Retail Investors Put the Squeeze on Hedge Funds

A note on how shorting works

Funds that “short” stocks borrow shares that they think will decline, sell those shares and then (ideally) pocket the difference when they buy them back at a lower price. Short sellers often target stocks with deteriorating business fundamentals — GameStop’s revenue declined sharply in Q3, and AMC’s business has struggled with moviegoing being hit hard by the pandemic. 

If short sellers get these bets wrong, and the stocks actually appreciate in value, it creates what is known as a “short squeeze.” In a short squeeze, short sellers are forced to cover their positions by buying more shares, which in turn pushes up the stock price even further. The small investors who ganged up in GameStop shares aimed, successfully, to create a “short squeeze” for big Wall Street investors.

The gains that were generated in this recent rally were eye-popping: Gamestop shares surged around 1700 percent for the month through January 27, and movie theater chain AMC saw its shares jump 300 percent in a day on Wednesday. However, the exuberant rise of these stocks at the hands of small investors has been short-lived. Trading platforms such as Robinhood, Schwab and TD Ameritrade all cut trading in GameStop, and the stock fell more than 40 percent on January 28.

Messages we can glean

There are several messages we can glean from the short-term volatility in a small number of stocks in recent weeks.

1. Whether it is the advent of social media, boredom born of the work-from-home environment of the pandemic, a general feeling of disenchantment as wealth inequality in the U.S. worsens by the day or the ability to communicate instantly on mobile devices, large groups of people simultaneously acting in a concerted fashion is a new phenomenon that we should probably just get used to. This will manifest in destructive ways, such as the riots at the Capitol on January 6^th and positive ways, like crowdfunding great ideas that struggle to gain traditional investment dollars. As is always the case with change, we will need to discourage and penalize the former and embrace the latter.
2. Seeking to influence prices for purpose and profit dates back to the beginning of recorded history. This act has made many wealthy and just as many poor; it has caused wars and toppled tyrants. At times it has been patently criminal, but that is unclear in the current circumstances. In this case, as is usual, there will be winners and losers which will include short-sellers and many of the lemmings that run off the cliff after the herd. If there is actual illegal manipulation those bad actors should be brought to justice and prosecuted to the full extent of the law.
3. Shed no tears for the losers. Those that engage in short-selling so-called hedge funds understand the risks and are no strangers to encouraging their sought-after result of a precipitous decline in the price of shares of companies they are shorting. For those “retail” investors who purchased shares of companies with virtually no earnings at PE’s that can’t be calculated, ignoring any notion of fundamentals, welcome to adulthood and the stock market. Hopefully the message sent to Wall Street fat cats will be worth the losses many will incur, but more importantly perhaps some will have moved one step further on the path to enlightenment. Unfortunately, there are likely to be many for whom the lesson will be more expensive than they can afford.
4. While this too shall pass, perhaps there will be repercussions. Most manias do fade over time, but this one may have some staying power. The Occupy Wall Street movement lasted for several months and required sleeping in a park as winter began to creep into New York City. The tech bubble took several years to unfold and the Holland tulip mania of the mid-1600s occurred over about three years. This most recent phenomenon is much easier to sustain in the new world. Nevertheless, we could see changes in regulation to prevent this behavior in the future, although it is difficult to say what form that might take given we may just be witnessing crowd action, not illegal manipulation. There is also some short-term havoc in index creation as GameStop, as of the close on 1/27/21, rocketed to be the second-largest holding in the Russell 2000 Index, meaning that a purchaser of the index on 1/28 might experience a painful result if repricing occurred shortly thereafter. It is also important to note that it is unlikely this price volatility would influence larger more widely held and traded stocks.

In the words of the late great Gilda Radner’s SNL character Roseanne Roseannadanna: “It just goes to show you, it’s always something – if it’s not one thing, it’s another.”