De-Grossing and the Butterfly Effect

Man, what a roller coaster the past few days has been.

As the dust from the atom bomb settles, I’ve been wondering just how contained this incident really is. I couldn’t help but think about the likelihood of a butterfly effect. When a GameStop short flaps its wings, ah nevermind, you’ve seen the movie.

Sure, the names don’t amount to much, as Michael Santol pointed in his column over the weekend:

The total market capitalization of the stocks with a short-to-float ratio above 20% is only about $40 billion. That’s one-tenth of 1% of total US market cap approaching $40 trillion.

But when leverage is involved and shorts are forced to cover, the de-grossing can hit other seemingly unrelated areas of the market. Last week, the long-selling and short-covering was fairly extreme, which you can see in the chart below.

This hit the market for about a minute.  Last Wednesday, the S&P 500 fell 2.6%, its largest daily decline since October. The VIX spiked to 37 after closing the previous day at 23. This has to be the first time we’ve seen that type of move absent a bigger market selloff.

And then…

The S&P 500 fell a whopping 3% peak-to-trough and came roaring back. It’s now less than 1% from all-time highs. This market is absurdly strong. Even if the de-grossing on its own weren’t enough to cause a sustained selloff, you would think that investors could use that as a reason for a pullback, given the run we’ve had. But no. It’s as if this doesn’t matter at all. Maybe it doesn’t.

Josh and I spoke about this, and many other topics on the latest edition of What Are Your Thoughts?

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