You Asked, So We’ll Answer
FOQ: What’s going on with GameStop stock?
Short: It’s a frenzied mania.
Long: For a moment, it seemed that GameStop’s stock just couldn’t be stopped, despite the fact that the company has seen five new CEOs since 2017, was on the brink of bankruptcy earlier this year when its stock hit a low of $2.57 in April 2020, and has seen profits steadily decline over recent years. GameStop shares closed Friday (1/22) at $65.01 and proceeded to jump to $144.47 by mid-morning Monday (1/25). It was the single most traded name in the U.S. stock market on Tuesday (1/26) as it continued to soar into afterhours. On the morning of Thursday (1/28) during pre-market trading, it hit its high of $514.99, before dropping to about $100 at the time of this writing yesterday. This all stemmed from retail traders and an army of individuals from Reddit’s “WallStreetBets” forum clashing with short sellers.
Recently, we’ve seen similar activity with other stocks like AMC, Blackberry and Bed Bath & Beyond.
FOQ: What’s “short selling”?
Short: Sell then buy. Weird, we know.
Long: When an investor goes short a stock, they are making a bet that the stock will decline in price. They borrow shares of the stock and immediately sell them, hoping that they can buy later at a lower price, return the borrowed shares to the original lender, and pocket the difference. A short squeeze occurs when a stock sharply jumps higher (in this case GameStop), forcing traders who had bet that its price would fall to buy it in order to forestall even greater losses. These investors who were short are essentially being “squeezed” out of their short position as they cut their losses.
FOQ: Should we get in on this?
Short: Absolutely not.
Long: If you want excitement, we suggest a casino. At least when you lose money there, you’ll still get free drinks! All jokes aside, there are a few lessons we can take from this insanity:
- Prices are fair: The global financial markets process millions of trades worth hundreds of billions of dollars each day. These trades reflect the viewpoints of buyers and sellers who are voluntarily transacting at current prices and putting their capital to work. Using these trades as inputs, the market functions as a powerful information-processing mechanism, aggregating vast amounts of information into prices and driving them toward fair value. Investors who actively trade based on new information, expectations, tastes, preferences, and other considerations are still setting prices. The competition and voluntary exchange among those market participants are the mechanisms that make those prices fair.
Given that stock prices, like GameStop’s, rise and fall based on a multiplicity of influences, how should investors interpret and act on these signals? We believe that trying to untangle all these influences and profit from perceived mispricing is not possible in a systematic and scalable manner.
- Stock prices are a derivative of supply and demand: For every buyer of a stock there is a seller, and vice versa. The collective supply and demand of all market participants sets the price on stocks and bonds. When there is a short squeeze, short sellers rush to buy more shares as a way to cover their short position. This drives up demand and reduces the supply, resulting in higher prices. The basic economic principle of supply and demand being a driving force behind stock prices is playing out with GameStop and many other stocks that are being short squeezed.
- Shorting stocks carries a lot of risk: Because there is no limit on how high a stock can go, the market risk you face as a short seller is potentially unlimited. A group of traders on Reddit effectively orchestrated one of the biggest short squeezes of all-time, and in the process forced a prominent hedge fund to seek close to $3 billion in outside capital to shore up its finances. Put simply, a message board took down a hedge fund that was short GameStop. Investors should be aware of the risk associated with shorting stocks before entering positions.
- Security lending fees are a short-term driver of stock returns: Although shorts are being squeezed out of positions, new bearish traders continue to bet against GameStop. On Tuesday, January 26th the cost-to-borrow fee was 30.58%, an unusually high figure. For comparison purposes, Tesla, the stock with the most short interest, had a borrowing fee of 0.30%. The stock with the 2nd most short interest, Apple, also had a borrowing fee of 0.30%.
Many investors may be tempted to get involved with the newest investment fad, but it’s important to consider the risks involved with chasing that next shiny object. We’ve seen this game play out before, and often it doesn’t end well. There have been books written and movies produced to tell the story of the downfall of many of these companies, and they don’t have a fairy-tale ending. There are no short cuts to building wealth and investors should remember that a long-term, disciplined investment approach based on robust research and implementation may be the most reliable path to success in investing.
John, Bill, Mark & Melanie