GameStop's Reddit-driven surge exposed shocking market vulnerabilities

"but overall stock gains will be unimpeded as profit growth surges"

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GameStop's recent rally highlights several weak spots in market functioning, Goldman Sachs said Friday. Still, the firm says investors need not worry.

The video-game retailer has stabilized around $70 after hordes of retail investors pumped up shares and subsequently fled the stock in January. The extraordinary price action prompted regulatory oversight, interest in Congress, and disruption to global trading platforms.

The phenomenon has since cooled, leaving Wall Street to mull what the trend means for markets. Strategists led by David Kostin are mixed. The "epic short squeeze" has pulled market structure into the spotlight, and a House hearing on the trade is sure to address topics like payment for order flow, trading restrictions, and short-covering.

GameStop's explosive climb also reveals that, for the retail investor, a stock's price supersedes valuation to a wild degree. Shares leaped as high as $483 late last month before swiftly paring gains. The year-to-date high gave GameStop an implied price-earnings ratio of more than 250 times, dwarfing the S&P 500's 20-times ratio and Tesla's disputed 170-times implied valuation. The retail investors piling into GameStop could truly believe the company is set to rapidly turn itself around, but such an immediate renovation is unlikely, Goldman said.

"Experience suggests firm makeovers typically take time and most investors are cynics until convinced otherwise," the team said.

The trend spilled over into other highly shorted stocks and fueled massive volatility through January. But retail investors' grip on the market has loosened, and the S&P 500 touched new highs last week as the GameStop event faded. Further gains are largely shielded from the Reddit traders and their disruptions, Goldman said.

For one, fourth-quarter earnings came in better than expected. Full-year profit forecasts have been revised higher across all 11 sectors, according to the team. Stocks stand to climb even higher through 2021 as vaccine distribution and new stimulus supercharges the US economic recovery.

Goldman expects S&P 500 earnings to grow 31% in 2021, handily exceeding the consensus estimate for 22% growth.

The selection of small-caps targeted by the Reddit traders pales in comparison to the rest of the market in both capitalization and output, the bank added. The retail investors' tactics initially shocked the establishment. But the broader market's rebound suggests the GameStop saga is a blip on the radar, and not the lasting drag some feared, Goldman said.