It has been portrayed as the revenge of the underdog, of Main Street getting one over on Wall Street. The saga of Gamestop, a video game retailer, has been all over the news in recent days, thanks to its incredible share price surge.
As the company’s annual report makes clear, the firm had been struggling. In the five years to January 31, 2020, its share price fell 85%, while the S&P 500 rose 79% over the same period. Its sales were down 28% over that period and the losses from continuing operations in the two most recent years totalled around $1.26bn. The company launched a “multi-year transformation initiative” in May 2019 that involved a switch into e-commerce but the pandemic added another problem; third quarter results showed a 30% decline in net sales compared with the previous year.
All the bad news could be in the price, of course, and stockmarket history is full of struggling companies that rebounded. But Gamestop’s remarkable rebound is down to something different — “a short squeeze”. Some hedge funds had speculated that the company’s shares would fall even further. They has thus “sold short”, a complex process that involves borrowing shares from another investor and selling them. If the bet works, they buy back the shares at a lower price, return them to the lender and pocket the profit.
In this case, the bet didn’t work. A group of retail investors who communicated through a reddit channel piled into the stock. Some of them bought the shares directly; others used call options, an instrument that gives investors the right (but not the obligation) to buy an asset at a set price. If the share price doesn’t reach that level, the option will expire worthless, but if it goes beyond the target price, the investor can cash in. It is a speculative bet.
The effect has been astonishing. From less than $20 on January 12, the share price has reached as high as $413. The shorts have been forced into retreat, losing billions of dollars. The company has reached a valuation of more than $20bn, striking for a company with the record outlined above (annual sales in 2019 were just $6.5bn, for example).
So is this just a jolly jape? Few will shed tears for hedge funds. Short-selling seems rather like wishing people bad luck; not quite cricket, as we say in Britain. But short-sellers are not the Wall Street establishment; far from it. “When I find a short-seller, I want to tear his heart out and eat it while he’s still alive” said Dick Fuld, the former head of Lehman Brothers. Short-sellers have proved good at sniffing out frauds and anyone who has seen “The Big Short” will know that they were perceptive critics of the housing bubble. It is a difficult game to play. The market tends to rise over the long run; companies hate short-sellers and try to frustrate them; at times of crisis (when the tactic is most likely to work), regulators can ban the practice.
Joining a bandwagon to buy a fast-rising stock is a dangerous business. There is an old stock market saying that “a tip is a tap”. It means that someone who is advising others to buy a security is doing so as a way of selling their own holding. It is, indeed, possible that some hedge funds helped to drive the Gamestop price up, because they were aware of the problems of the short-sellers.
This is a time-honoured practice. In the 1920s, there was the famous example of the “radio pool” in which “a group of highly placed Wall Streeters drove up the price of RCA stock, took their gains, and then left the other investors with plunging prices”. Joseph Kennedy, patriarch of the clan (who was later chairman of the SEC), used the practice of “wash sales” — “making sales and purchases from fictitious accounts to create the illusion of genuine activity and lure other investors into a market”.
Anyone who joined the Gamestop game early on is sitting on massive paper profits. But paper profits only count when you sell. And that requires a steady supply of new buyers. By definition, everyone can’t get out at the top. Given that the underlying value of Gamestop shares is probably nothing like $300-$400, that could mean big losses. And the retail investors who lose out will be unable to blame short-sellers for their problems.
What is slightly odd about this is that politicians like Alexandra Ocasio-Cortez have piled into the issue. She was upset that some brokers restricted the ability of investors to buy Gamestop shares earlier this week. But those restrictions were explained by the need for Robinhood to post collateral with the clearing houses on such high trading volumes; a requirement that stems from the Dodd-Frank Act, designed to curb Wall Street excesses. Does Ms Ocasio-Cortez want her constituents to make risky bets on the market? Seems odd.
The short squeeze is not confined to Gamestop. Some of the best performing shares this year have been the most shorted stocks and the ones with the weakest balance sheets. But that raises a couple of questions. The point of a stockmarket is that investors allocate capital to the best companies; that doesn’t seem to be happening. And regulators (including central banks) often take a relaxed view of equity gyrations on the grounds that the market is “efficient”; that case seems harder to make.
Beware the madness of crowds; who knows where they will stampede next? There is an old story about an oil prospector who dies and arrives at the gates of heaven. St Peter sadly informs him that the quota for former oil prospectors is full. The wildcatter says “I’ll sort that out” and yells through the pearly gates “Oil found in hell”. Pretty soon, men rush out of the gates and head below. St Peter smiles and opens the gate to admit the prospector. “No thanks” the latter replies “I want to check out whether that hell rumour is true”.