Are You Prepared for the Next Short Squeeze?

This week’s tumultuous markets showed us the power of the crowd, even when the crowd is an untraditional one. Retail investor sentiment has caused pain in the short seller’s market before, but the past week saw market movement at unprecedented levels in recent times, as evidenced by the massive trading volumes on the NYSE and NASDAQ. Could the pain caused in institutional investor portfolios have been avoided if there was more transparency into investor crowding, and particularly into retail investor crowding? The answer is very likely, yes.

We currently have crowding data on the Omega Point from our risk model partners. Looking at two of these factors, Short Interest and Hedge Fund Crowding from the Wolfe QES US Broad risk model, we can see major moves in the factor returns this past week. Exposure to these factors in portfolios surely would have been drivers of return (positive or negative, depending on the direction of the exposure).

Using these factors to screen for risky names ahead of earnings season, or other market events, can provide some level of risk mitigation. However, these factors tend to mainly capture crowding in the institutional space. Recently, our colleagues at Wolfe Research took this a step further by constructing usable retail investor crowding data, which is an area that has historically been a blind spot for institutional investors.

Wolfe has developed indicators to identify stocks with high exposure to retail speculation by leveraging the Reddit community threads, historical popularity metrics from Robinhood, and data from a major retail brokerage firm. Below, we summarize the research from Wolfe (“A Battle Between Retail and Institutional Investors”) and discuss methods to avoid names in your portfolio that are in danger of being swept up in the retail investment wave.

We expect to have this data available on the Omega Point platform imminently.

Capturing Retail Crowding

Wolfe has done a phenomenal job addressing a major need in the market by aggregating retail sentiment and flow data across disparate, unstructured sources and distilling that data into actionable indicators. Their recent research note, “A Battle Between Retail and Institutional Investors”, goes into scrupulous detail on the sources they’ve tapped into, methodologies used to aggregate the data, and empirical evidence of the data’s validity for use in portfolio construction. We would highly recommend giving the paper a read, but will summarize the main points here.

‍Short Sellers Beware of the Retail Crowded Tech & Consumer Sectors

‍Wolfe points out that retail investors are highly influenced by companies that are discussed in the news, regardless of whether the news is positive or negative. As a result, there is a significant bias towards these stocks from retail investors. Additionally, the retail investor community tends to concentrate their holdings in technology and consumer companies, as well as stocks that are highly shorted.

‍Retail Red Alert Screen

‍Increased accessibility for retail investors, especially within younger generations, to the market in recent years coupled with the rise in popularity of retail investing during the pandemic has made short squeezes more likely and more common than they have been historically. Wolfe notes that in January 2021, almost 40 stocks (out of a group of 150 heavily shorted names) outperformed the market by over 50%. This is 2x that of the 2009 market rally, which previously held the record for most short squeezed stocks.

To give investors more transparency into this phenomenon, Wolfe has constructed a screen, called the “Retail Red Alert Screen”, to highlight names that are likely to be heavily impacted by further retail-induced market moves. These are names that would be very risky to hold, especially in a short book. The screen has three main components:

1. Reddit - daily mentions within the r/wallstreetbets Reddit community, processed using Wolfe’s proprietary Natural Language Processing framework
2. Robinhood - historical participation as determined by Robinhood’s popularity indicators (for more information on the Robintrack dataset, see our Factor Spotlight post from last summer)
3. Retail brokerage volume - intraday trading volume through a major retail broker

Furthermore, the research demonstrates that removing these stocks can improve risk-adjusted returns and help short sellers specifically avoid squeezes. In particular, Wolfe created various factor portfolios to capture Reddit sentiment, Robinhood popularity, retail trading flows, and a composite of all three. The composite portfolio in particular outperformed the Russell 3000 (equal-weighted) from Feb 2020 through now - a strong sign that including names from the composite portfolio in a short book can lead to some short-selling pain.

The Reddit portfolio, along with a screen to only include high short interest stocks, had cumulative performance of almost 150% in the last two months and outperformed the Russell 3000 significantly. As Wolfe notes, this illustrates that the retail investor community has immense power in forcing heavily shorted stocks to go on the run.

‍Hedge Funds May Continue to De-lever

‍While the impact from this past week was mainly to short sellers, hedge fund long positions could also become targets of the retail investment craze and cause further impact to overcrowded long hedge fund positions. This possibility has resulted in some de-risking on the long side, as we can see from the HF Crowding factor return decline shown in the introduction of this article. Wolfe conjectures that if retail investors continue to create major swings in the market, we may see a large scale sell-off of crowded long names. Exposure to heavily crowded long names is an area that investors should look to potentially mitigate risks.

A Silver Lining

While the experience from this past week was dim, especially for institutional short sellers, there is a silver lining! To avoid future pain from crowding, whether it’s institutional or retail crowding, investors can put in place a systematic process to identify stocks that pose risk to their book, both long and short.

There’s plenty of research flying around that includes static “hot” lists of stocks to avoid during this current retail wave, but in order for these screens to stand the test of time, they need to be dynamic. While GameStop was the hot stock of this past week, it’s sure to be a different target in the future.

With the Omega Point platform, investors can incorporate powerful datasets, such as the ones from Wolfe Research discussed here, alongside of their portfolio data to systematically and dynamically employ a robust framework for stock screening.

US & Global Market Summary

US Market: 01/25/21 - 01/29/21

• Wall Street ended its worst week since October amid a trading frenzy fueled by retail investors piling into stocks that are being shorted by big investors.
• The Cboe Vix — a measure of expected volatility known as Wall Street’s “fear gauge” — ended at 32.4, well above its long-term average of just below 20, as another hectic session propelled recent day-trader favorites such as GameStop and AMC Entertainment higher.
• Pressured to respond by frustrated retail investors and lawmakers, the US Securities and Exchange Commission said on Friday that it would review the trading restrictions imposed by Robinhood and others.
• Consumer spending in the U.S. declined by 0.2% in December, according to data from the Bureau of Economic Analysis. It fell for the second straight month due to a rise in coronavirus cases, although a little less than economists had predicted.
• Household incomes rose 0.6%, which could prime the economy for growth later this year.
• The European Union’s comparatively slow rollout of vaccines and recent delays to supply are creating concerns about prolonged lockdowns and weighing on markets, investors said.
• Shares of Novavax soared after it said its Covid-19 vaccine was 89% effective.

Normalized Factor Returns: Axioma US Equity Risk Model (AXUS4-MH)

• Earnings Yield finally breaks into positive territory after riding 6 consecutive weeks of gains
• Profitability and Growth show strong movement once again while taking over 2 of the top 3 spots.
• After 7 straight weeks atop the U.S. Leaderboard, Momentum finally retreats with a small loss for the week.
• Value continues to slide deeper into negative territory
• Market Sensitivity finishes as this week’s biggest loser yet again.
• US Total Risk (using the Russell 3000 as proxy) decreased by 8bps.

‍Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)

• Growth and Momentum finished in the two top spots for a record setting 8th week in a row representing the week’s only positive movers.
• Volatility, Value and Size all continue to show weakness.
• Market Sensitivity and Exchange Rate Sensitivity once again finish the week as the 2 biggest losers.
• Global Risk (using the ACWI as proxy) increased by 14bps.

Regards,
Alyx