Bear Traps Report’s McDonald on how meme stocks are distorting passive funds

“The meme stocks are massively distorting the passively-managed funds,” says Larry McDonald, editor of the Bear Traps Report.

McDonald sat with CNBC to discuss the impact of meme stocks on ETFs and the viability of these businesses in the long run. On “Worldwide Exchange”, he said:

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“At one point in January and February, XRT – the largest retail ETF went from a 1% holding in these stocks to almost a 20% holding. When you have a market capitalisation that grows quickly, the ETFs can’t recalibrate, leading to massive distortion.”

McDonald reiterates that meme stocks are highly speculative

McDonald compared the credit market with the equity market and highlighted that bonds were trading at 96 in 2019 when AMC Entertainment Holdings Inc (NYSE: AMC) was exchanging hands at $9 a share. In comparison, bonds were down to 80 cents on the dollar last week, but AMC was trading as high as $60 a share.

“If you are on the board of one of these passive ETFs, and you see this type of massive distortion where the credit markets are saying this is trouble, but the equity markets are in speculative ‘La La Land’, you have to do something,” he said.

AMC Entertainment sold millions of shares last week and yet continued to boom in the stock market with a close to 100% gain. The theatre chain intends to use the proceeds from the share sales to minimise its debt that will likely improve its credit position – a phenomenon that McDonald finds unusual.

“FED is not allowing the business cycle to function over longer periods of time. So, the cleansing process of the credit markets, which normally takes out the bad companies, get somewhat eliminated. Consequently, a company that should have gone bankrupt can end up raising capital and boosting its credit environment,” McDonald added.

McDonald warns investors they can get wiped out overnight

Commenting on the future price, McDonald highlighted that the credit markets hinted at a possible drawdown in January and February when the meme stocks were trading unusually high. Ultimately, the stocks saw an about 70% drawdown. Now is a similar situation again. He said:

“If you want to speculate and ride the wave, have a stop loss and make sure you take half of your gains off the table that reduces your downside. You really shouldn’t be in these plays because it’s extremely speculative, and you can get wiped out overnight. But if you have to, make sure that you’re managing risk the best you can.”