GameStop frenzy reveals potential for broader market stress

Some investors worry that the wild swings in shares of GameStop and other "meme stocks" may have exacerbated concerns over market volatility

As the trading frenzy that took shares of GameStop Corp and other favorites of retail investors on a wild ride recedes, investors are eyeing signs of potential market stress that could weigh on broader stock performance in coming weeks.

For now, US equities appear to be looking past the upsurge in volatility that led the S&P 500 to its biggest weekly decline since October last week, as solid earnings, fiscal stimulus expectations and progress in country-wide vaccination efforts lead stocks back to record highs.

Some investors, however, worry that the wild swings in shares of GameStop and other "meme stocks" may have exacerbated concerns over market volatility and elevated valuations that could make investors more risk-averse.

"The recent retail activity was concerning for the broader market," said Benjamin Bowler, head of global equity derivatives research at BofA Global Research.

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Liquidity in futures on the S&P 500 dried up as market makers and other investors sought to reduce risk during the GameStop surge, according to BofA analysts. Earlier this week, "market fragility," as measured by the bank, stood at its highest level since March 2020, making US equities exceptionally vulnerable to sudden market shocks, the firm said.

Moves in the Cboe Volatility Index, known as Wall Street's "fear gauge," also indicate that investors may be more sensitive to market turbulence than usual: last Wednesday the index surged 14 points, its biggest one-day gain since March, as the S&P 500 lost 2.6 per cent.

The fear gauge's climb was 8 to 10 points greater than the expected move following such a drop in the S&P 500, according to Stuart Kaiser, strategist at UBS. The outsized reaction, he said, points to heightened jitters among investors that could suggest bigger market sell-offs in response to negative developments.

The VIX has since reverted to its post-pandemic lows as US equities have rallied this week. Even so, "I wouldn't say we're completely past it yet," Kaiser said.

Next week, investors will be looking towards quarterly corporate results from Cisco Systems Inc, General Motors Co and Walt Disney Co as well as data on US consumer prices.

For now, options markets aren't quite giving a green light.

Investor demand for calls on the S&P 500, used to position for gains in the index, has jumped after having plummeted to a multi-decade low earlier in the week, according to Charlie McElligott, managing director, cross-asset macro strategy at Nomura. The swing in demand points to risk of a pullback and choppy trade in the next few weeks, he said.

Longer-term, several market analysts say the GameStop effect may be no more than a blip on the radar screen for markets as a whole. Drops in the VIX of 20 per cent or more tend to bode well for stocks, with the S&P 500 rising 2.6 per cent a month later, according to Christopher Murphy, co-head of derivatives strategy at Susquehanna Financial Group.

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Still, the exuberance that magnified the market's fault lines hasn't completely faded. According to data from Trade Alert, options activity shows heavy demand for upside calls in the SPDR S&P Retail ETF, which includes GameStop, and the iShares Silver Trust, which was also rocked by retail trading.

As a result, some investors say they plan to tread cautiously for the time being, especially if they are exposed to passive funds that hold a large number of small-cap stocks that could be sensitive to a sudden retail frenzy.

"Time will tell whether this has a more lasting effect on the market," said Matt Forester, chief investment officer of Lockwood Advisors. "We need to police our holdings to make sure we're not overly exposed to these trends."