By Nancy Johnshoy, CFA, Senior Vice President – Portfolio Manager & Market Strategist
Rarely have my colleagues and I had so many people asking us the very same question. What in the world is going on with GameStop? The ongoing stock frenzy fueled by social media is intriguing for many reasons.
Ever seen the movies Hoosiers, Rocky, or Seabiscuit? The underdog story is one of the most classic and compelling storylines with universal appeal. Perhaps that is why the GameStop stock drama has captivated our attention with such intensity. We are going to explain how this whole thing worked.
Short Selling Basics
The first element is the short sale. Short selling occurs when professional investors identify a company that they feel is at risk for failure or significant price decline. The short sale is a way for these investors to essentially bet that a company will fail in a perfectly legal way that makes them money. They borrow shares of that company’s stock to sell with the intention of buying them back later at a lower price. Remember that they sold shares that were “borrowed,” which obligates them to buy them back. Buying back is called “covering your short” and theoretically results in a profit equal to the difference between what you sold the shares for initially minus what it costs you to buy them back. Short selling is risky because it has limited upside, but unlimited downside. After all, a stock cannot decline to more than zero, so your gain is limited to what you paid to buy the stock. On the flip side, there is no limit to what you may have to pay to buy those shares back. More on this later.
Enter Social Media
Now is the time in our story when the little guys enter. In a very real sense, this event was made possible by social media. As confusing and confounding as the world that lives “online” is to older generations, many people today live a significant portion of their time on Snapchat, Tik Tok, and messaging forums like Reddit and Quora. On these, trade ideas are likely accompanied by “emojis” (see left) to indicate a level of confidence in the potential success of a transaction. Day trading has exploded during the pandemic, with trading activity often taking place on platforms like Robinhood, and discussions about trading on forums like Reddit and Twitter. Reddit, as an example, is a network of communities, or discussion boards, based on people’s interests. WallStreetBets, a Reddit discussion group geared towards higher-risk investment strategies, grew to about 1 million members in the early days of the pandemic. As of right now. membership has mushroomed to 6.5 million users. The psyche of the WallStreetBets investor is embodied by their battle cry of YOLO! (which means You Only Live Once! – and yes, I had to look it up).
Stock Market Movers
Let’s talk about GameStop. GameStop is brick-and-mortar game retailer with more than 5,000 stores. With challenges created by the pandemic, mall closures, and growing competition from digital game downloads, GameStop has been a popular play among the short sellers. Although it feels like this happened overnight, this story has been building over the last two years. Some prominent participants in these discussion groups have been making a case for GameStop for almost two years. As Reddit and retail traders started to take note of GameStop, they also took notice of how heavily shorted the stock was — information that is not at all difficult to obtain. And they figured out a way that, acting together, they could “stick it to the big guys” and make a profit doing it. In a nutshell, that is how a huge group of anonymous people who have all somehow coordinated enough buying momentum to drive GameStop and several companies in similar situations to prices that are dramatically higher than any reasonable valuation.
Let’s get real! At the end of July 2020, GameStop was trading at around $4 per share. Eight Wall Street analysts maintain ratings on the stock: four recommending hold, two sells, and two strong sells. There are 69.8 million outstanding shares of stock; the earnings loss per share in 2020 was -$4.18. The 10-day average daily trading volume is 101.9 million shares. Shockingly, huge levels of speculative buying have driven the price from $4 to as high as $481 per share! The stock saw huge daily swings and a gain in January of a whopping 1,625%. Sounds good, right? Let’s move on to a look at who wins and who loses in this scenario.
Initially the losers are easy to tag. The hedge funds and institutional investors who shorted the stock clearly got caught in a classic “short squeeze,” where traders are forced to cover short positions after a rapid rise in price due to supply and demand factors in the market and not to company fundamentals. A principal player on the short seller side is hedge fund Melvin Capital Management, which reportedly lost 53% in January amid a record rally in GameStop and other stocks the fund was betting against. Some estimates are that short sellers lost as much as $91 billion in January. Seabiscuit is in the lead coming around the final corner!
There will be plenty of “underdogs” who win at the end of the day. The ones who will benefit the most are the Reddit users who initiated the frenzy — if and only if they manage to exit their position at the right time. However, it appears that high numbers of smaller investors with FOMO (Fear Of Missing Out) are still trying to pile in and continue to drive the price of GameStop higher. One top trending Reddit post on Monday stated, “IM NOT SELLING THIS UNTIL AT LEAST $1000+ GME.” It is important to note that the essential element of a short squeeze is that there are institutional traders who are forced to cover short interest to limit losses. Most, like Melvin Capital, appear to have closed out their short positions. It will not surprise me to learn that a whole different group of investors are shorting this stock today at the current price of $300+ and may win at the expense of euphoric retail buyers when the bubble deflates. Ever heard of Musical Chairs?
This trading activity has garnered the attention of regulators, politicians, and institutional investors for whom short selling is a part of their strategy. To be clear, short selling is a limited part of market activity with around $800 billion in short bets outstanding at any one time — a small percentage of the market capitalization of U.S. stocks. Ironically, some of the negative impacts from this event may harm some of the trading platforms like Robinhood that cater to smaller investors and active traders with a zero-commission platform. Robinhood’s decision last week to restrict trading on volatile, surging stocks, including GameStop, touched off a firestorm of rage from people using the popular trading app, as well several class-action lawsuits brought by users alleging the platform wrongly stood in their way. Without going too deep into the weeds, these decisions to curtail trading were in response to the “collateral payment” required by the middleman that processes and completes trades for brokers. Some firms, Robinhood for example, did not have the capital to meet the required collateral payments and were forced to limit trading.
Truth & Consequences
What does all this mean for traditional investors? The bottom line is — not much. The primary users of short-selling strategies are hedge funds. Hedge funds are investment vehicles that pool money from wealthy individuals. They are less regulated, which gives those who manage hedge funds a bit more latitude to employ high-risk investment strategies. Strategies like ours at First Business Bank, based on fundamental analysis and long-term principals of investing, will see little impact from this once the dust settles. Of course, we’re always delighted to discuss your portfolio if you have questions about your investments with us.