Even those who don't follow financial news have been fascinated in recent days by the saga of shares in GameStop (ticker: GME), a troubled videogame retailer. To simplify what happened, several mostly non-professional stock traders banded together, using an internet message board called Reddit, to push the stock price higher. The goal was to force some hedge funds that had taken a short position on the shares to cover in a hurry.
Since a picture is worth a thousand words, this is the chart (credit: TradingView) for the stock since early November:
The shares were trading in the low to high teens until the 2nd week of January, when the stock price started rising and reached a high of just under $400 at the end of the month. Since then, it has collapsed back to just above $50 at the close on February 9th—a nearly 90% drop. Because a lot has been said already on what happened, we thought we would only address the questions that matter for your portfolio.
But first, let's clarify the concept of shorting stocks: one can profit from a declining stock price by borrowing shares from a broker, selling them at the prevailing market price (this is the “short” part), and repurchasing them later at a lower price before returning them to the broker. It is buying low and selling high, but with a reversed timeline.
To explain why GameStop's stock price surged by 2,500%, one needs to understand that a "short squeeze" took place. This typically occurs when the number of shares sold short represents a significant multiple of the average daily trading volume. For instance, imagine that a hedge fund is short 250,000 shares of GameStop, but the stock trades 4,000 shares a day on average. It would take the fund more than 60 days to buy back its shares. If the stock price starts rising quickly, paper losses mount, and as the fund buys back shares, the price spirals quickly even higher.
Later, the short squeeze spread to other stocks that were illiquid and heavily shorted such as the movie theatre chain AMC Entertainment. On January 29th, we warned on Facebook and Twitter that individuals piling into these hot stocks risked big losses when the euphoria fades and cautioned long-term investors to stay away.
Not surprisingly, some of you called us and asked whether it mattered to your portfolio and whether you should be worried about it.
Is This Type of Unusual Volatility New?
No. Day-trading, short-squeezes, and the financial tools that go with them, such as stock options or margin loans, have been available for decades. Such volatility tends to ebb and flow and can be a sign of overall increased speculative activity, especially from less sophisticated participants.
Should I Be Worried About Stock Market Manipulation in My Portfolio?
No. First, the stocks whose price is more likely to be manipulated are very small and illiquid, i.e., only a small number of shares trade every day. Although some of the funds you own may hold such shares, your portfolio is diversified across hundreds of companies. No matter how volatile, any one stock cannot have a crippling impact on your overall portfolio. There's also no chance that you might get rich by owning the next GameStop, sorry!
Is Wall Street Rigged Against Small Investors?
Yes… and no. There are some dark corners of the stock market where professionals have an advantage: short selling, trading penny stocks, bankruptcies, and options, to name a few. It is our opinion that only the most sophisticated investors should participate in these areas. Reassuringly, most Americans do not: instead, they own stocks through funds held in their retirement accounts or pension. They are very unlikely to be the victim of such market manipulation. They will endure the overall market volatility but should benefit over time from stocks’ long-term growth potential.
Are Regulators Doing Their Job?
Yes. There have been plenty of bi-partisan calls from politicians "to do something." Some were poorly informed, as some actions taken by brokerage firms were driven by regulations and capital requirements intended to protect investors. Specific activities do have the potential to be illegal—spreading misinformation, or "pump and dump" schemes, for instance—but a 10-fold increase in a stock price is not in itself a sign of something nefarious. Our experience is that regulators already have the tools to monitor, investigate and prosecute bad actors.
Do Short Sellers Serve a Constructive Purpose in Capital Markets?
Yes. Although we will not shed any tears for those hedge-funds that lost millions in the GameStop saga, we believe that short-sellers have a useful role to play overall. First, they have historically uncovered many accounting frauds at publicly traded companies over time, the most famous examples of which were Enron or Wirecard more recently. Short selling is also a useful tool in improving market efficiency during certain corporate events, such as mergers, acquisitions, or spin-offs. Very few CEOs of publicly-traded companies will agree with us but, overall, we think short-sellers help keep management teams honest in the same way that a free press helps keep our politicians honest.
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