How Gamestop got caught between two sides

Happy Friday, although the days do blend together lately! The stock market is essentially flat for this first month of the year, but there’s plenty of interesting drama behind the scenes. This week stocks experienced their worst day in three months due to......GameStop?! Lots more on that below.

We do expect a lot of volatility in these first three months of the year due to daily news on stimulus (or no stimulus), vaccines, and Covid-19 cases. However, right now volatility is exacerbated by retail traders and Wall Street.

GameStop: What Happened and Why It Matters

This is a battle between short sellers – hedge funds in this case – and a new generation of traders who use Reddit and other social networking sites to share investment strategies.

Short-selling is the key to this story: Short-selling is a way to make money on stocks that decline in value. To sell ‘short’ you borrow a stock from a broker and sell it immediately at the current price, say $100. You have the $100, but you owe the broker a share of the stock.

If the price of the stock drops to $70, you ‘cover’ the short by buying a share at the cheaper price, then return the borrowed stock to the broker. You keep $30 difference in profit.
If the stock price goes up to $150, now it costs you a lot more to buy it back, and your loss will be $50.

Losses to a short seller can be unlimited because the price can go up an infinite amount. The higher the price goes, the bigger the loss. The share of stock must be returned, so the loss will get locked in at some point. (Clear Perspectives does not engage in short selling in your portfolio.)

Hedge funds chose specific companies like GameStop that seemed to be left behind by consumers or an industry and shorted their stock to profit from their assumed decline. This is controversial because hedge fund managers have been accused of making misleading statements about companies to drive their stock prices down. It can cause severe losses to owners of the company stock.

A retail trader noticed hedge funds taking a massive number of short trades against GameStop and a few other companies and publicized it on a popular investing corner of the social media site Reddit.com. Small-time traders there encouraged each other to buy GameStop stock to drive the price up and force huge losses on the hedge funds, which would be a victory for the little guy in a David vs. Goliath battle (as they see it).

Did it work? The combined purchases of small traders drove up GameStop’s (GME) price enormously. The hedge fund was forced to buy back GameStop stock at higher prices, forcing prices up even more! Hedge funds have lost billions on their short sales so far.

GME price in the month of January:

This process is called a short squeeze, and it’s happened before. After Elon Musk tweeted about Tesla last year, the Tesla stock value soared from $1 billion in January to $13 billion by year-end, causing big gains for retail investors and “the largest mark-to-market loss” for short sellers that many analysts had ever seen (Motley Fool). The GameStop short squeeze is even bigger, with the potential loss for short sellers approaching $20 billion as of Friday. (CNBC)

The fallout: This week Robinhood and other daytrading platforms stopped all trades on GameStop several times, to the dismay of retail investors. One hedge fund booked a $3.75 billion loss; another may declare bankruptcy. A major financier who owned a 13% stake in GameStop may have netted $2.4 billion in profits. (Reuters) One individual investor has chosen to stay in despite having a $20 million paper profit, to the delight of those following his lead. (Wall Street Journal interview)

There is discussion of adding financial regulations, with very different schools of thought on which aspect of this situation should be more carefully regulated-- the hedge funds that may be harming businesses and small traders, the small traders putting their finances at risk, or both.

Why did this occur now?

This past year has been referred to as a ‘boredom market,’ generating interest from investors whose job was safe, but otherwise had nothing to do. Gamblers didn’t have much in the way of sports betting available. Swapping stock strategies on social media is entertaining.
Trading commissions on stocks disappeared last year, removing a barrier to entry. As you see below, the number of retail trades soared as soon as commissions fell to zero.
Smart phones have made trading instantaneous from anywhere. There are now 2.5 billion smartphones in the world, and 100,000 new brokerage accounts are added every week. Almost half of those are outside the US.

Why does it matter to me?

The highly diversified nature of your portfolio means you are unlikely to experience specific effects from the volatility of GME and other select companies except where they affect the broader market. One possible outcome, however, is that the broader market may be negatively affected by investors’ concern that hedge fund losses will turn into forced liquidation that hits all corners of the market. That could cause investors to de-risk, which would cause a pullback or correction. Essentially, unexpected things like this can shake people’s confidence.

We recommend staying the course for this first quarter, as the economy is expected to improve quite a bit by summer.

Uplifting news

When Oregon health-care workers stuck in traffic during a snowstorm were running out of time to administer 6 leftover doses of the Moderna vaccine, they went from car to car to offer the shot to drivers in the middle of the highway so as not to waste them. We cheer all our clients who are doctors, nurses and other essential workers, and we all want to do our part to keep them safe until this virus is tamed.