PRW News

“Gaming the Market” Article

Last week, we fielded questions about the wild trading activity in GameStop (GME) stock. Several other stocks were also the subject of wild swings but GME was the poster child. We watched this continuing battle from the sidelines, with keen interest. On one side is the hedge fund crowd who has made a bearish bet on a company with a broken business model. On the other side of the trade is an emboldened group of mostly younger, social media driven embolden retail investors. These disciples of Reddit (social news aggregation site) and Robinhood (a fairly new investment trading platform), are relishing their newfound power and are the force behind this epic, and historic, short squeeze (defined below). While we ponder the broader implications of this phenomenon, a few quotes come to mind:

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.” – Charles Mackay author of “Extraordinary Popular Delusions and the Madness of Crowds.”

“He who sells what isn’t his, must buy it back or go to prison.”  – Daniel Drew (Short seller, Wall Street Financier and founder of Drew University)

These two quotes frame the GameStop situation well.  We witnessed a herd mentality leading to a “short squeeze”. What is a short squeeze? Instead of buying low and selling high, the short seller hopes to sell high and buy low. In a short sale, one (often a hedge fund) does his or her fundamental homework, determines a company is overvalued, then borrows the overvalued stock from a broker. Once the shares have been borrowed, the short seller sells the borrowed shares expecting to buy the shares back at a lower price, thus booking a profit.  Short selling can be a dicey proposition because a short seller’s losses are theoretically unlimited. A stock can keep going up and the short seller must eventually buy the shares back to “cover” the short.  Short selling is not a new strategy, the practice has been around since circa 1900, the days of Mackay and Drew.

What is new to the short selling equation is the advent of the social media trader as a participant. The Robinhood/Reddit (R/R) trader is the force that ignited the shares of GME (Twitter, and other social media sites have also helped to fuel the fire). One month ago, GME traded for $18.84. Last Thursday, it traded as high as $469.42 before closing at $325.00 on Friday.

The new breed of retail traders/speculators are sitting on some new additional cash (some from stimulus), have time on their hands (as the virus limits other activities), and can buy fractional shares, which decreases the dollar amount entry threshold for trading.  Smaller account deposit requirements and commission free trading are also allowing for more participation.   In short, it is easy to open an account, easy to find a social media community/platform and easy to rally around a common cause. 

For some, this is a chance for David to take on Goliath i.e.  the old guard in the hedge fund community. A review of Reddit WallStreetBets (WSB), a channel for investors to share their investment ideas, makes this point clear.  It would be inaccurate to sum up the R/R trading community as young and inexperienced, however. Bloomberg TV quoted a Reddit WallStreetBets moderator on Friday who said: “retail investors can be every bit as sophisticated as an institutional investor, and, in some cases even more so. We have researchers, mathematicians, momentum traders, gamblers, and so much more.”  As tends to happen when there is blood in the water, we have also seen evidence of institutional money finding its way into these trades as well.

So where does this end? Eventually where it began.  The key word is “eventually.” The R/R trader figured out a new powerful way to exploit a known flaw in the system. Namely, that heavily shorted companies (high short interest stocks) could be manipulated higher with the help of social media driven herd buying to squeeze short sellers. This game does not go on forever. People recover their senses slowly, one by one, as Mackay instructs. Ultimately, fundamentals matter.  Along the way, some will have profits, some will have pain. The pain will occur on both sides of the trade.  It is not the first time we have seen hedge funds get caught with leveraged positions and suffering large losses.  Unfortunately, an outgrowth of recent events is both some shaking of confidence in the markets as well as some increase in volatility that comes from the forced selling in the market to cover the losses.

Following last week’s volatility (something we have been expecting this year), we have had calls for action by regulators and seen hedge funds and purveyors of short ideas become more private.  This weekend, Barron’s noted that hedge funds are increasingly using artificial intelligence (AI) to track the footprints of retail investors in the social media world which may serve to reduce the social media driven investors advantage.  Between the potential for more regulation and hedge funds adapting, we believe that the short-squeeze strategy may be a victim of its success.  The bigger picture at play here, however, is the rise of the retail investor (millions of new trading accounts added over the past year creating surging trade volumes) which does signal the advent of a new dynamic in the financial markets that bears watching.

The efficient market thesis has often been challenged and last week’s action further illustrated that markets can disconnect from fundamentals in momentum driven periods.  Our goal continues to be to keep you from disconnecting from your investment strategy.  Our mantra continues- Stay diversified, focus on the long-term and ignore the market noise.

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