Market volatility increased last week with stocks having their worst week since October and finishing down for the month of January.

A catalyst for the pickup in volatility was recent interest by retail investors in heavily shorted stocks. Shorting, or short-selling, is when an investor borrows shares and immediately sells them, hoping to buy them later at a lower price, return them to the lender, and make a profit. Stocks that are heavily shorted are perceived to have a business model that is in secular decline or a stock price that is expensive relative to the profitability outlook for the company.

Utilizing social media, retail investors have been able to significantly bid up the price of certain speculative, highly shorted stocks. This caused what is known as a short squeeze in these stocks. Investors (primarily hedge funds) that had shorted certain stocks (sold stock to other investors without owning the underlying stock) were forced to buy the underlying stock that the retail investors took an interest in. In order to raise cash to buy the shorted stock, short-sellers can be forced to sell their long positions (investments that they view favorably) and generally de-risk their portfolios—thus causing overall selling pressure and volatility in the market. We have the following observations on the situation.

Regulatory actions, broker risk limits, or unexpected losses could all dampen the activity and market impact of retail traders, as Thursday’s temporary reversal made clear. However, there is a significant amount of excess U.S. savings that could continue to fuel this speculative trading boom. Consumers are flush with cash with net worth at an all-time high. During 2020 credit card debt declined by more than 10%, checking deposits grew by $4 trillion, and savings grew by $5 trillion.

History has shown that stock market performance following past short squeezes has depended on the underlying economic environment. On this we remain positive and we believe the recent selloff is presenting an opportunity for long-term investors. While the virus continues to be a headwind for consumer-facing industries, we are seeing significant progress on the vaccine front that will ultimately cause the pandemic to fade later this year.

The vaccine rollout received a positive boost last week when Johnson and Johnson (JNJ) announced their single-shot vaccine was robustly effective at preventing illness, hospitalizations and deaths in a massive global trial. JNJ emphasized that the vaccine was 85 percent effective at preventing severe illness and that there were no cases of Covid-related hospitalization and death.

A major advantage of JNJ’s vaccine is that it can be stored at regular refrigeration temperatures, in addition to being a single shot. JNJ has an agreement with the U.S. government to provide 100 million doses by the end of June. We expect this vaccine to be the third to soon receive emergency use authorization. This will significantly help the vaccine supply shortage that currently exists and put us on a path toward herd immunity that is needed for a full opening of the economy. Estimates are now showing that 50% of the U.S. population should be vaccinated by May.

While the virus and lockdowns are a significant headwind for the near-term outlook, we anticipate a sharp acceleration as the economy reopen and vaccines are deployed. Importantly, consumer spending later this year will be supported by: 1) Massive excess savings (touched on above), 2) Solid core income growth (driven by job growth), 3) Record-high consumer net worth, 4) Healthy balance sheets, 5) Ultra-low interest payments, 6) Lots of pent-up demand, and 7) Additional stimulus payments.

Meanwhile, we continue to see strength in housing, health care, technology, and manufacturing. Just this morning, Markit announced that their manufacturing business survey reached a record high on accelerating output and new orders. We are also halfway through fourth-quarter earnings season and are seeing much better-than-expected results. This is providing support for stocks as we wait for the economy to fully reopen with a healthy consumer.

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