GameStop Erased the Stock Market’s January Gains. February Could Be Worse.

Of course, there was more than just wild trading for the stock market to deal with. Investors learned that the U.S. economy had grown at a 4% clip, a decent number in normal times, but not when the economy is trying to recover from the Covid-19 carnage. The long-awaited reveal of

Johnson & Johnson’s

(ticker: JNJ) vaccine data—the one that was supposed to help rejuvenate the reopening trade—fell short of the market’s high expectations.

But investors were transfixed by the surge in heavily shorted stocks like

GameStop

(GME) and

AMC Entertainment Holdings

(AMC), companies that had been left for dead but whose stocks were certainly not, thanks to a mob of Reddit investors.

The good news: The pain is likely to be short-lived.

Let’s start with the vaccine. Expectations had been for J&J to report an efficacy rate of at least 80%, but it came in at just 66%. Its stock fell 3.6% on Friday after the news was announced, and S&P 500 futures suffered a quick drop amid all the noise from the short-squeeze stocks. Experts were quick to defend the vaccine, however. They noted that it prevented severe symptoms in 85% of patients, meaning that even those who caught the virus had cough, sniffles, and fevers but avoided the worst outcomes, while reaching the same level in treating the more-contagious South African strain.

“Those headline numbers may not be as impressive, but this vaccine has a role to play,” says Dave Donabedian, chief investment officer at CIBC Private Wealth Management.

That should be great news for the U.S. economy. Things—obviously—aren’t booming at the moment. Fourth-quarter gross domestic product grew by 4%, a touch slower than the 4.2% economists had predicted, but still solid given the Covid-related shutdowns during the last three months of the year. We’ll also get a glimpse of what January looks like when payrolls are released on Feb. 5—the U.S. is expected to have added 150,000 jobs this past month, up from a loss of 140,000 in December.

Growth should accelerate in the months ahead, thanks to the vaccines and to fiscal stimulus, which will almost certainly be coming, one way or another. Bank of America economist Michelle Meyer expects the U.S. economy to grow at a 6% clip in 2021 and by 4.5% in 2022. Full employment could also be reached by the end of 2022, which would lift inflation to the Federal Reserve’s target rate. And if that’s the case, Fed Chairman Jerome Powell could begin raising rates by the end of 2023. “This would clearly be an exceptional outcome,” Meyer writes. “If all goes as planned, Chair Powell and [Treasury Secretary Janet] Yellen will be able to take a bow.”

Powell did nothing to suggest a rate increase or even the beginning of a taper of bond purchases at this past week’s Federal Open Market Committee meeting. He continued to insist the Fed will remain easy until it surpasses its targeted inflation rate and job growth has recovered. The subtext: The Fed is no longer relying on economic models to gauge when it should tighten monetary policy, but will try to use the available data to judge the strength of the economy.

This change has contributed to shorter-term market volatility, says Lakshman Achuthan, co-founder of the Economic Cycle Research Institute. “The Fed has given up on the framework they had and that Wall Street was following,” he says. “Now it’s a bit untethered and susceptible to the narrative.”

And what a narrative it has been. The GameStop short squeeze has quickly become a morality tale of little guys taking on the man. I’d prefer to see it for what it really is—a bunch of small investors have discovered the joys, and potential profitability, of day trading in a way they haven’t since the dot-com boom and bust.

One thing traders need to make profits is volatility, and that’s been missing for many years. But it shouldn’t come as a surprise that the return of day trading coincides with a market that is not only heading higher but also is doing so sharply, similar to what investors experienced in 1998 and 1999. One of the things that ended my trading career and sent me into journalism was the lack of volatility starting around 2003.

What’s happening with GameStop isn’t even that new. Wall Street firms like

Barclays

and

Jefferies

have been sending their clients lists of the stocks that are seeing the most retail activity. And the surge in GameStop and other heavily shorted names hasn’t been all that different than the mania for marijuana stocks in 2018, for bankrupt companies like

Hertz Global Holdings

(HTZGQ) back in June, or even the rally in electric-vehicle stocks in November. The recent trades have just caught the market’s attention in a way the others didn’t. That’s partly because investors didn’t have much of an “fundamental” argument for buying GameStop at $300, in the way they could for

Tilray

(TLRY)—just think of all the marijuana it will sell once pot is legalized!—or the coming domination of electric vehicles.

But the other big difference is that institutional investors—hedge funds—were heavily short GameStop,

BlackBerry

(BB), and the rest. They had assumed the businesses were dying, so the stocks must be too. “GME is a reminder not to short troubled companies at the start of an economic cycle,” writes Nicholas Colas, co-founder of DataTrek Research. “Retail investor wolf packs are new, but if you’ve ever sat on a hedge fund trading desk you know squeezing shorts has been a Wall Street blood sport for decades.”

That’s clear from the way stocks that make up Wall Street’s lists of the most-shorted companies have been popping one by one. But just the fact short sellers are involved doesn’t make these stocks soar the way they have. The missing element is liquidity. In August, options traders were able to push up

Apple

(AAPL) and other FAANGs higher—Apple gained 22% during that month before peaking on Sept. 1—but the sheer enormity of the companies means it’s more difficult for a mob of traders to push the shares around.

Not so with GameStop and its ilk. Jefferies strategist Steven DeSanctis notes that the most-shorted stocks in the small-company Russell 2000 have outperformed the least-shorted by 28.3 percentage points, the largest on record. The difference for stocks in the large-cap Russell 1000 is just 5.4 points, only the ninth-biggest gap since 1996. The difference in performance can be explained by the lower number of shares in small-cap stocks. “The volume is up, but liquidity down,” DeSanctis says.

But credit should be given where it’s due. It might have been a mob that caused GameStop to surge more than 1,600% in January, but traditional investors like The Big Short’s Michael Burry, head of Scion Asset Management, along with newer ones like “DeepF—ingValue,” have been making the argument for buying the stock for a couple of years now, and putting their money to work. And these trades really were deep value, requiring patience for them to pay off.

But one didn’t have to hold through the pain to see that something different was happening with GameStop during the past six months. It rose 24% on Aug. 31, when RC Ventures, managed by Ryan Cohen, first disclosed a 9% stake in the company. It gained 22% on Sept. 16, when it started taking orders for

Sony’s

PlayStation 5. On Oct 8, it soared 44% after announcing a multiyear partnership with

Microsoft

(MSFT). The stock traded sideways for a while but never came close to testing its pre-Oct. 8 lows. To a fundamental analyst, the company might have looked dead in the water. To a technician, it was anything but.

As for the market, it has been needing a rest—and it will probably get one. One of the side effects of the short squeeze is that it has forced hedge funds to sell the stocks that they own to be able to cover their shorts. That includes ones like Apple and

Facebook

(FB), which dropped 5.1% and 5.9% this past week, respectively, despite strong earnings reports. The heightened market volatility also forces some funds to reduce their long holdings as a way to reduce risk.

Though the chances are small, the possibility of contagion is real. And if nothing else, it will force investors to reconsider what they hold and what they want to own for the long term. “We fully expect this kind of pullback will be a healthy buying opportunity,” says BTIG strategist Julian Emanuel. “Ringing out some of this speculation is likely to be a positive.”

The pullback comes right on schedule. This February is the second month of the presidential cycle, and it’s usually quite terrible, with the market averaging a 1.1% drop. Every sector has averaged a loss during the second month of the presidential cycle. It isn’t that every February is bad—returns were positive 12 times out of 23—it just tends to be that way. “You should NOT assume that February of 2021 is ‘doomed’ to be a bad month for stocks,” writes Sundial Capital Research’s Jay Kaeppel. “What you DO need to recognize is that when Month 2 is ‘Good’ it is OK. And when Month 2 is bad it is often very bad.”

Hang on to your hats.

Write to Ben Levisohn at Ben.Levisohn@barrons.com