Understanding the mother of all short squeezes: GameStop Corp.

Texas-based videogame retailer GameStop Corp.’s (GME) stocks soared this week from $76.79 on Monday to $147.98 on Tuesday and $347.51 on Wednesday. The shares began 2021 at $18.84. GME’s 1,745% gain in the space of a month did not reflect anything as substantial as a positive earnings surprise or a technological breakthrough. GameStop is a national retail store chain that resells video-games. Anyone can download from home the same games in high-resolution from the Internet in seconds, possibly through discounted bundled subscriptions. GameStop is equivalent to Blockbuster in the age of Netflix. The company’s financials reflect that: annual revenues are down more than -40% since 2015, and net earnings swung from $390m to a loss of -$130m over the same period.

Hedge funds Melvin Capital ($14bn in assets) and Citron Research had fastened on GameStop as a short sale. That trading decision hardly seemed reckless, judging by the company’s fundamentals. The short sellers had not reckoned, however, with the growing market power of retail investors fired up by online social forums on the website Reddit. Encouraged by claims such as the one that GameStop and the BlackBerry Limited were going “to the [expletive deleted] moon,” these stock enthusiasts exulted in sticking it to the big players.

In GameStop’s case, the new-style market operators exploited the fact that GME short positions totaled 136% of all shares outstanding. (This can occur if short-sellers who borrow stock then re-lend it to other short sellers.) The online instigators fired-up followers, many of them relatively new to trading, further squeezed the shorts through frenetic activity in call options. When a company’s shares are heavily shorted, an up-move in prices can morph into a cascade of short-covering buy orders (often forced by the brokers lending the stocks) that further fuel a vertical rally. This is what is called a “short squeeze.” GameStop will be studied in history as the mother of all short squeezes.

What lessons can we draw from this bizarre episode?

  • Even the sharpest minds on Wall Street are fallible. The little guys indeed took a victory lap when Citron Research closed out most of its position at a 100% loss. Melvin Capital required a $2.75 billion capital rescue from two other financial firms and amassed billion of losses in a few weeks. All investors must approach investing with humbleness, control their greed, and diversify their portfolios, knowing that there is always a chance that a trade may not work.

  • Retail investors may erroneously feel emboldened by their recent speculative trading successes (options, short squeezes, profitless and bankrupt companies, SPACs, IPOs). History unequivocally demonstrates that if something can’t work, ultimately it won’t. When the music stops, it will be an extremely grim awakening for many new “investment tourists.”

  • Extreme disconnects between company fundamentals and stock prices, like the GameStop affair, can create significant, broad market turmoil elsewhere. When trades go bad for large investors, not only must they unwind the souring positions but they are often forced to liquidate their jewels in the crown to meet their brokers’ and investors’ requests. Large forced liquidations of high-quality positions are usually the ones that create seismic tremors in the markets.

There is some good news too, though. The novel speculative fever has not infected the entire market. Hard though it may be to believe in the context of record-setting stock averages, the S&P 500 Value Index is slightly below its level of one year ago. Within the Growth Index as well there are many reasonably priced stocks. Their upside is not premised on a blizzard of retail options orders that have no effect on the prices of underlying shares under ordinary conditions.

In short, investors who have acquired immunity to the present, localized outbreak of market hysteria still have plenty of opportunities to make sound, evidence-based investments.

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