GameStop Stock Will Teach Many Lessons
Shares of GameStop, a video game retailer, are all over the news as the poster-boy for "meme stocks." This small list of companies have put Wall Street in quite the tizzy and garnered the interest of speculators, government bureaucrats, and news media of all stripes. Why? Because this story has all the makings of a suspense novel. We've got the Empire (Wall Street hedge funds who have been shorting the stock) controlled by the wealthy elite and the Rebels (played by the scrappy day-traders who gather on Reddit) locked in an epic battle. Understanding the struggle requires an explanation of both the finance jargon and the culture of social media.
First, the Finance
The most basic principle of investing is to buy low and sell high. Most individual investors employ strategies that only involve buying a stock, holding it for a while, and then selling it (hopefully at a profit). To implement this strategy, you need to find stocks that you think will increase in value over time. Finding the next big product and getting in on the investment early is the ideal situation. Think buying shares in Apple in 2007 or Tesla in 2010. This is the approach used by most ordinary, non-finance people in their 401k, IRA, and other brokerage accounts.
Professional, or “institutional,” investors often add more complicated strategies to their investing repertoire. For example, what if you thought the price of a stock was likely to go down, not up? Think Toys R Us in 2017. One could profit from the sudden drop in price by selling the stock short, effectively selling high and buying low.
Short selling is an investment strategy where one may sell shares of stock that are not already owned. To execute the trade, the target company shares are borrowed from a broker and sold into the market by the investor. The investor gets the proceeds of the sale, but still must repay the shares he borrowed from the broker at some point in the future. If the plan works, the stock price drops and the investor is able to buy shares in the market at a lower price and return them to the broker from whom he borrowed. The difference between the initial “sale” price and the ending “buy” price represents the investor’s profit (less a fee paid to the broker).
What could possibly go wrong? Plenty. Let’s say that our Harvard-educated hedge fund manager is wrong about the direction of the stock price; it goes up instead of down. He must still replace the borrowed shares only now he must pay more to buy them back than he received when he sold them short. That’s called a loss. How bad can the loss get? Theoretically, it’s infinite because the stock can go up and up and up forever. However, the profit of a short trade is limited because the stock price cannot fall below zero. Compare this to the traditional buy-hold-sell strategy, which has limited downside with unlimited upside, and you can see that short selling is much riskier.
GameStop
GameStop is a brick and mortar video game retailer. As the purchase and consumption of gaming has moved online, the sustainability of the GameStop business model has been increasingly questioned by investors. Compounding the doubts about the business and like many retailers, they have also been suffering during the COVID lockdowns that began in 2020. Investors might consider these factors to be indicators of poor “fundamentals,” which refers to metrics that are used to estimate the true economic value of the business. For this and other reasons, institutional investors (hedge funds) view this as a stock that is likely to fall and have been shorting it in significant amounts, which up until recently has indeed caused the price to fall. Success having many fathers, other investors have joined the shorts to increase the total short interest on the stock substantially.
Enter Social Media
In the social media world, everyone knows the big players like Facebook and Twitter. Reddit is a similar online community where people can post messages and organize around shared interests. The individual topic areas on Reddit are called subreddits. One subreddit in particular, called “wallstreetbets,” has caught a lot of attention because it started encouraging members to buy shares in high profile shorts to drive their stock prices up. One such target is GameStop. Wait, won’t that hurt our short-selling, Harvard-educated, hedge fund managers? Yep, you betcha! And that appears to be much of the motivation behind what has become yet another populist movement. In fact, they have managed to drive the price up from below $20 at the beginning of this year (2021) to a high of $483 in just a few days. If you read the posts on r/wallstreetbets, you can see the members, all 6.3 million of them, encouraging each other to hold their positions (i.e., not sell) hoping to drive the stock price even higher.
Market Psychology: Momentum and Short Squeezes
Stock market analysis is often discussed as two camps, fundamental and technical. Fundamental analysis tries to figure out what a company is actually worth based on valuation metrics like cash flow, return on assets, risk premiums, and the like. It then compares the current stock price to the theoretically “correct” price and determines whether the stock is currently under- (buy it) or over- valued (sell it). Technical analysis tries to gauge the relative supply and demand for a stock based on its price and volume activity. The technician is only interested in direction; buy if the price is trending up and sell if it is trending down.
Some have argued that fundamentals dominate in the long-term, while technicals dominate in the short-term. Over short periods of time, when investors (both institutions and individuals) see shares of certain companies rising rapidly, they will jump on board, trying to ride the wave to riches. Under these conditions primary motivation of the market is greed. More people buying the stock then propels the stock even higher, which attracts even more attention and more buyers building momentum into a self-propelling boom. The longer this continues, the more people join and the bigger the bubble gets.
The GameStop incident is different in that it seems to also be driven by other kinds of motivations that we’ve never really seen in the markets. In social media parlance, the fear of missing out (FOMO) motivates people to participate in these populist movements. The posts in r/wallstreetbets and other subreddits show a clear intent to make money but also to “stick it to” the Wall Street elites who have been “sticking it to” the little guy forever. They are full of calls for “YOLO (you only live once) investments to buy with whatever money you can afford to lose.” Claims of members having invested tens of thousands and even millions in GameStop shares are common. The hope is to inflict so much pain on the hedge fund shorts that they are forced to exit their positions by buying shares to cover the ones borrowed from their brokers. This forced buying will add a final push to the stock price, increasing the profits for all the individual investors who participated in the “short squeeze” attack.
How Will It End
The anti-hedge fund attacks have seemed to succeed in driving up the price, which no doubt has hurt the intended targets. However, not much thought seems to have gone into the exit strategy for the rank-and-file rebel. Even just a few days into the populist horde’s major assault cracks have begun to show. When a popular trading app tried to slow the purchase of GameStop shares, the stock saw a precipitous 40% decline. If the counter-culture Reddit crowd manages to hold together, the price could stay up for a while, but eventually the weight of the fundamentals and the greed of profit-takers will take its inevitable toll. This can only end with a crash in price for GameStop and the handful of other “meme stocks” as everyone rushes for the exit at the same time. Could it trigger a broader sell-off into the rest of the stock market? That might be the fear, the other great stock market motivator, pushing calls for interventions by market makers and government agencies.
