GameStop, Bitcoin & Other Signs of a Market Top - Time to Rebalance

By: Patrick Cote, CFA, CFP®

You may have heard about GameStop this past week as its stock price has been on a wild ride.  It went from $4 per share last summer to over $325 per share recently, which means an initial investment of $1,000 would be worth over $81,000 just six months later.  Similarly, Bitcoin has been back in the news lately after reaching all-time highs of about $40,000 lately.

They share an uncomfortable characteristic – their market prices are now separated from their underlying value.  As a video game retailer, GameStop has struggled recently both due to the pandemic and also because there is a long-term trend towards people buying games online.  In fact, the recent GameStop surge has been driven not by company fundamentals, but by a group of social media users who are trying to put the “short squeeze” on hedge funds who had been betting GameStop shares would drop in price. 

Similarly, Bitcoin is also at the center of much debate in the investment industry – it only exists as an entry in an accounting ledger shared around the world – by definition, there is no inherent value to it, Bitcoin is only worth what other people are willing to pay for it.

Unfortunately, these situations typically end badly for most people.  The worst-hurt investors are the ones who join the party late and buy near the top, then see the biggest declines in their investments.   With GameStop, some of the hedge funds caught on the wrong side (i.e., betting GameStop share prices would drop) are now facing financial difficulties.

Although hedge funds are not likely to get much sympathy, it may not be healthy for the financial system.  If a number of smaller investors do lose all or most of their investments, they may lose their appetite for investing altogether.  For the investors who were able to lock in extraordinary gains, it will be important not to try to chase spectacular returns in the future, nor to be disappointed in average stock market returns of 9% (since most individual investors actually underperform the stock market average).

There are plenty of examples of bubbles in history (remember the Dutch tulip bubble of the 1600s or the dot com craze of the late 90s?).  Unfortunately, these bubbles typically ended badly for most people, often involving a stock market correction or crash.  These bubbles can run for a long period of time, making it notoriously difficult to predict their crash. 

Although the stock market fell a bit over the past week, we are still close to all-time highs.  Stock market valuations are also very high by historical standards – the last time we were at these levels was the dot com bubble of 2000.  These types of bubbles can occur at the top of the market. 

Despite these signs of a market top and the potential for a short-term stock market correction or crash, the fundamentals are looking very good for stocks over the next few years:  there are massive government stimulus packages being rolled out in the US and around the world (good for stocks); interest rates continue to be near zero (good for stocks), and there is a large amount of pent-up demand which will likely be unleashed as the vaccines are rolled out and something close to “normal” pre-pandemic life returns (also good for stocks).

So what should you do as an investor?  First and foremost, take a look at your overall financial setup to make sure you have the basics in place (an emergency fund of 3 – 12 months’ worth of expenses in cash or equivalents like a bank account and no “bad” debt like outstanding credit card balances).  Next, look at your investments to make sure you are not over-allocated to stocks.  If so, it is really important to rebalance.  You may be overweighted in equities (stocks) now because they have done very well recently.  As a result, take a look at your equity mutual fund holdings as a percent of your overall portfolio.  If you want to have a portfolio of 60% stocks and 40% bonds, you might find yourself with a 70/30 portfolio now.  You would therefore sell enough stock holdings and buy enough bonds to bring yourself back to your target allocation of 60/40.  Ideally, you would be able to sell in a tax-deferred account to avoid taxes on your capital gains – if not, try to make sure the gains are long-term capital gains (investments held more than one year).

Rebalancing has two big benefits:  it brings you back to your preferred risk level within your portfolio (e.g., the 60/40 split) and adds a bit to your returns over time because it forces you to buy low and sell high.  Since we are near record highs, you would be taking advantage of the market run by selling stocks high now.