What happened
Shares of fintech platform Upstart (UPST -2.09%) rocketed 13.7% higher on Monday.
The company, founded in 2012 and public since late 2020, has long predicated itself on the use of AI to better underwrite loans. However, since late 2021, the former highflier has experienced a brutal drawdown, as buyers of Upstart's loans fled the platform in droves amid high inflation and fears of a recession. That led not only to the stock being taken to the woodshed, but for its short interest to rise to a whopping 32.5% of shares outstanding as of the end of June.
However, financial and fintech stocks appear to be rising today as well as other economically sensitive stocks especially harmed by rapidly rising interest rates. This is likely due to some better-than-expected inflation readings last week, while job growth remains robust.
Given Upstart's sky-high short interest, recent optimism over the economy is leading to a pretty epic short squeeze on the stock ahead of earnings season.
So what
One of the dangers of short selling is that unlike buying a stock where your loss is limited to 100%, when you borrow a stock and sell it short, your losses could potentially be unlimited. Therefore, when a heavily shorted stock runs higher, the short seller's prime broker may issue a margin call and force the short seller to buy back their stock at a loss.
That could be what's happening with Upstart today. After all, many of the economic headwinds that caused such a big sell-off over the past 18 months appear to be subsiding. In 2021, the inflationary scare caused interest rates to go higher and delinquencies to increase for Upstart's personal and auto loans.
Not only did delinquencies tick up, but because Upstart's loan buyers, mostly banks and credit unions, were seeing their cost of capital rapidly rise, with a lot of uncertainty as to how high it would go, many essentially stopped buying loans. And since Upstart doesn't have a banking license and therefore doesn't own its own deposits, it was at the mercy of these third parties.
However, inflation is now coming down, with many thinking the Federal Reserve is nearly done with its federal funds rate hikes even though the jobs market has remained strong. Moreover, Upstart has announced a couple of long-term funding deals that will provide it with some committed capital. That will help mitigate, though not totally eliminate, the threat of large capital flights in the medium term.
Investors perhaps are now anticipating a Goldilocks scenario "soft landing" for the economy, which would be an ideal scenario for Upstart and the worst one for its short sellers.
Now what
With today's rally, Upstart is now up a stunning 300% on the year and now trades at a $4.4 billion market cap and six times sales. The company is currently making losses, as it's had to decrease originations.
It's pretty hard to value Upstart precisely because we don't really know how much funding will return when interest rates settle or how much market share Upstart can regain in the personal loan space once funding comes back.
Still, with its short interest still likely high, AI being a new buzzword, and the potential for an economic recovery and optimism this earnings season, it wouldn't surprise me to see the stock go higher.
Investors should just beware this rally may be mostly due to non-fundamental factors.
