By now, most of us have heard plenty about the frenzy going on around GameStop (ticker GME), a brick-and-mortar video game retailer. For quick background, GameStop is not in a good financial position and hasn’t been for some time. Their business model is based around retail malls selling a product that is rapidly becoming completely digital. Their stock has reflected this reality and their resulting financial position for quite some time. Until now. Suddenly, over the course of about one week, GME has surged from less than $20 per share to over $400 per share at one point. Many investors and news outlets are taking notice, trying to figure out what’s going on and if they can get in on the action.

At its core, this is a standoff between hedge fund managers and an internet mob (as if we needed any more of that in our lives). This is not a rational analysis of GME as an investment. At the center of the frenzy are “naked short-sellers.” These are speculators who borrow a stock and then sell it with the promise to replace it at some point in the future. If the stock drops in value over that time, they pocket the difference. This is one of the riskiest gambles in security markets, as theoretically, the losses can be unlimited while the gains are capped (a stock can only go to $0).

Let’s paint the picture: Imagine you borrow a stock and, as with any borrowing, you have to put up collateral. You then sell that borrowed stock at $10 per share, expecting it to drop in price. But suddenly, that stock goes the opposite direction and rises to $200 per share, or $500 per share, or even higher. You are forced to buy it back at that price to repay the lender for their stock you already sold. Additionally, as the price moves against you, you need to keep putting up more and more collateral, so your short position doesn’t get closed out by the lender, who is increasingly concerned they won’t get their stock back.

Short selling happens frequently in the market, with little fanfare. This time, however, the short sellers of GameStop ran afoul with one of the stranger places on the internet. “WallStreetBets” (WSB) is a Reddit forum mainly consisting of younger people gambling money in the stock market and then posting their losses, which are often astronomical, or their gains, which also are occasionally astronomical. Think of it like an internet forum for amateur stock speculators, but with a very, very strange culture. Most of the users (and there are millions of them) don’t even fully understand what they’re doing or how markets operate. Tech apps like Robinhood allow them to trade small amounts with very low barriers to entry.

The GameStop story all started when one WSB user, who had been holding positions in GME for a couple of years, actually started making money. The stock saw a small bump after positive news about the Board of Directors. After years of nothing, suddenly that user started posting impressive, if not unheard of, returns. However, it snowballed. More forum users wanted in on the action and began piling on the position. Next came the critical error; a few of the fund managers shorting the position took notice and arrogantly dismissed the forum.

Now, if you have ever witnessed the power of angry internet users before, you can guess what happened next. It was Cancel Culture for stock markets. The hedge funds were in the crosshairs and they were caught unprepared. Realizing that GME was shorted over 140% at the time, all the WSB users had to do was blindly buy up as much as they could afford and not lose their nerve and sell. Eventually, the hedge funds would be forced to close out their short positions and buy back the stocks at higher and higher valuations, driving the price up even more. A classic Short Squeeze. The question now is who will blink first? Hedge funds can either cut their losses or continue to borrow money and re-up their short-sells, and the internet mob can collapse and panic sell or continue to relentlessly buy up the stock with little consideration for the endgame.

Short Squeeze

What was once a small battle on the internet has reached critical mass. Billionaires and politicians are tweeting about it, the SEC is supposedly monitoring the sub-reddit, the trading app Robinhood shut off the ability for users to purchase more GME, only giving them the option to sell. (Suspiciously, some of the hedge funds betting against GME have direct ties to Robinhood. While there are valid reasons for trading to be restricted on a stock, this appears to possibly be market manipulation and could prove to be a monumental blunder). While I don’t advise anyone to jump into this battle, we can observe and reinforce lessons that investors tend to forget over time.

GameStop: Brick and mortar in a digital world.

Lesson 1 – The Market is Efficient, Not Rational

One of the hedge fund managers lamented the “irrational” behavior of the WSB investors. He was unhappy because he ignored one of the most basic lessons of investing; the market can remain irrational longer than you can remain solvent. He was gambling and pretending like he was investing and didn’t like it when someone else gambled against him. Many hedge funds and brokers are very good at fooling people into giving them money to gamble with. They dress it up with fancy language and mathematical sounding terms, but often they are just gambling with other people’s money, trumpeting their gains, and kicking their losses under the rug. When they lose, they blame it on the irrational behavior of other people.

The market is efficient, which means it aggregates information into its pricing more rapidly than any of us can do on an individual basis. Computer trading only makes it more efficient. That doesn’t mean the information it aggregates is always logical or rational. It aggregates sentiments like fear and greed and, in this case, spite, just as readily as earnings or balance sheets. You cannot expect to predict which direction irrational sentiments will go or when, so you should not expect to be able to predict the market. It is irrational to expect to be able to position your portfolio for unpredictable short-term movements. Do so at your own peril.

Lesson 2 – Speculation is Not Investing

This is for the most part a zero-sum game that is being played. When the dust has settled, virtually all the gains made will come at the expense of someone else. Real investing is not like that. When you invest in a company, there is a clear expectation of future income in the form of dividends or interest. You can earn a return and no one else must lose return for that to happen; that’s the beauty and power of wealth creation and capital markets.

Speculating with options or picking stocks for short-term swings is gambling. There is no expectation of future income, only the hope that you guessed correctly which direction the price will go over a meaningless time frame. Return does not come from the earnings of a company creating goods and services for people, it comes from someone else on the other side of the betting table. Once trading costs and spreads are factored in, it is a less-than-zero-sum game. Gambling when the house takes their rake. Don’t confuse that with investing.

Lesson 3 – It’s Not What You Make, But What You Keep

On paper, many of the WSB gamblers are making a lot of money. Their account statements show massive gains. However, stocks are valued based on the last trade that took place, not the next trade that will take place. The current value is not necessarily indicative of what you would get if you sold all the stock you owned right at that point. It all depends on how thinly the stock is traded. If you have an army of internet users buying shares up regardless of the price, the valuations of your holdings will reflect that. If, however, that buying interest stopped, there is no guarantee that someone will be willing to buy your shares at anything close to the last traded value. It’s a core feature of markets that many investors don’t understand; this is a negotiated market. If I want to sell my shares, someone needs to be willing to buy them from me at an agreed upon price. For most stocks this isn’t an issue because there are plenty of buyers and sellers and the stock is being treated like an investment rather than a slot machine.

If and when WSB “wins”, then what? Who’s going to be willing to buy their stock for the ridiculous price it’s been trading at once the short squeeze has run its course? Paper gains will turn to dust when they realize that there is no longer a market for their shares. It will be a rush for the bottom, and a lot of people are going to be left holding a very empty bag. Don’t put yourself in that position.

It’s important to note that this not anything new. Market bubbles and short squeezes have happened for a long time. This is essentially a short squeeze by way of “pump and dump”. My real concern is not that the market cannot handle something like this, it’s that many small-time retail investors will be on the “dump” side of that equation. Their faith in markets will be forever shattered simply because of their own ignorance. Good investing fundamentals do not change when these types of stories pop up; if anything, they are reinforced.

Nathan Twining
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