3 Takeaways From the GameStop Debacle

This full-page ad for Robinhood was featured in the Tuesday edition of The Washington Post. It was also misleading, so I fixed it.

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If you've been paying attention to the news over the last week, you've probably noticed GameStop has been in the news a lot. The company, which sells physical video games, consoles, and accessories, was involved in something called a short squeeze. The story behind the debacle is more complicated than it appears and involves a large cast of characters, including hedge fund managers, professional traders at large institutional investment companies, securities regulators, regular Jane/Joe retail investors, and an army of angry, overzealous investors who organized on the WallStreetBets subreddit.

I'm not going to use this space to explain what happened and why; there are excellent summaries available to read online or, if you prefer audio, to listen to in podcast format. If you're interested, here are two good resources (the podcast provides an great timeline of what happened):

1. "The Whole Messy, Ridiculous GameStop Saga in One Sentence" by Derek Thompson of The Atlantic.

2. E19 of All-In with Chamath, Jason, Sacks & Friedberg: "Breaking Down Robinhood's GameStop Decision: Why did it happen and how can it be prevented in the future?". 1 hour, 26 minutes.

Again, I'm not going to summarize what happened. Instead, I want to highlight the three most important takeaways for investors.

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#1: Wall Street Finds A Way

There's a scene in Jurassic Park where Dr. Ian Malcom (Jeff Goldblum) delivers the line "life finds a way". In the context of the movie the quote means that no matter what happens in life, species and nature will always find a way to reproduce and survive - even in nature's harshest conditions.

Wall Street operates in a similar manner. There are rules and regulations in place to ensure our free market system (which maybe isn't so free, but I'll get to that in takeaway #2) runs smoothly. For the most part, buying and selling of securities occurs on weekdays without too many hiccups. However, under extreme conditions, the rules can be changed in order to ensure the system continues to survive. For example, Robinhood made the surprising decision to restrict trading of shares in companies like GameStop, AMC, BlackBerry, and Nokia as shares of those companies hit new highs*.

For additional examples of Wall Street changing the rules mid-game, I recommend the book Business Adventures: Twelve Classic Tales from the World of Wall Street by John Brooks.

The takeaway: Wall Street will always do what is necessary in order for the system to survive. Unfortunately, some investors may be negatively impacted when the rules are changed.

*Without getting too wonky, I believe Robinhood was forced to restrict trading of certain companies because it was undercapitalized.

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#2: Zero-Commission Doesn't Mean Free

Robinhood was one of the first companies to offer zero-commission trades for stocks and ETFs. The move placed pressure on the large brokerage companies, so E*Trade, Fidelity, Schwab, and TD Ameritrade quickly followed suit.

Overall, I believe the elimination of trading fees was positive for investors. Trading fees, often a barrier to entry, have been falling for decades. Their elimination, combined with gamified trading apps like Robinhood, opened up investing to millions of people - especially younger investors.

But, as we've seen over the past week, there are downsides to zero-commission trades.

First, there's the behavioral aspect. Unburdened by trading fees, investors have been incentivized to trade more frequently. Millions of day traders, professional and amateur alike, can now buy and sell stocks and ETFs throughout the day.

Second, and most relevant in this case, is that zero-commission doesn't always mean free...and Robinhood is the poster child for "free" trading. That's because Robinhood generates revenue from high-frequency trading and payments for order flow, a practice whereby a broker receives compensation for directing orders to different parties for trade execution. For example, Robinhood earns significant revenue by directing trades and data to firms such as Citadel Securities*, who in turn use that data to front-run Robinhood's investors. This isn't illegal, but I believe it's a conflict of interest.

The takeaway: When it comes to trading, "free" doesn't always mean free. Investors should try to understand what service providers do with user data as well as how the company makes money.

*Citadel Securities was one of two firms that provided $2.75 billion to Melvin Capital, a hedge fund that was shorting GameStop and losing billions while the share price skyrocketed. An injection of cash like this is known as backstopping.

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#3: Ignore FOMO

If you spend any time in r/WallStreetBets on Reddit, you'll find posts and screenshots from users bragging about their earnings from trades in companies like GameStop. Seeing other people earn money, sometimes big money, off of trading can inspire jealousy or fear of missing out (FOMO). Once the trading frenzy subsides, and you never know when that might be, someone is going to be left holding the bag, and that someone might just be you.

The takeaway: When you hear about others' investing successes, try to ignore FOMO. While some people made big money gambling on GameStop, the majority did not.

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In Conclusion

To wrap up this post I'm going to drag out another pop culture reference: The Terminator. This time I'm going to paraphrase Kyle Reese:

"Wall Street can't be bargained with. It can't be reasoned with. It doesn't feel pity, or remorse, or fear. And it absolutely will not stop, ever, until you are dead."

Be careful when investing. If you don't know what you're doing I recommend educating yourself or, better yet, avoiding hot stocks that are probably too good to be true.

Or, to once again paraphrase Kyle Reese, "Come with me if you want to be a better investor".

The September Effect

All things considered, I think it's safe to say nearly everyone is surprised by the relatively fast rebound of the stock market. Aside form a few dips here and there, the steep decline that began in February has been erased as the market crawled back to all-time highs.

Let's look at how the S&P 500 Index has performed:

• On February 2nd the S&P was up 4.81%...and then reality began to set in

• By March 23rd the index was down 30.75%

• After that, the market was volatile, but the direction was mostly up

• By September 2nd the index had regained all it had lost and up 10.84% YTD

• Since the 2nd, we've experienced declines and what I can only describe as an uncertain market

• As of September 16th the S&P 500 is up 5.53% YTD

On July 31st I gave you seven reasons why financial markets recovered while the economy continues to struggle. The same reasons still apply, but based on the decline at the beginning of this month I'm going to add another reason to the list: The September Effect.

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History Repeats Itself (Sometimes)

Historically, September is the month when the stock market's three leading indices, the Dow, the S&P 500, and the NASDAQ, usually perform the worst. There's even a name for this anomaly: the September Effect.

Market volatility or losses aren't guaranteed in September, but they occur with enough regularity that the phenomenon was noted in a research paper in 2013. If you're interested, and I'm sure you are, here's a link to Stock Market Performance: High and Low Months by Vichet Sum.

When looking at monthly returns in 70 countries over decades, September was the worst month measured by median return.

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Causes of the September Effect

I don't know why financial markets sometimes decline during the month of September, but I did some research and found some theories:

1. Seasonal behavior bias. With fall approaching, investors decide to change their portfolios. I guess this is kind of like putting away your summer clothes in favor of more weather-appropriate gear. 

2. Attention. Investors, returning from summer vacation, are finally ready to focus attention on their investment portfolios. This may translate to selling positions that have performed well over the past year. Of course the same investors could just as easily buy stocks in September, driving up demand and share prices.

3. Mutual funds selling large positions. Many mutual funds have their fiscal years end in September. During this time the funds may sell positions at a loss in order to reduce the size of their capital gain distributions.

4. One of the mysteries of life. This is what I used to tell my daughters whenever they asked a question I couldn't answer.

Out of all the theories listed above I like #4 the most. It also happens to be the explanation I came up with on my own. None of the other options seem like they would play a significant role in the anomaly.

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So what should you do? You probably know what comes next, but I'll repeat myself:

1. Focus on the things you can control.

2. Stick to your financial plan.

3. Wear a mask.

4. Wash your hands.

5. Get some exercise. Yes, every day.

6. Get a flu shot.

7. Limit your social media intake.

"The Girl with the Dragon Tattoo", the Economy, and Financial Markets

Over the past few months I've had several clients ask me why financial markets appear to be decoupled from the economy. Both have been negatively impacted by the COVID-19 pandemic, but financial markets have rebounded while the economy continues to struggle. I've given a lot of thought to this issue and I've come to the conclusion that there are multiple reasons for the divergence.

Rereading a Favorite Book Pays Off

While rereading one of my all-time favorite books, The Girl with the Dragon Tattoo by the late Stieg Larsson, I found a passage that got me thinking again about the question of why financial markets have diverged from economic reality. In the epilogue, one of the main characters, Mikael Blomkvist, is being interviewed by a journalist on a television talk show:

"The idea that Sweden's economy is headed for a crash is nonsense. . . .You have to distinguish between two things--the Swedish economy and the Swedish stock market. The Swedish economy is the sum of all the goods and services that are produced in this country every day. There are telephones from Ericsson, cars from Volvo, chickens from Scan, and shipments from Kiruna to Skovde*. That's the Swedish economy, and it's just as strong or weak today as it was a week ago. . . .The Stock Exchange is something very different. There is no economy and no production of goods and services. There are only fantasies in which people from one hour to the next decide that this or that company is worth so many billions, more or less. It doesn't have a thing to do with reality or with the Swedish economy."

*Kiruna is the northernmost town in Sweden, while Skovde is near the south.

At Least Seven Reasons I Can Think Of

I believe it's possible to answer the original question if we follow the character's advice and "distinguish between two things" - the economy of the U.S., not Sweden, and financial markets. I'm going to focus on the financial markets rather than the economy because, let's be honest, the economy of the U.S. isn't going to improve until either (1) everyone begins following mask and social distancing guidelines, which will lead to marginal, but probably significant improvement in the overall economy  or (2) there's a vaccine, when things can begin to return to normal, or whatever the new normal is at that time. Unfortunately, if you spend any time at all reading, watching, or listening to the news or social media, it is obvious that option #1 isn't likely to happen anytime soon.

With that out of the way, here are the seven reasons why I believe the financial markets aren't in sync with the economy:

1. Due to historically low interest rates, investors are searching for higher rates of return. High-yield savings accounts, Certificates of Deposit, and bonds aren't going to cut it. Despite the many risks, the only place with the potential to earn a higher rate of return is the stock market.

2. Corporate earnings have exceeded analyst expectations (for some companies). This is especially true when it comes to large tech companies, such as Alphabet, Amazon, Apple, Facebook, and Netflix, because consumers have increasingly used the services these companies provide.

3. Markets are forward-looking. Investors have processed the bad news and are now readying for the recovery. This is especially true for wealthy households, which are less likely to feel the pain of an economic downturn.

4. The actions of the Federal Reserve have bolstered investors' confidence that financial markets won't go completely off the rails. The Fed has moved aggressively to ensure businesses have access to the cash necessary to keep things running.

5. Government stimulus in the form of direct payments to individuals and households, unemployment benefits, and the Paycheck Protection Program (PPP) have calmed investors. It appears there will be another round of stimulus measures - if all of our elected officials can stop acting like children and actually work together. 

6. Investment apps, such as Robinhood, which make it easy to invest, and commission-free trades have lowered the barriers to entry for many investors. While I believe the net effects of these things are positive, they have probably led to more speculation in financial markets.

7. Sports and casinos haven’t been an option during the pandemic, which has forced those who gamble to look for other outlets, specifically the stock market. There's been a sharp increase in streamers broadcasting their day-trading routines. I encourage you to ignore these people, just as I encourage you to ignore other forms of financial entertainment, such as pretty much everything on CNBC.

A Few Reminders

1. Wear a mask.

2. Wash your hands.

3. Get some exercise.

4. Limit your social media intake.

Hang In There

If 2020 were a Marvel movie, this might be the moment when the Avengers show up and save the day.

Wishful thinking, I know.

Unfortunately, it appears the United States isn't in wave #2 of the pandemic because we never really left wave #1. Due to the uncertainty, no one really knows how financial markets or the economy will react in the coming months.

In a couple weeks I'll share my thoughts about the second quarter of 2020. In the meantime, here are some thoughts about the second half of the year.

Reasons for Optimism

1. Solid economic foundation
   The U.S. economy was healthy leading into the COVID-19 crisis. The ensuing recession was caused by an external shock, not a typical end to the business cycle driven by economic overheating. This could hold promise for the recovery.

2. Attractive value vs. bonds
   With bond yields down (and prices up), the gap in the value between stocks and bonds, as reflected in the equity risk premium, is wide. This suggests investors can potentially realize greater reward from stocks.

Reasons for Caution

1. Hidden vulnerabilities
   The lockdown-driven decline in economic activity and spike in unemployment has left the U.S. economy more exposed to risks. It remains to be seen whether there are any hidden vulnerabilities in the system, including hiccups in reopening progress. Markets do not like uncertainty.

2. Risk of second wave of infection
   COVID-19 is a novel virus, meaning it has no exact precedent. A new round of infection is possible and its burden on the health care system and potential for renewed closures is unknown. The upside is that countries would enter a second wave wiser and more prepared, with availability of greater testing, contact tracing, protective gear and drug interventions.

3. Heightened geopolitical tensions
   The U.S.-China relationship is further strained since the COVID crisis, defined by greater competition and less cooperation. Bouts of market volatility are likely should tensions flare. In addition, U.S. onshoring and the likely move toward deglobalization will have margin and inflation implications down the road.

4. Absolute valuations are not cheap
   Stock prices are attractive relative to bonds, but by the most common measure of valuation, P/E ratio, they are not cheap. Stock prices relative to 12-month forward earnings per share stood at 21x at the end of May. Pandemic-related uncertainty has made the earnings outlook for many companies blurry at best.

For better or worse, it appears very few people in the U.S. are prepared to endure another shutdown. So, a few reminders:

1. Wear a mask.

2. Wash your hands.

3. Get some exercise.

4. Wear a mask.

Reading / Watching / Listening / Playing

Here's what's keeping me busy in my spare time:

• The Deficit Myth: Modern Monetary Theory and the Birth of the People's Economy by Stephanie Kelton. To some, a book that suggests deficit spending isn't the monster we've been taught to fear is heresy. I haven't made up my mind yet, but I'm open to learning more about Modern Monetary Theory (MMT). In July, I'm joining a book club to read & discuss this book.

• Floor is Lava on Netflix. I'm watching this ridiculous game show with my kids. Full disclosure: I was the one who found this series and lobbied to watch it with my kids. It's both dumb and fun, which is just what I need at this point in 2020.

• Revisionist History, season five. Malcolm Gladwell's podcast returned last week to start its fifth season. So far, Gladwell continues to pull together seemingly different stories or facts with fascinating results. I find it best to enjoy this during a mid-day walk when I need to clear my head.

• Assassin's Creed: Odyssey. We won't be traveling this year, for obvious reasons, so I've been enjoying this game on my Xbox One. I may not be able to travel to modern Greece, but at least I can explore ancient Greece via Ubisoft's amazingly well-rendered game.

Investing Is Hard. Focus On What You Can Control.

When I say "investing is hard", what I really mean is that staying invested is hard. Especially when, as of this writing, the S&P 500 is down 26% year-to-date. Or when you’re bombarded by non-stop coronavirus-related news information from traditional and social media. Or when you can log in to your financial accounts anytime you want and watch the value decrease.

For investors of all ages, 2020 has been a difficult year - and we’re not even through the first quarter! It has been a long time since investors have seen such wild swings in financial markets. Since 2009, staying invested has been easy. Sure, there have been ups and downs, but mostly ups. And the market always goes up, right? Wrong, but after 10 years, and an absolutely stellar 2019, we've become accustomed to positive returns.

I could tell you to ignore the latest updates about the coronavirus pandemic, but you won’t do that. The virus has disrupted so many aspects of life that it’s natural to want to find out when it will end.

I could tell you to stop checking the value of your investments, but you won't do that. Technology has made it easy for us to quickly log in to our accounts or receive automated notifications of the balance, performance, etc.

I could tell you to ignore the daily news about the financial markets, but you won't do that. There's information everywhere and it's nearly impossible to avoid.

I could tell you not to listen to talking heads make predictions about what the markets will do, but you won't do that. Like daily news about financial markets, it's almost impossible to avoid hearing from someone who knows what's going to happen in the financial markets today, tomorrow, or next year. Here's a secret: No one can predict, at least not consistently, what's going to happen.

You're human, at least I think most of you are, which means you will track the latest news about the coronavirus, you will worry about your investments, you will be curious about the day-to-day changes in your account, and you will want to know what's going to happen to your accounts in the future.

Here’s something else you can do: Focus on what you can control.

You can control your own behavior. Spend quality time with loved ones. Try not to eat too much junk food. Make time in your day for some exercise. Read a book. Take a break, even an hour, from news, markets, noise, social media, commentary, opinions, and speculations and give yourself some space to think.

Finally, do one more thing: Since we’re in the Age of Coronavirus, your portfolio is like your face: Don’t touch it.

Ongoing Volatility in the Financial Markets

There's no way to spin this: Monday was a rough day for investors.

• The Dow was down 7.8%

• The S&P 500 fell 7.6%

• The Nasdaq Composite slid 7.3%

Reminder: Take a deep breath. And another. It's all going to be okay.

Health Crisis: Downturn to Recovery

Historically, downturns caused by health crises don't last forever. The charts above show the SARS and Zika crises from 2003 and 2016, respectively. In both cases, the sell-off trough lasted for much of the first quarter before stocks resumed their upward trend.

I can't tell you when things will turn or by how much, but my expectation is that investors bearing today's risk will be compensated with positive expected returns. Unfortunately, history has shown no reliable way to identify a market peak or bottom. This means it is unwise to make market moves based on fear or speculation, events difficult and traumatic events transpire.

In other words, stick to your financial plan.

It's Okay to Be Nervous

Note: My friend and fellow financial planner Will Kaplan, CFP® wrote the following three paragraphs. I couldn't improve upon them, so I asked him if I could include them here. Enjoy.

Feeling nervous as the market drops is normal. That is part of our biological response to bad news. As humans we feel bad news about twice as intensely as we experience good news. It's just how we are wired and part of why being investors is so challenging.

Courage does not mean that you are not afraid. Courage is doing something even though it is scary. It is okay to be afraid, but fear should not be our only guide.

Discipline is remembering that we know markets go down from time to time and remembering that we have a plan for when they do. We rebalance the portfolio (when necessary) to maintain the asset allocation. We want to be buying when markets are down and selling when markets are up. The challenge isn't in knowing what to do, but in being disciplined and not allowing our emotional response to derail our plan.

One Last Thought

The late Jack Bogle, founder of Vanguard, once commented in other periods of heightened volatility in the markets, "The expression is 'don't just stand there, do something' and the best rule I think is 'don't do something, just stand there.'"

While the news in the short-term may get worse before it gets better, long-term perspective and patience are necessary to ride out short-term volatility in the markets. Hang in there.

Keep Calm and Stick to Your Financial Plan

It has been a challenging week for investors.

As of Thursday, February 27, 2020, the three major U.S. stock indices are in negative territory year-to-date. Let's look at the damage:

• Dow Industrials -9.71%

• Nasdaq Composite -4.53%

• S&P 500 -7.80%

The cause? Fear and uncertainty over the global impact of the coronavirus.

The headlines are frightening, the posts on social media are scary (and probably riddled with incorrect information, but that's whole different issue), and the responses from elected officials are unsatisfactory.

For investors, your age, experience, and the total value of your portfolio are irrelevant because nearly 100% of you are thinking the same thing: This. Doesn't. Feel. Good.

Take a deep breath. And another.

It's all going to be okay.

How Have Other Diseases Affected Financial Markets?

This afternoon I spoke with a friend who works in public health. She's highly-educated and very smart. In other words, she knows what she's talking about when it comes to these types of things.

Part of our conversation focused on previous epidemics/pandemics and their affect on financial markets. The chart above might be difficult to read, so here's a link to a larger version. When viewing the larger chart, you can see a host of pandemics/epidemics and, most important, the macro trends in the S&P 500. However, it's impossible to see the micro trends, so I had to do some digging:

• During the height of the SARS virus back in 2003, the S&P 500 Index fell by 12.8%

• During the Zika virus, which occurred at the end of 2015 and in 2016, the market fell by 12.9%

My point is that during previous pandemics/epidemics the financial markets suffered some scary declines. The important takeaway is that markets recovered relatively quickly.

Some Perspective

If you want some statistics about the coronavirus check out this site, which aggregates statistics from health agencies across the world. Some numbers to consider:
 

• At the time of this writing, there were 83,379 coronavirus cases and 2,858 deaths

• Every year an estimated 290,000 to 650,000 people die in the world due to complications from seasonal flu viruses

I'm not attempting to minimize the threat posed by the coronavirus or the deaths that have occurred. I simply want to give you some perspective about this issue.

So, get a flu shot, wash your hands, eat well, exercise regularly, and don't forget to breathe.

If you're still nervous about the coronavirus and how it might affect global markets and your portfolio, that's okay. Just keep the big picture in mind when thinking about this week's declines:

One Last Thought

In the movie Braveheart, there's a scene where English heavy cavalry are bearing down on William Wallace, played by Mel Gibson, and his army of Scottish warriors. It would be truly terrifying to have heavy cavalry charging at you. In the movie, Wallace/Gibson tells his soldiers to "HOLD".

I recommend you do the same when it comes to investing. Keep calm and stick to your financial plan.

Discover & share this Braveheart GIF with everyone you know. GIPHY is how you search, share, discover, and create GIFs.

Listening / Playing / Reading / Watching

Here's what has my attention this week:

• Pandemic by Z-Man Games. This is a great cooperative board game where up to four players try to keep the world safe from outbreaks and pandemics.

• Outbreak starring Dustin Hoffman and Morgan Freeman.

What I Learned In 2019

Another Year Older

Whenever my birthday comes around I reflect on the things I've learned during the year. My birthday just happens to fall near the end of the year, which is fortunate because I can use what I've learned when developing my New Year's resolutions. I'll share my resolutions in the next email. In the meantime, here are three of the things I learned, or lessons that were reinforced, during 2019:

1. Regardless of income, nearly everyone overspends in the same categories. I've worked with individuals and couples of all ages and income levels. Whenever I do a cash flow analysis, the results are the same: Shopping, dining out, groceries, and subscription services are the categories that kill budgets. I even created a calculator to help people see how much they spend on subscriptions.

2. Income inequality is bad, but you're probably better off than you think you are. The people I work with are doing well financially, but they don't always feel like they are. This is understandable given the high cost of living in major cities, child care expenses, etc. I don't have any easy solutions to resolve this problem, but sometimes it's helpful to have a reminder that you're probably better off than you think you are. Check out the table in this article to see how you measure up.

3. How we invest continues to evolve at a rapid pace, but the basic principles of investing are still valid. During 2019 we saw trading commissions for stocks and ETFs go to zero, major consolidation in the financial services industry (Schwab buying TD Ameritrade), the proliferation of online investing tools (Robinhood, Personal Capital), and major outflows from mutual funds and inflows to ETFs. All of the changes and slick tools haven't changed the fact that it's important to build a diversified portfolio, keep your costs low, and stick to your plan. Don't have a plan? Use this tool to get started.

Listening / Playing / Reading / Watching

Here's what's keeping me busy in my spare time:

• The Ride of a Lifetime: Lessons Learned from 15 Years as CEO of the Walt Disney Company by Robert Iger. I just started this and will let you know what I think about it as I read more.

• The Andromeda Evolution by Michael Crichton and Daniel H. Wilson. Sadly, Crichton died in 2008. Fortunately, Wilson does a decent job of expanding the story started in The Andromeda Strain.

• Gears 5 on Xbox One. Who knew the stagnating video game series would reinvent itself with an open-world? Gorgeous and fun to play. I'm looking forward to the inevitable Gears 6.

DFP in the News: Forbes.com, "2 Things You Can Control With Your Money"

I was quoted in an article on Forbes.com!

Enjoy!

Chuck Donalies, CFP®