With the inauguration and Capitol riots weeks behind us, an upcoming impeachment trial, and coronavirus news turning overwhelmingly positive as vaccine distribution challenges turned to widespread success, an unlikely candidate filled the hole in the news cycle last week: the story of an obscure internet forum and a virtually obsolete retail stock.
For those not hiding under a rock, the story of wild action in the stock of GameStop and various social and technological forces dominated the news for a week, leaving even people who have never bought a stock in their lives to wonder, “What in the world is going on?”
The essence of the story started with a pretty uninteresting and straightforward development: The seemingly obsolete business model and declining revenues of brick-and-mortar video game retailer, GameStop, caught the attention of some Wall Street hedge funds, and they began aggressively “shorting” the stock to profit from what they saw as the company’s eventual decline.
“Shorting” a stock can be described in layman’s terms as “betting that a stock goes down,” but in real life, it has a mechanical operation to it. That operation is that shares of a stock get sold before they are owned, hoping to “buy them back” later at a lower price, pocketing the difference from the price decline.
This process is a hundred years old, very common, and traditionally can be very useful in markets, as it:
- Helps to make a market (two sides expressing two different views on a stock).
- Enables some investors to hedge positions and mitigate risk in a diversified portfolio.
- Adds discovery and optics to a market as short-sellers share information and research about a company that the rest of the street may not see (i.e., it was famously the research of short-sellers that helped uncover accounting fraud at Enron, for example).
For short-sellers to “sell a stock they do not own,” they are essentially asking their broker to loan them shares of the stock borrowed from someone else. It is the first unique or noteworthy aspect of this story — 140% of the total shares of GameStop had been sold short. In other words, a lot more shares had been sold than even existed. What does this mean? Short-sellers were naked in their aggressive positioning in betting on GameStop’s demise. They had not “borrowed” shares to go short; instead, they had piled on leverage in what was now a wildly aggressive high-risk but potentially high-return strategy.
And this is what gave way to what really made this a story, as the overwhelmingly one-sided and aggressive nature of this short positioning caught the eye of some far-more-sophisticated investors than they have let on. This group took to Reddit and one particular forum, WallStreetBets, to start vocalizing their claim. Whatever level of behind-the-scenes coordination there was early on is likely overthought and certainly irrelevant, as (a) people collaborating to buy in concert is not illegal and (b) the size and gravitas of this group is not significant enough to warrant actual collusion.
Additionally, their efforts were not merely vocal but reflected “skin in the game,” as all indicators are that they bought as they “chirped” and, in fact, continued to buy throughout the events of last week. The huge run-up in the stock could not have happened, and absolutely did not happen, from their purchases alone or their purchases in tandem with their Reddit pontificating.
The forced buying of the short-sellers, blindsided by the move higher, created a feedback loop, and this was, of course, what some of these opportunistic investors saw as the outcome.
Just as forced selling creates a negative feedback loop when an asset price crashes, forced buying creates the reverse effect. Had the shorts represented 20%-40% of the float of the stock, they either would have been perfectly content to let the other side have its day and ride out the volatility in pursuit of the ultimate fundamental outcome or, where forced buying was provoked, it would have been minimal, short-lived, and underwhelming.
However, at 140% short interest, the response was violent, purely out of mathematical necessity. What extended this escapade was that, as incumbent short-sellers were forced into covering their positions, other short-sellers saw the opportunity to take a fresh short position based on fundamentals. It meant the short squeeze wouldn’t die. Those on the Reddit side had no motivation to stop buying or to sell their positions and take gains as long as they saw the short interest so dangerously elevated. It undoubtedly added several days to the saga.
Of course, minute-by-minute reports of a stock going up 20%, 100%, 200%, 400% do more than make certain bystanders wonder what is going on. It also lures in those attracted to the idea of what seems to be free and easy money. Whether it was the alleged social statement attracting some people (very minimal economic impact in this segment) or the sheer force of “free money” that many naive and inexperienced investors aspired for, an ample amount of “retail” investors piled in the stock in the late innings of the short squeeze.
Consequently, last week’s high $350 stock price has now found something more resembling Earth in the $65 range (down minus 80%). No doubt, a significant amount of the investor base who have absorbed this capital loss were “latecomers” piling in the trade after the short squeeze played out. Their highly risky pursuit of free money has cost them dearly.
The other highly discussed part of this story is the decision by Robinhood, a popular trading app with a significant amount of “small” investors as its customers, to disallow purchases of GameStop late last week. It has drawn the ire of strange bedfellows from Rep. Alexandria Ocasio-Cortez on the Left to Sen. Ted Cruz on the Right, allegedly put off by what they claim to be an attempt to protect big and powerful hedge funds from small investors.
With all noise and politicization removed, the simple reality is that Robinhood was in over its head regarding its “net capital requirements.” Regulators demand capital cushions from brokers who match buyers and sellers to account for the difference between a “trade date” and a “settlement date.” Brokers are on the hook for that cash “in limbo,” and the explosion of trading volume in this stock, even aside from margin activity, which is itself a separate complicating factor, pushed Robinhood to the brink, forcing it to raise significant liquidity from its investors to ramp up its capital cushion.
While this explanation works against more satisfying political or social narratives, the reality is that it defies the imagination of self-interest to think that Robinhood would create the public relations nightmare it has stepped into, alienating its core customer base and doing unfathomable damage to its brand were it not for forced regulatory conditions.
The saga is ending with more of a whimper than a bang. Still, excessive short speculation was discovered and punished by opportunistic investors who executed well, when all is said and done. And on the other side of the mountain, excessive long speculation was subsequently punished by the mere reality of markets and price discovery. Mr. Market is a punishing force, sometimes patient for days and even weeks, but in the end, it will exact its ends as it sees fit.
— David Bahnsen is the founder and managing partner and chief investment officer of The Bahnsen Group, a wealth management firm based in Newport Beach, California.
