Through our research we have identified a dramatically differentiated source of alpha that is uncorrelated with traditional risk factors and managers, and as the foundation to our investment approach, we have built a range of actuarial based asset management solutions that aim to mitigate and inure investors’ portfolios against this risk.

Disclosures

The above statements are not an endorsement of any company or a recommendation to buy, sell or hold any security. The views stated herein are only current through the date stated and are subject to change at any time based on market or other conditions and New Age Alpha disclaims any responsibility to update such views. Any Human Factor information or charts presented herein or utilized in the Human Factor system are provided for illustrative purposes only and should not be construed as providing investment advice or as a recommendation to buy or sell any particular security. The Human Factor information provided herein is a snapshot taken at a particular point in time and any analysis or information contained in this document is outdated and should not be relied upon as investment advice. Moreover, the information presented in this document may have changed materially from the date on which it was created. New Age Alpha does not currently own GME and did not own it at the times set forth in this article. There is no intention for New Age Alpha to include this security in its portfolios unless it becomes part of the established universe of eligible securities that are part of each specific investment strategy (e.g. the S&P 500®). It is important to note that there can be no guarantee that the application of the Human Factor to investment portfolios or certain stocks or securities can produce profitable results. For full disclosure: https://www.newagealpha.com/disclaimers

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