Mob Rule Strikes Wall Street - The GameStop Saga
As was demonstrated on January 6 at our nation’s capital, a mob is capable of many things, but what happens when the mob hits Wall Street? If you followed the trading story surrounding GameStop, you witnessed firsthand how a mob of buyers can swiftly consume a publicly-traded stock.
The story that’s been told is framed as the little guys (and gals)—the mob—going up against Wall Street titans—the hedge funds—who were heavily short GameStop shares. The mob, through the use of social media and old school chat rooms on sites like Reddit, orchestrated a short squeeze that brought the power elites to their knees.
What we are seeing is a modern-day David and Goliath, but instead of striking back with strength, Goliath (the power elites) simply changed the rules of the game. When brokerage firm upstart Robinhood halted the mob by placing trading restrictions on GameStop shares, a fury of outrage followed.
It is a fascinating story, one that I have seen play out before. For years I’ve watched short-sellers destroy stocks and sometimes whole companies, often with rumors lacking facts. Unlike some in my profession, I am not opposed to short-selling. Short sellers play a critical role in the healthy functioning of markets.
However, in my opinion, the rules applied to short-sellers have always been looser than the rules applied to investors who simply buy stocks. The perception I have on short selling is akin to the Wild West when a sheriff might look the other way.
It seems as if short-sellers get away with things that buyers of stocks cannot. The GameStop story spotlights this dichotomy, but what has happened is no surprise to me.
What is short-selling?
Without going into unnecessary details, short selling involves borrowing shares of stock sold on the open market. The short seller profits when the stock price goes down and the shares can be repurchased at a lower price.
Critical to understanding a short sale is to know that shorting a stock involves leverage. That means if a trade goes against the short (the stock’s price rises), the short seller must either pony up more collateral to meet margin requirements, or the stock must be repurchased to close the short position.
When a stock is shorted and the stock’s price starts rising, the shorts must do something to either preserve their position (add collateral) or exit their position (buy back the stock).
The term “short squeeze” refers to a situation when a stock that is rising in price is pushed higher as short-sellers are forced to buy back shares. That additional buying exacerbates the upward move in the stock’s price and, with it, the losses to the short seller.
A short squeeze is the short investor’s worse nightmare.
I hesitate to make any sweeping conclusions regarding the GameStop story. Instead, I can summarize some of the facts as we know them now.
GameStop is a retailer of video games. Like most retailers, the company has struggled during the pandemic. Even before the pandemic, the company was at the epicenter of a debate over brick-and-mortar retail versus online retail and physical delivery of games versus online downloads.
Several large, influential hedge funds bet that GameStop could not survive, so they shorted the stock. According to Yahoo Finance, some institutions like Citron Research used their exposure in the media to forcefully express their negative outlook for the company.
There is nothing new to the GameStop story, as many stocks in the market are shorted all the time.
What was new was a large group of smaller investors, through social media, identified these heavily shorted stocks, including GameStop, and started a coordinated attack. This mob of investors knew that significant buying interest in these stocks could set in motion a short squeeze.
Also new in this story was what the brokerage firms did. They intervened in a way that appeared to protect the hedge funds. These brokerage firms prohibited buying of GameStop for one day. This restriction was unusual because it only applied to purchases (not sales).
In other words, trading in the stock was not halted entirely as would normally be the case; only buying was prohibited. This prevented the buyers from continuing the “squeeze.”
When the brokerage firms implemented this new and supposedly temporary policy, it set off a firestorm of complaints that trading rules were changed to protect the hedge funds. I find it very hard to see a defense for what happened, but what the brokerage firms did was not illegal.
This could be a seminal event in the history of Wall Street. Indeed, the short-selling game will be changed forever if the shorts are at risk of this sort of run on their positions by the mob. If smaller investors become emboldened by their success, they will always be a risk to the shorts.
Previously mentioned Citron Research already announced they are getting out of the short-selling business entirely.
The issue going forward, however, will boil down to “coordination” amongst investors. Coordinated trading by investors runs afoul of Wall Street’s current rules regulated by the Securities Exchange Commission. Small investors are at risk of running afoul of the rules because their actions are documented on social media.
As an aside, further strengthening the case that there has been an effort to protect the hedge funds, social media companies shut down many of the venues where these small investors were chatting. Nonetheless, as “what happened” is discussed, I believe what was said on these social media platforms will become the story's focus (more on why in a moment).
Less likely to become a part of the story is how independent hedge funds are often found with similar short positions. Is that somehow coordinated? Evidence of wrongdoing by hedge funds rarely, if ever, comes to light. It has always struck me how it’s possible that shorts simultaneously reach the same investment opinion on a company at precisely the same moment in time.
I am decidedly not a conspiracy theorist, and I have little knowledge of what has transpired this past week beyond what you have seen and read in the financial press. I did find myself (whether right or wrong) cheering for the small investors, but that is just my predisposition. Minnesotans (like me) tend to favor underdogs, which I attribute to lifetimes spent cheering for the Minnesota Vikings.
What we’ll see in the coming weeks will be a test for the Washington politicians. Hedge fund managers are significant contributors to both political parties. Despite a seemingly straightforward opportunity for politicians to demonstrate support for the “little guy,” there will be money at risk if they go too far in attempting to punish the power elites.
As is often seen, Washington's narratives on events tend to morph in weird ways when campaign contributions are involved. You may be surprised by how politicians align on this story, especially surprised by those who typically wrap themselves in the banner of “protecting the little guy.” How individual politicians align will speak volumes on where they get their funding.
I would reiterate that I do not see the world through the lens of conspiracy; my training is in economic theory, which is sufficient to know that the money will matter as this story evolves.
I just hope the small investors get a fair shake. Their effort will likely impose a little more discipline to shorting. I see that as a good thing for the markets.
I am always in favor of leveling the playing field. All investors should have the same opportunity, whether they are the mob or the power elite. Each of us should be able to judge stocks (buying or selling) and be given an equal opportunity to invest.
Everyone benefits from rules that are conceived fairly and applied equally.
At Nicollet, we buy stocks for our clients. We are not short-sellers. We believe there is sufficient money to be made owning successful companies, and we stick to that type of investing.
However, in doing our research, we uncover companies we find over-valued or at risk of complete failure. We just don’t act on those conclusions. We find satisfaction in investing in success and avoid piling on to someone’s failure. Call us old school, but we are who we are.