Investors are gaming the market

There is a war going on between retail investors and Wall Street at the moment and it involves an unlikely company, Gamestop. The computer game retailer has been struggling for years as it tried to compete with online sales and the move to digital downloads for the Playstation and Xbox. Last April, they were trading at $3.25. At time of writing (Thursday @ 10:16) they are trading at $347.51 after increasing by 134.84% yesterday. What is going on? How has this small company at the centre of a war between investors and Wall Street?

Perfect Storm

First of all, it is important to understand the circumstances for people investing at home, known as retail investors. There has been a lot of factors that has seen an increase in retail investing over the last year:

  1. Covid 19 – A lot of people have lost their jobs due to Covid and are sitting at home with nothing to do.
  2. No sports betting – When Covid struck last year, most sporting events were suspended so people had nothing to bet on. A lot of people turned to the stock market to get their thrills (more prove at how addictive betting can be).
  3. Commission free investing – Online brokerages such as Robinhood allows people to invest commission free, making it easy and cheap for people to invest in the stock market.
  4. Message boards – a lot of investors are talking on message boards, such as wallstreetbets on Reddit, where investors can co-ordinate in what investments they should make.

The short squeeze

The story of what is happening with GameStop started last September, when Ryan Cohen, an investor and owner of the online pet store, Chewy, bought a 13% stake in GameStop and took a place on the Board. He started lobbying the company to go online and become a rival to Amazon. Investors were excited by this. Wall Street saw a bloodbath. There was no way this small company was going to be able to take on Amazon and win. So they started to short the stock.

This is where we need to explain what shorting is. It involves borrowing shares for another investor for a fee and sells it immediately. When the stock falls in value, as they expect it to, they buy back the shares cheaply and return them to the owner, keeping the difference as profit. It involves a lot of risk because if the stock rises in price, there is no ceiling on how much it can rise to whereas if it falls, the furthest it can fall to is zero.

When the price rises, if a short seller wants to close their position, they have to buy back the shares at a higher price and take the hit. With GameStop, retail investors have been buying shares, driving up the price. This has been coordinated on online forums and built into a frenzy. Short sellers had to join in the buying to buy back the borrowed shares, driving up the share price even further. This is known as a “short squeeze”. Added to that, investors were told to tell their brokers not to allow their shares to be used in short selling. Making less shares available drove up the share price further.

One hedge fund company, Melvin Capital Management, lost $3.75 billion by shorting GameStop. Other short sellers had to exit the investment suffering massive losses.

What next?

This isn’t over. Companies like Blackberry are up 280% this year. US cinema chain AMC is up 840%. We saw something similar with bankrupt Hertz last year. It is clear that these companies are not the future, it doesn’t make sense that their share price is rising by so much.

These are in a bubble and the bigger the bubble, the bigger the pop. Markets are efficient, especially over the long term. The share price of these companies will come back to reflect the real value of the company based on future earnings. If you are left holding stock in these companies when the bubble bursts, the retail investor will lose everything. And where will they be then? The big Wall Street firms will still be around. Melvin Capital got a $2.75 billion injection of liquidity by its backers. No one will bail out the small investor who lost everything.

Don’t get caught up in the excitement of it all. Keep your investments in quality companies and look to make money over the long term.