ote: If you would prefer the audio version of Investing Insights click here to listen to our podcast Episode 12: Stock Valuations Are Sky High – What Comes Next?
Today’s story is about riches lost and gained and for some lost again and the potential consequences these events may have for the markets and investors in the years ahead.
After decades of getting accustomed to the internet fundamentally changing the economy, entire business sectors and how we interact with each other; it is again the stock market’s turn to experience fundamental changes to the old order. The world has been watching a formerly irrelevant, struggling company, GameStop (Ticker:GME), become a market legend thanks to a hedge fund manager and a few stock trading groups on the internet.
The mother of all financial battles has been waged with GameStop stock stuck in the middle, powerless to control the ultimate outcome. GameStop is a pawn in an epic struggle between big finance and a legion of disaffected retail investors. This battle royal has elevated GameStop from a heavily shorted $260 million market cap company with a dim future, to a heavily shorted $20 billion market cap company with a dim future.
Let us put some quick math to the recent price moves of GameStop stock. In April of 2020, the stock was around $4.00 a share, on January 27th, 2021 the stock traded at $347 a share. That is a return for an investor over that period of more than 8,500%! The price went parabolic around January 21st, 2021 when it traded around $43 a share, by the 27th the price had skyrocketed to and unbelievable $347 a share.
GameStop Share Price (1 Year)
Some traders are making millions or tens of millions of dollars on their GameStop holdings, while several hedge funds are losing billions of dollars. A huge number of small retail traders have been taking it to the billion-dollar hedge funds that have large short positions in GameStop, and these retail traders are a vicious pack out for blood. This zero-sum battle between small retail investors taking long positions (betting the stock will go up) and big money hedge funds on the short side of the trade (betting the stock will go down) led to a massive short squeeze that propelled the price of GameStop into a parabolic move to the moon.
The Story of GameStop
The story of the GameStop short squeeze all began in the spring of 2019 when Dr. Michael Burry of Scion Asset Management, a famous and talented investor and basis for the main character in the movie “The Big Short”, took an interest in the company. He believed the valuation of the company was way too low and the expectation of bankruptcy was overblown, meaning there was money to be made for his fund.
Scion began buying up shares of the company between $2 to a little over $4 a share when the market valuation was less than half of the company’s book value. Scion eventually built up a $15 million position in the company when it was one of the most shorted stocks in the market. Burry’s plan it appears, was to help push the market to realize the undervalued nature of the company and perhaps induce a short squeeze by encouraging company’s board of directors to buy back a large number of its shares using the company’s significant cash position. The share buyback ended up reducing the number of shares outstanding by almost 40% to around 64 million shares.
The decrease in shares outstanding is important because the stock was heavily shorted and by reducing the shares in the market the likelihood of a short squeeze dramatically increased. Before I share the rest of the story, this is a good time to pause and I will explain how a short position in a stock works, what a short squeeze is and what causes them to occur.
An investor who shorts a stock is betting that the price will go down in the not-too-distant future. To open a short position on a specific stock a short seller enters essentially two distinct transactions. They must first borrow shares of the stock they believe will decline in value from someone who owns shares of the target stock. The shorting investor pays interest on the value of the shares for the right to borrow them. Next, the investor that is taking a short position on the stock sells the borrowed shares into the market at the current market price hoping they can buy the shares back at a lower price in the future and then return the shares they borrowed. If successful, the investor that shorted a stock that declines in value will earn the difference between the price of the stock when they sold the borrowed shares and the price of the stock when they bought the borrowed shares back, less interest and commissions paid to the broker. These transactions, borrowing and then selling shares of a stock happen behind the scenes at the broker when an investor shorts a stock, but the previous example explains the mechanics.
What makes shorting stocks risky is that there is no theoretical limit to one’s losses. When you buy a stock, you risk losing 100% of your money if the stock goes to zero. However, there is no limit to how much a stock can go up, so if you are shorting a stock your losses are theoretically limitless. Also, when a stock’s price rises significantly, short sellers are often required to put more money in their brokerage account as collateral because the broker needs to make sure the short seller can make good on their obligation to buy the stock shares they borrowed back, at now a much higher price, and return them to the lender. The higher the stock price goes, the more collateral the broker needs to collect to make sure they are made whole at the end of the trade. Another risk of short selling is that as the price of the shares rise, so does the short seller’s cost of borrowing the shares because interest is paid on the value of the borrowed shares.
When a large percentage of a company’s total shares outstanding are being lent out to short sellers, the conditions for a short squeeze in an individual stock become present. A short squeeze can occur when the value of a highly shorted stock begins to move higher, undercapitalized short sellers may then be forced to buy back the now more expensive shares they borrowed in the market to stop their losses and prevent a margin call. The buying activity by covering short sellers pushes the price even higher. A virtuous cycle of rapid price increases in the stock can take over as more and more short sellers run out of capital to meet margin calls as the price accelerates higher and higher.
A short squeeze is a short seller’s worst nightmare and in late 2020 the perfect conditions for a short squeeze in GameStop became present with at least 100% of GameStop’s shares outstanding being lent out, market sentiment was overly negative on the company, the risk of bankruptcy was dramatically overblown and finally the share price was gradually rising. We now return to the financial drama that was playing out in GameStop stock through second half of 2020.
In a trading group on the website Reddit, called WallStreetBets (WSB), with around a million followers, there was a well-researched amateur trader who was making the case to the group that GameStop was a potential winning stock. He referenced Burry’s research and had done his own research as well. He began building a large leveraged long position for himself in the stock and sharing his research and conviction in the trade with the Reddit group.
GameStop became a regularly talked about name on WSB and the share price began to slowly rise starting in mid-2020. The stock was still arguably underpriced when a large group of retail traders active on WSB began buying shares and Burry’s influence on the board led the stock to continue rising towards fair value as Burry has theorized it would.
While GameStop stock was seeing increasing volume in share buying, the rocket fuel for the mother of all short squeezes had not yet been loaded into the tank. That is until another influential contributor on WSB weighed in with a widely read post. This post not only agreed with the fundamental thesis that the stock was undervalued, but he also theorized that if the stock price continued to rise a short squeeze was inevitable. Then he presented another reason to buy GameStop, he introduced the idea that a GameStop short squeeze could destroy a few specific hedge funds that had disclosed large short positions in the stock. He introduced the populist buying argument that resonated massively across the audience on WSB. He argued that the members of WSB may have the opportunity to take down a few institutions of the wealthy through GameStop and for the first-time small retail investors could turn the financial system against the most powerful and unscrupulous investors. That post loaded the rocket fuel and on January 21st, 2021 the rocket was ignited through large scale retail buying of GameStop and the price shot up to $347 a share by the 27th.
A new market dynamic was born, populist rage. The coordinated action of small retail investors against powerful institutional investors worked! A major hedge fund had to be bailed out by investors and the estimated total losses by short sellers was in the tens of billions by the end of January. A massive transfer of wealth from billionaires to small retail investors had taken place, at least on paper. The WSB contributor that had been initially talking up GameStop and sharing his research had turned about $58,000 into $48 million and had joined the ranks of the wealthy elite with a single trade. This story has it all, I am sure a movie will be in the works.
The GameStop short squeeze was not an isolated incident, we know this because at the same time GameStop stock was exploding in value so was Nokia, AMC Theaters, Blackberry and dozens of other companies that these Reddit connected traders identified as potential short squeeze candidates and rushed to buy them at the same time. These dramatic short squeezes and particularly the trading around GameStop went beyond speculative trading for many buyers, the trade became an outlet to viscerally lash out at the financial establishment, wealth inequality and the accurate view that the economy and the markets do not provide an equal playing field for all participants. Much of the price move of GameStop is the direct result of an explosion of populist outrage in the same vein as the populist political strife that has been simmering in the U.S. over the last 20 years, which has finally begun to boil over in our body politic.
After any unusual market event like the epic short squeeze of GameStop, investors, regulators and politicians will look to assign blame. This time it is pretty easy to identify were most of the blame lies, Federal Reserve policy is to blame. The FED has been taking action to hold interest rates artificially low for over ten years. Investors have therefore been forced into riskier assets like stocks to earn acceptable returns, which in turn has driven stocks to record valuations. Given that the rich are the primary owners of stock, wealth inequality has exploded over the last decade and a half leading to widespread political and social unrest, the rise of populist sentiment, and of course the proliferation of young speculative traders looking to quickly change their financial prospects and drink from the same fountain the rich have been enjoying.
The Convergence of Populist Finance and Speculative Day-Trading
Populist investing as we have seen with GameStop is a new market dynamic and investor behavior that has the potential to significantly change the risk profile of markets. The usual market drivers, greed and fear, are a secondary motivation of a populist trade, supplanted instead by economic grievance and a fatalist view of risk, profit and loss. The populist mindset is clear in the Reddit trading groups that are coalescing around GameStop, the WSB traders fully acknowledge the trade is no longer about fundamentals and the company is not worth $20 billion dollars. A common theme in the threads of these irreverent internet groups is represented well by this politically incorrect excerpt from a WSB post: “they (being the big hedge funds) have underestimated how retarded we are, I don’t care if I lose my money in this trade, I like the stock”.
The speculators in the Reddit groups are primarily younger millennials numbering in the millions, who came out of school around 2008 and 2009 and faced difficult job prospects because of the financial crisis (a result of financial abuse). Many came out of college with huge debt loads because of sharply rising college costs and then found themselves struggling to get ahead economically because of the high cost of living in the urban areas where they work. This generation has been locked out of the expensive housing market and have taken another major economic hit because of the pandemic. A large percentage of this generation is still forced to live with their parents, and they are understandably angry. Post after post talks about the economic devastation they themselves or their parents suffered because of the great recession and now the pandemic.
This mighty band of retail investors successfully launched an attack to great effect on the speculative short positions of multi-billion-dollar hedge funds out of righteous anger towards the impunity with which the financial establishment and the hedge fund class has operated over the last two decades with disastrous consequences for the economy and their personal economic stability. Their grievances are real, but they have also taken notice of their own success. These internet groups were surprised by the victory they achieved in the GameStop attach, even if short lived, and realized how powerful they can be and how profitable their trades can become when they act together to exploit specific trading opportunities.
How Will the GameStop Story End?
GameStop’s parabolic rise, as well as the other major short squeezes we have seen over the last few weeks was made possible by a unique convergence of greed driven speculation, coordinated trading on a previously unthinkable scale thanks to the internet, and the populist anger of a disaffected generation. How is this period of extreme speculation going to end? I think the answer to that question is fairly obvious, it will end with tears and financial pain for a massive number of mainly small retail investors. Does a valuation of $20 billion make sense for a company like GameStop? Absolutely not! Short squeezes are nothing new, the fundamental value of GameStop is likely between $20 and $50 a share, fundamentals will eventually win the day.
The GameStop short squeeze was so massive not just because of populist trading motivations of a rightfully imbittered generation, but also because of growing speculative trading among that generation. Like poker fifteen years ago, day-trading among younger investors is a new form of entertainment that has, for lack of a better word, become a fad. Traders are live streaming their day-trading activities and many have massive followings. No-cost brokerage firms like Robinhood have exploded in popularity. As much as half of all Robinhood accounts had positions in GameStop at one-point, long-term investing is not the objective of many young market participants, speculation and quick money is the goal.
The type of markets we are in today are very reminiscent of the late 1990’s. Day-trading was popular then, which is not surprising after enough people took notice of a relentlessly rising stock market with a focus on tech stocks (sound familiar). However, there are other parallels including huge IPO activity, insane valuations of startup companies, declining interest rates and the list goes on.
Younger traders are right that the stock market is not a level playing field, the actions of hedge funds and brokerage firms have again proved this point as the GameStop drama has played out, unfortunately, the retail investors will be left holding the bag again in the end. Like in the late 90’s, speculation usually becomes most popular when it is easiest. Markets relentlessly move up day-after-day until they do not, that lesson will almost certainly be learned again when smaller day-traders are left with empty accounts or owing a brokerage firm money.
Navigating A Frenzied Market
What should long-term investors take away from this story and the mounting evidence of increasingly frenzied markets? Most importantly, while this story is unique, it is not new. We have seen frenzied markets like this in the recent past and in the distant past, each time it did not end well for both speculators and long-term investors. It is not important to understand all the causes of the unusual market actions of present, but it is important to consider what the investing story I shared with you today portends for the coming years. Populist trading, loose financial policy, internet threads of connected traders acting in concert, stretched stock valuations and widespread speculation are likely to continue providing tailwinds for the stock market for longer than you might ever think possible. But rest assured, it will end, and long-term investors should be positioned accordingly.
Ever increasing optimism and by extension risk taking among investors is what has driven the markets to the point we find ourselves today. During periods of near peak market frenzies, investors tend to gradually increase the risk of their portfolios as they chase returns. This behavior drives much of the momentum common in markets heading towards their medium or long-term peaks.
The best, but most difficult defense to execute in times like these, is to stick with the same portfolio and risk exposures you originally decided was prudent and comfortable when returns were not so positive. Fight the urge to chase higher returns, engage in short-term speculative trading, and any other investing strategy change that during more normal times you would never consider. The financial, economic, and political problems that have whipped up the markets as of late are not insignificant. Most problems, even big ones, usually get resolved over time. Time also compounds your wealth with even just average returns, making speculative periods in the markets like we are experiencing today insignificant over the long run. Manage your risk, stick to your strategy, and let time do the rest.