The financial news has been filled with stories of huge gains in some of the most obscure stocks and battles between Wall Street titans and the proverbial little guy over these trades. Regulators and politicians have also started to chime in on action. So, what’s this all about and should any of us care?
Profiting on Terrible Investments
This all starts with something called “short-selling,” so let’s dive into what that is and how it works. Everyone knows that to make money in the stock market, you have to buy low and sell high. What many people don’t realize is that you don’t have to do it in that order; meaning you can sell high and buy low.
On the surface, this doesn’t make sense. Afterall, how can you sell something you don’t own? The answer is you borrow the shares from someone and give them back later. In practice, an investor would borrow the shares from their brokerage firm (usually from another client), sell them (presumably at a high price) and then at some point in the future, purchase those shares (hopefully at a lower price) to give back to the brokerage firm. This happens all the time and is often used as part of a greater investment strategy. This is also a very common trading strategy of hedge funds. Hedge funds often use what’s called a “Long-Short” strategy where they buy good companies’ stock and simultaneously sell struggling companies’ stock. The idea is if the market goes up, the good companies will go up more than the bad companies will and if the market goes down, the bad companies will go down more than the good companies. The fund profits from the difference between the two.
In theory this sounds good, but there are risks and much of those risks lay in the short positions. Short selling doesn’t lend itself well to a long-term position because the stock market generally moves higher and as the saying goes, “a rising tide lifts all boats.” At some point, those shorted shares must be purchased and returned to whom they were borrowed from. Plus, if there are a lot of short-sellers on a particular stock, there then must be a big future demand for those shares since they all must be repurchased at some point later. The term for that is a stock’s “short interest”. The worst thing you can do as a short-seller is hang on to a short position while all the other short-sellers close out their trades by buying and running the price up. If you sit by and let that happen, you’ll be stuck buying your shares at a much higher price. Remember, the whole goal is to buy low.
That takes us to today’s news. There’s no mystery about which companies are struggling. Take the store GameStop as an example. They mostly sell software on CD’s at the mall. You don’t need a staff of analysts to know that’s not a promising business. Therefore, that company has a lot of short interest in its stock. In fact, so many investors have shorted it that most of their shares outstanding have to be bought in the future to cover those short-sales. Earlier this month, 72.2 out of a total of 102.2 million shares were borrowed. Most of these positions were held by big hedge funds.
The Internet is Glorious
The internet has democratized information. In the investment world, this means Wall Street no longer has a monopoly on data. Regular folks now have access to most of the same information the trading desks do at the major investment firms. This is one reason trading costs have largely disappeared. Merrill Lynch can no longer justify $200 per trade because of their unique knowledge of the market.
Commissions have been replaced with backhanded trading profits that usually come at the expense of ordinary investors. So, when a group of individuals, about 1000 people, successfully took advantage of some of the biggest names in the investment world, it created quite a stir.
They teamed up through community forums and chat groups. One particular group called “WallStreetBets” on the Reddit social media site came up with the idea that if they collectively started buying heavily shorted stocks, they could run up prices enough to cause short-sellers to have to rush in to cover their positions (called a short squeeze). That short seller buying would then drive the price up even further. All they had to do was light the fire and watch the hedge funds do the rest. Roughly 140 days later, the dam broke. In a matter of weeks, the stock in GameStop went from under $20 to over $300. Hedge funds lost nearly 23 billion dollars on this one stock alone in recent weeks.
It’s been a blood bath for many of the biggest names on Wall Street at the hands of the little guy. GameStop is just one of the stocks this is happening to. Others include AMC Theaters, Bed Bath and Beyond, Blackberry and Nokia. The collective losses in many of these funds rival the losses during the financial crisis and have the potential to render some hedge funds insolvent.
Cry Me a River
The real irony in this is how an industry famous for fighting regulation and gaming the system is now crying foul. Their claim is that the collusion among a group of retail investors is somehow illegal and these message boards should be shutdown. It also appears Wall Street likes to protect its own as some firms began limiting buy trades on these heavily shorted stocks.
One online trading platform, Robinhood, received tremendous blowback from investors after announcing it would block purchases of GameStop stock. It said traders could sell their shares but wouldn’t let anyone buy the stock. Robinhood denied it received any outside pressure from hedge funds that were losing tens of billions of dollars on the trading, or from market makers having to cover the positions. Many saw the restrictions as an attempt to protect Wall Street insiders.
Regulators are now weighing in on the situation and it’ll be interesting to see if the SEC pursues any enforcement action against the WallStreetBets group for share price manipulation. It seems rather amusing to think the SEC would sue the retail group for driving shares up while not caring about institutional investors shorting stocks to drive them down. In our opinion, there is absolutely nothing wrong with what the Redditt group did. They simply identified a situation and profited from it.
The U.S. House Financial Services and Senate Banking committees have already announced hearings centered around recent activity with GameStop and other volatile retail stocks. Based on comments from some committee members, the focus will be on the role institutions played and not the retail investors. Typically, one would think Washington would be on the side of their big money donors, but this has received too much publicity to protect Wall Street.
Should You Care?
The news surrounding a handful of speculative stocks really doesn’t matter to most investors. These are largely small stocks with little following. The trading frenzy isn’t driving the market as a whole and will likely settle down in a few weeks. This is more interesting to traders than investors. Those are two very different groups of people with very different goals and strategies.
What is more interesting is to see how cozy big-money firms, the exchanges and even regulators are with each other and how they work to protect their own interest. Robinhood promotes itself as empowering young online investors. But in reality, they’re financed by the biggest names in Silicon Valley and make money by passing customer trades along to bigger brokerage firms, like Citadel, which pay Robinhood for the chance to fulfill its customer stock orders. Citadel also runs a hedge fund which participated in a $2.75 billion emergency cash infusion into Melvin Capital Management, a short seller that was facing steep losses due to the huge rally in GameStop’s stock. Cozy indeed.
Who would have thought GameStop would be the company headlining the news on Wall Street? Check out our memo on this David vs. Goliath battle of retail investors vs. Wall Street.