Part one of a two-part series.
It ended as quickly as it began. The GameStop stock frenzy game has stopped, with share prices plummeting, as expected. (Albeit, options traders brought the stock back up last week.)
Undoubtedly there was some carnage, but capitalism isn’t meant to protect people from themselves. It’s meant to provide an opportunity. And that’s what some locked-down millennials and like-minded investors took advantage of in their coordinated effort to outsmart the hedgies — and make a lot of money while doing so.
Hedge funds such as Melvin Capital were short-selling GameStop stock; i.e., betting that its share price would fall. Short sellers win when the price of the underlying stock goes down, but everyone else who owns the stock loses.
There was some logic in shorting the stock. GameStop is today’s Blockbuster — a retail entertainment chain that’s, as the video games it sells are now primarily being purchased online.
Yet an online group called WallStreetBets, which is part of Reddit, gathered enough momentum to drive the stock price into the stratosphere. Enough WallStreetBettors bought the stock and told others to buy it that it defied its financial fundamentals and soared, rising from $17.25 a share on Jan. 4 to $347.51 on Jan. 27. If you invested $10,000 on Jan. 4, it would have been worth $200,000 just 23 days later.
At the same time, Melvin Capital saw its portfolio lose more than half of its value. Ditto for other hedge funds following the same strategy.
Manipulating the Market?
Some have praised GameStop traders as winning one for the little guy, as many average investors made money off of their trades. The narrative makes the traders into the virtuous David going up against the big, bad Goliath hedge funds.
Conversely, The Motley Fool and some others have compared the GameStop frenzy to a “pump and dump” scheme, which is what happens when an investor or group of investors hypes a stock to boost its price, then sells it before the price falls. This illegal, fraudulent practice used to be carried out by cold calling unsuspecting investors, but now pumpers use social media and online forums to drive prices higher.
Investors on WallStreetBets, though, do not appear to be doing anything illegal. They trade stock tips and information on options investing. We all take a risk when we take advice and stock tips. Many appear eager to take that risk, as WallStreetBets had signed up 6.3 million users to its forum by the end of January.
But it’s called WallStreetBets for a reason. “Bets” is the key word here. It’s not investment based on experience and knowledge, it’s investment based on whatever whim drives the group to invest in a particular stock. And what goes up eventually comes down.
Investors who timed their bets well made money. Those that didn’t lost big.
Meanwhile, the trading volume for companies such as GameStop (GME), AMC Entertainment (AMC) and Express Inc. (EXPR) was heavier than even a big brokerage could handle. Normal trading was disrupted and block trades couldn’t be executed.
Stocks receded in value as quickly as they rose, leaving investors who bought at the wrong time with huge losses. GME stock was recently selling at $40.69. It rose back up to more than $100. but it will likely fall back down soon.
The WallStreetBets crowd moved on and had limited success boosting the price of silver through the SLV exchange-traded fund (ETF). Silver reached record highs pre-market, but those who missed that temporary spike likely lost money. Once markets opened, the price of silver dropped. By the next day, it had receded 20%.
A group of traders may be able to jack up the price of a stock by buying a significant volume of it, but silver trades at a much higher volume than GME stock — Bloomberg reported that silver’s average daily volume on the New York futures market is close to $11 billion, while daily volume for GME stock averaged about $50 million.
The Robinhood Experience
Some blamed Robinhood, the preferred trading platform for the WallStreetBets crowd, when GME’s stock price dropped. Financial Planning noted that “conspiracy theories have emerged that the retail brokerages were bowing to hedge funds.”
The catalyst for GME stock’s drop in price was a limit on trading that Robinhood and other brokerages placed on certain stocks, including GME and AMC, on Jan. 27. With investors unable to buy additional shares, but still able to sell what they owned, the price plummeted.
But the aptly named Robinhood appeared to be having a liquidity crisis, which would be understandable under the circumstances. Ironically, Robinhood’s success, reflected in an explosion in trading volume, appears to have nearly caused the company’s demise.
Robinhood CEO denied the liquidity crisis, but it would have been hazardous for the company to admit it had one. When a company lacks the cash to operate its business, it may go bankrupt, as Bear Stearns did in 2007 at the start of the U.S. financial crisis.
Robinhood, though, received a $1 billion infusion, followed by another $2.4 billion, providing more cash to cover the high volume of trades taking place.
Not only was Robinhood’s business at stake, so was that of its clearing house, the Depository Trust and Clearing Corporation, which required an additional $3 billion in collateral from Robinhood to cover its trades. Clearinghouses don’t like to be caught short.
Some Robinhood traders may have been upset by the momentum-killing actions, but, as finance professor and former institutional investor Ryan Z. Farley told Financial Planning, “At the end of the day, money speaks louder than reputation.”
Regulators May Get Involved
If a hedge fund created as much disruption to the markets as WallStreetBets traders did, regulators would have undoubtedly stepped in. But WallStreetBets is an unregulated forum. For better or worse, that may change.
Lawmakers as disparate in their political views as socialist U.S. Representative Alexandria Ocasio-Cortez (AOC) and conservative U.S. Senator Ted Cruz came out on the side of small investors and criticized Robinhood for its actions.
Hearings were announced by oversight committees in both the Senate and the House. Allison Herren Lee, the Securities and Exchange Commission’s acting chair, said the commission is “actively monitoring” the situation and has vowed to root out any wrongdoing, while top financial regulators met with the Treasury Department.
Will they come down on the side of Robinhood and its clearinghouse, or will they come down on the side of small investors, many of whom became much less small trading on Robinhood based on information from WallStreetBets?
According to The Wall Street Journal, “Barring evidence that people were trying to manipulate the market, regulators may not have much to do. One of the core principles of market regulation in the U.S. is transparency — give investors information and let them decide. The GameStop drama was nothing if not transparent.”