Chief Market Strategist, Quincy Krosby, Ph.D. Prudential Financial Too Much of a Good Thing? FEBRUARY 2021 COMMENTARY

With the prospect of Highlights another fiscal relief/ • The Fed is prepared to allow interest rates to run above its long-standing 2% inflation target, as it seeks to ensure maximum employment. stimulus package, • “Mania” was adopted to chronicle the daily moves by the retail traders pouring coupled with low into GameStop—in a daring “gamma squeeze”—and other stocks. • Apprehension about monetary and fiscal stimulus fueling excessive risk-taking interest rates, and a Fed has been tempered by the market sell-off.

committed to keeping Every so often, the famous warning from former Chairman of the Federal Reserve Alan rates low for longer, Greenspan on Dec. 5, 1996—“How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged concerns are growing contractions?”—resurfaces in a much simpler form: the market is forming a bubble similar to 1999. Back then, it was a period of intense optimism, in which profits didn’t matter; it was a louder and louder that dot-com boom regardless of what came before the dot. It was the “New Paradigm”—until it the so-called “Reddit wasn’t. day traders” are being As the Greenspan Fed began raising rates in 1999 and 2000—Jan. 1, 1999, the 10-year Treasury was 4.72%; Jan. 1, 2000, the 10-year Treasury was 6.66%—in order to ward fueled by central bank off potential inflationary pressures stemming from the strong economy, market strategists easy money and fiscal continued to stress that the technology sector, for the most part, was immune to higher rates. In February 2000, with Y2K concerns forgotten, Greenspan’s semiannual testimony to largesse. Congress prompted markets to pull back when he suggested that further interest rate hikes would be necessary. NASDAQ, home to the booming technology sector, would peak on March 10, 2000.

Of course, each market chapter is unique, with distinct contributing characteristics and events, but there’s typically a recurring theme of a shift in Federal Reserve monetary policy that telegraphs tightening on the horizon.

Federal Reserve Chairman Jerome Powell has said numerous times that the Fed is prepared to allow rates to run above its long-standing 2% inflation target before raising interest rates, as it seeks to ensure maximum employment. Powell outlined what constitutes a strong labor market from the Fed’s perspective, including wage growth and full workforce participation that incorporates minorities, before declaring that maximum employment has been achieved.

With the prospect of another fiscal relief/stimulus package, coupled with low interest rates, and a Fed committed to keeping rates low for longer, concerns are growing louder and louder that the so-called “Reddit day traders” are being fueled by central bank easy money and fiscal largesse. In 1999, comments compared the “irrational” surge in January, “mania” was adopted to chronicle the daily moves by technology names to the lead-up to 1929, while today the the retail traders pouring into silver, GameStop, AMC, Hostess comparisons allude to both 1999 and 1929. Brands and even Nokia. Does anyone even remember when the Blackberry was considered the must-have smartphone? In an oft-cited 2001 study, Purdue University research revealed But it’s a heavily shorted and thinly traded name, and that’s that 95 companies that attached a “.com” (or “.net”) to their what makes it attractive to the retail traders. The moves, core names witnessed a nearly 74% rise in their stock price amplified by seemingly thousands if not millions of retail traders within 10 days of the initial announcement. who simultaneously are buying call options on their target companies, are forcing the market makers who sold them the Today, strong share price rises have been associated with many call options to buy the underlying stocks in order to hedge initial public offerings including QuantumScape, DoorDash and their risk. , only to see the exuberance ease if not fade completely. This is the classic “gamma squeeze.” And hedge funds that THE FED’S RESPONSE have shorted (betting that the share price will go down) the same stocks that the retail pack is It wasn’t a surprise that at the press buying, are forced to “cover their conference following the Federal Open shorts” by purchasing the stock at Market Committee (FOMC) meeting on a higher price. Jan. 27, the day the traders captured The market is recalibrating the world’s attention with their daring and beginning February If stopped right there in the process, “gamma squeeze” on GameStop, with an economy that is it would be limited to a corner of the the first question posed to Powell demonstrably healing. overall market, keeping the broader was focused on the day’s events and market generally immune from the the “wild ride” in the market. Powell battle between the Main Street trader said, “I don’t want to comment on a and the Wall Street pro. The concern particular company or day’s market stems from the sales made by hedge activity or things like that. It’s just not funds to cover their losses when really something that I would typically covering their shorts and forced to buy comment on.” them at a higher price. Looking at the market at the end of January, there are A further question referred specifically interesting “oversold” stocks across to GameStop, and the mounting sectors, suggesting that forced selling criticism that “super easy monetary by hedge funds was necessitated policy, asset purchases and zero by the need to shore up hedge fund interest rates are potentially fueling a “books” following the short squeeze bubble that could cause economic attacks. fallout should it burst.” The chairman’s response was that the Fed did what It is becoming clear that professional was necessary to help the economy investors have been involved and, to pull out of an “unprecedented” shock, some extent, are leading the frenzy as and that there’s “Nothing close to it they post commentary on the blogs in our modern economic history.” In followed by the larger retail trading addition, Powell stressed that the relationship between low community. And most likely, high-frequency trading that relies interest rates and asset valuations is not as “tight as people on algorithms is adding to the speed at which short stock think because a lot of different factors are driving asset prices targets are moving. But the most intriguing question is whether at any given time.” Moreover, he characterized financial stability we see a similar move on targets of vital national interest, vulnerabilities as “moderate.” including the U.S. dollar and Treasuries, commodities, etc.

The International Monetary Fund (IMF) warned about Senator Elizabeth Warren, interviewed on CNBC, said, “We “excessive risk-taking” in a blog posted on Jan. 27, as investors need an SEC that has clear rules about market manipulation continue to bet on “persistent policy backstop.” The message and then has the backbone to get in and enforce those rules.” cautioned that along with market exuberance a “sense of She was adamant that to have a “healthy stock market, you’ve complacency appears to be permeating markets.” got to have a cop on the beat.”

The debate now is focused on who the “cop on the beat” is BUBBLE WATCH supposed to patrol. Senator Ted Cruz and Congresswoman Headlines across the financial press have so overused “bubble” Alexandria Ocasio-Cortez have managed to agree on a central in describing the market’s performance, that at the end of point that has garnered widespread agreement, as well as

2 Quincy Krosby controversy, that the restrictions put in place by the trading Conversely, day traders aren’t all just angry 25-year-olds. platforms used by the traders hurt the legitimate rights of the Experienced professionals have joined the fray, as money goes traders versus the interests of the hedge funds. This is at the to where it’s best treated—until it isn’t. core of the questions surrounding the democratization of the markets: Should complaints made by the hedge funds take This will sort itself out, and as the market was already poised precedence over the rights of the retail trader? for a deeper pullback, this will allow the market to burn off froth and bring valuations back to a more reasonable level. On the last trading day of January, in response to the Apprehension about the ongoing monetary and fiscal stimulus continued mayhem in the markets, the SEC said that it is fueling excessive risk-taking has been tempered by the sell-off “closely monitoring the extreme price volatility of certain itself. The market is recalibrating and beginning February with trading prices.” Further, the statement sends the message that an economy that is demonstrably healing. “aggressive enforcement” will be taken if market manipulation is discovered. COVID-19 cases are leveling off, vaccine-related logistics are beginning to show a higher rate of daily inoculations, and, At the end of January, “put” buying (betting that the share price according to the most recent Kaiser Family Foundation’s goes down) has picked up in heavily shorted names, and prices survey, more Americans want the COVID-19 vaccine “as soon for downside protection are rising steadily as traders appear as possible” rather than on a “wait and see how it’s working” concerned that the frenzy could see a swift end. basis.

Headlines about “variants” are worrisome, but pharmaceutical RIDING OUT THE FRENZY companies are already preparing to introduce booster shots As we enter February, a statistically difficult month for the to neutralize them. Until COVID-19 is completely eradicated market, concerns are growing about how long the trading we will need booster shots, but we will also have reopened “mania” can last. Do hedge funds exit the “short” business the economy. The high-frequency data releases coupled with completely, or do they wait it out and see if threats of potential fourth-quarter earnings reports indicate that we are looking at a lawsuits or government regulation thwart the continued siege? more normal second half of 2021. Or does it just fizzle out and die a natural death? Investors will have to absorb the consequences of too much While each side of the debate throws stones at the other, liquidity and leverage in all pockets of the market, and the neither side can be defined that easily. Hedge funds, for debate will surely continue. We need to keep in mind that example, do intensive fundamental research on companies and when Alan Greenspan issued his “irrational exuberance” usually take their short positioning following a period of deep warning it was 1996, and it took four years for the bubble to review. The waiting period to see if they made the right choice pop. Granted, markets run far more quickly with today’s high- can be excruciatingly long. Hedge fund managers and investors frequency trading, but market downdrafts help ground market aren’t just slick Wall Street types as portrayed on film. Many expectations and exuberance, and keep them rational. pension funds, particularly during periods of low interest rates, will allocate funds to hedge funds in order to increase returns.

References include the following: Associated Press, Barron’s, Bespoke Investment Group, Bloomberg, CNBC, Cornerstone Macro Research, The Economist, Evercore ISI, Federal Reserve, The , Fox Business, Goldman Sachs, International Monetary Fund, Morgan Stanley, The Times, Real Money – TheStreet, Renaissance Macro, Reuters and . The views and opinions are those of the author at the time of publication and are subject to change at any time due to market or economic conditions. This document has been prepared solely for informational purposes. This is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The Prudential Insurance Company of America, Newark, NJ, and its affiliates. Prudential and its distributors and representatives do not provide tax, accounting, or legal advice. Please consult your own attorney or accountant. In providing these materials, the issuing companies and distributor listed above are not acting as your fiduciary as defined by any applicable laws and regulations. © 2021 Prudential Financial, Inc. and its related entities. Prudential Annuities, Prudential, the Prudential logo and the Rock symbol are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide. 1033222-00011-00

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