By: Blake Holman, Trust Portfolio Manager
That’s probably too much emphasis on the word “game,” but you get the picture. What started as a joke has become a costly game, indeed, with broad regulatory and legislative implications.
Robinhood, the trading app which markets itself as “democratizing investing,” has vacillated from hero to villain at the same speed as the stock prices it has helped push up. Over the past ten days, GameStop has gone from an obscure brick, and mortar retail location headed down the path of bankrupt icons like Blockbuster Video and Sears Roebuck to the darling of Wall Street.
Its stock price has soared 1,600% in just two weeks and made overnight millionaires out of a motley crew of Reddit day traders.
The smartest minds on Wall Street with the most sophisticated algorithms and analytical models known to man had determined that GameStop was a candidate for bankruptcy.
The stock had so little positive sentiment that 140% of its total shares outstanding (those issued by the company and traded by the public) had wagers against them, i.e., the bet was that they would decline in value. So, with that being the case, how did the stock go parabolic?
When an investor “shorts” a stock, they borrow the stock from the account of an investor who holds it in the custody of a broker/dealer (think Charles Schwab or E*Trade), and then they sell that stock at the current market price. If the stock price declines, the short seller buys it on the open market and deposits it back into the investor’s account from whom the share was originally borrowed, pocketing the difference. If the stock price goes up, they have to buy it at the higher price to replace the share, and the short seller loses money.
Companies with a lot of short interests occasionally surprise on the upside, and their share price increases. When that happens, the short-sellers have to buy a lot of shares to cover their bets.
Those purchases drive the price even higher (like with any commodity or service, more buyers than sellers = higher prices). This is the definition of a “short squeeze.” Very large companies like Apple or Microsoft with trillion dollar+ valuations (mega-cap companies) are less susceptible to extreme volatility because their sheer size makes it difficult for even a large group of investors to have a material effect on the price of their shares. Small companies, like GameStop, have so little activity and so little value relative to their “mega-cap” counterparts that even a small change to the demand side of the equation can have a sizeable impact on their share price. The combination of a small market capitalization (around $1 billion) and a ridiculous short interest (140%) made for a toxic and profitable mix for the Reddit crowd.
As the retail investors on Reddit began purchasing shares, the company’s price started to move up, jumping from $20/share to $30/share. When that happened, some of the “shorts” had to cover by buying shares at the new, higher price. That action drove the price to around $60/share in a day or two. Within a few trading days of that move, brokers called on shorts to cover their bets more fully, and the cycle exploded in a frenzy of purchasing. The mother of all short squeezes was born. As the Reddit traders got rich overnight, the stock became a conversation topic outside of typical media channels. The Reddit page “Wallstreetbets” leaped from 2 million members to 5 million members, all eager to get in on the action. This acted like a shot of pure adrenaline and pushed GameStop’s valuation into the stratosphere. Similar action has taken place in a cadre of burnouts like “Naked brands,” AMC Theatres, and Express, Inc. The story is always the same. Large purchases by the Wallstreetbets crowd chased a bunch of shorts into covering, and short squeezes were born anew.
So how will it end?
Poverty for the hedge funds who didn’t cover soon enough, and poverty for the Wallstreetbets crowd who buy in too late. This will end when the company valuations return to earth (a few months at most) and anybody who did not sell during the frenzy will be left holding shares of, quite possibly, soon-to-be bankrupt companies. There aren’t any good guys or bad guys in this story. There are only the people who are going to get rich and the people who are going to finance that newfound wealth with their losses.
Questions?
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