The stock price of used-game retailer GameStop (GME) has increased by 1,745% over the past several weeks in a massive short-squeeze. But it wasn't the only company whose share price skyrocketed. Just on Wednesday (1/27/21), AMC Entertainment (+301%), Blockbuster (+120%), and Express (+214%) all saw their values go vertical. Amid all the craziness and barrage of news stories, it can be helpful to take a step back to examine what exactly is happening to cause these surges and the broader implications it will all have for the stock market in general.
What is Short Selling?
When people invest in a stock, they purchase the shares in anticipation that the price will increase over time. They are said to 'long' the stock. However, if investors believe the stock price is overvalued and is likely to decline, it is also possible to 'short' the stock. Shorting the stock is when an investor borrows shares of the company and then immediately sells them on the market with the hopes of being able to repurchase the shares in the future at a much lower price. Short selling can be profitable, but it is also extremely risky. With a long position in a stock, the potential loss is limited to the value invested. Short-sellers, however, theoretically face infinite losses if the value of the stock increases rather than decreases.
While short-sellers do not have the best reputation (they have been referred to as hyenas, jackals, vermin, vultures, and "un-American"), studies have shown that they provide a valuable service. Their presence improves market efficiency, either by bringing attention to stocks that have advanced beyond their intrinsic value or by uncovering questionable or even downright illegal practices (anyone remember Luckin Coffee?).
The Short Squeeze
Several hedge funds (most notably Melvin Capital) had taken large short positions on several companies, believing their share prices would fall. However, members of the multi-million user Reddit forum r/WallStreetBets, devised a plan to begin buying shares of these most-shorted companies to push their prices higher. This ultimately forced the hedge fund short-sellers and options market makers to buy the stock themselves to close out their short positions losing massive sums of money. This phenomenon is known as a 'short squeeze' and rocketed several companies' prices to astronomical highs.
The flurry of forced buying created a feedback loop that pushed GameStop, for example, up over 1,000% in just two weeks. The short sellers (namely hedge funds) have lost billions of dollars in the process. Melvin Capital, a vocal short-seller of GameStop, required a cash infusion of $3 billion from its owners Citadel and Point72 to shore up its balance sheet. Calls for additional bailouts from the government have also begun to emerge.
Implications for the Market and Beyond
Apart from countless news stories and media hysteria, there are a few important implications from this massive short squeeze. First, the large 2.6% decline in the Dow Jones on Wednesday can be attributed, in part, to the short-selling. As hedge funds exited their short positions by buying back shares, they were simultaneously forced to sell their positions in other companies to fund the transaction. This put an enormous amount of short-term downward pressure on the market. While it was the largest single-day decline since October, the market largely rebounded the next day.
However, more importantly, and with longer-lasting implications, is government regulators' response and the discount brokerage platforms on which many of these shares were purchased. The coordination by investors on r/WallStreetBets raises questions as to whether or not the actions of many involved violated SEC' pump and dump' rules. While initial losers from the short squeeze were the hedge funds, many individual investors holding shares of vastly overvalued companies also stand to lose a tremendous amount of money when the price crashes back down, all but ensured how decoupled from the companies' fundamentals the stock prices now are.
Perhaps the most long-lasting impact will be the degrading of trust between what are perceived to be small individual investors and large institutional investment firms. Online discount brokerage platforms like Robinhood marketed themselves as investment tools for 'the little guy.' However, their decision to halt trading on many of the companies affected by the short squeeze was viewed as the platform aligning with the hedge funds and against the individual in the investment battle. Similarly, any crackdown on r/WallStreetBets or other similar investment forums to prevent something similar will likely be viewed as further proof the elites against the regular guy rig the system.
The GameStop short squeeze is a fascinating tale of markets' unpredictability and the vulnerability of many highly leveraged investment firms. While many view this as a victory for the 'little guy,' the story remains unfinished. Many individual investors stand to lose out considerably if the share price falls back to realistic valuations. Investors that began buying shares early on are in a position to make a lot of money; however, those who joined later and that purchased stock after the price soared may be in trouble.
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Please remember that past performance may not be indicative of future results. Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.
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