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GameStop mania may have ruined this hot Wall Street trade

Brian Sozzi
·3-min read

And just like that, up in smoke goes Wall Street’s late 2020-early 2021 money-making “reflation trade.”

The reflation trade is Wall Street jargon for investors betting on a strong second half economic recovery this year as more people get vaccinated for COVID-19. In advance of what would amount to a V-shaped economic recovery, investors today buy cyclically-focused stocks usually in the small-cap, energy and financial sectors. The companies in these areas tend to do the best financially when consumers are back out spending and traveling.

And it was a trade that had been working rather well amid positive news on COVID-19 vaccines and stimulus prospects. From Dec. 1 to Jan. 15, the small-cap Russell 2000 Index (^RUT) surged 17%. The Energy Select Sector SPDR ETF (XLE) and KBW Bank Index (KBWB) had gained 17% and 5%, respectively.

But that buying activity in reflation names has reversed course noticeably over the past five sessions. The Russell 2000 has shed 1%, the Energy Select Sector SPDR ETF is down 6% and the KBW Bank Index has lost 7%.

“Short squeezes in speculative names are contributing to a spike in out-of-favor names in the U.S. and now Europe. Given the exceptional volatility in some spec names there is likely to be spillover into other parts of the market near term. There is talk of reflation trade unwinding,” says EvercoreISI strategist Dennis DeBusschere.

The reasons for the unwinding are starting to build, as DeBusschere suggests.

Strategists point to weakening reads on the U.S. economy (see the soft December employment report, lackluster retail sales data, etc.) and potential difficulties in President Biden getting his $1.9 trillion stimulus plan. Meanwhile, new mutations of the coronavirus has cast concerns on the long-term effectiveness of various vaccines.

And then, rampant speculation in heavily shorted stocks such as GameStop, AMC, Express and Build-a-Bear have some on the Street worried about a broader market top. That has also pressured the rosy reflation trade narrative.

“I think this is a sign that we are getting to a top and we are going to get a pullback. That’s just one of the signs,” Morgan Stanley strategist Andrew Slimmon told Yahoo Finance Live, referring to the insane gains of late in fundamentally weak companies.

The reversal of the reflation trade hints at more market volatility ahead as investors try to determine what sectors to go aggressively into again.

Says Suntrust Trust Chief Market Strategist Keith Lerner, “Several indicators suggest the market is becoming stretched to the upside on a short-term basis and set to move into choppier waters.”

Brian Sozzi is an editor-at-large and anchor at Yahoo Finance. Follow Sozzi on Twitter @BrianSozzi and on LinkedIn.

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