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There was a lot of very important financial news this week. Apple, Microsoft, and Tesla announced their earnings, the Fed held a meeting, and the first estimate of fourth quarter U.S. GDP was released. But all of that important information was overshadowed by the trading activity of retail investors on Reddit. The GameStop story has transcended the pages of the Wall Street Journal and has captured the attention of many who are not usually interested in such things. Unfortunately, it has also attracted the attention of the SEC and Congress.

GameStop flag flying adjacent to NYSE flag

How We Got Here

GameStop is a brick-and-mortar video game retailer that went public in 2002.  The company showed strong earnings growth throughout the ‘00s, riding the growing popularity of video games. But like many other specialty retailers, they began to experience declines in growth as competitors like Walmart and Amazon grew in prominence. Improved download speeds also led to the ability to directly purchase games online instead of having to visit a store.  These trends had a direct impact on GameStop’s results and the stock price reflected the poor performance, dropping from $58 per share in late 2013 down to a low of about $3 by April of 2020. Betting against GameStop became a popular trade with large hedge funds during this period, and it was one of the most shorted stocks in the U.S. equity market at the beginning of 2020.

Which brings us to the rebellion. Shares of GameStop had already been a popular topic on stock-trading message boards for most of 2020, but had traded virtually flat from May through the end of August. On August 31st, a large investor disclosed that they had purchased a significant stake in the company and the shares rose 24%. Shortly afterwards, a poster on a Reddit forum called WallStreetBets pointed out the level of short interest in the stock and suggested that many hedge funds had probably lost a lot of money on their short positions.  This morphed into a rallying cry against hedge funds and Wall Street in general. Posters began to realize that if they bought enough shares of stock, they could make the price go up and cause losses in hedge fund portfolios that were betting on a decline in GameStop shares. Their mantra quickly became “Never sell. Never surrender” and they began to use leverage and options contracts to put upward pressure on the stock.

By late January it had become clear that the plan was having an impact. The stock of GameStop rose 125% the first three weeks in January. The Wall Street Journal reported that a large hedge fund called Melvin Capital Management, which previously disclosed a large short position in GameStop, was down 15% the first three weeks in January. The perceived success of ‘the plan’ beget even more buying from retail investors. Many hedge funds that were previously short the stock have also had to buy back the stock to get out of their positions which has led to additional sharp increases in the price. Shares of GameStop are now up about 1600% this year despite no major changes in the underlying business, and the stock-trading message boards have begun to try the same strategy on other highly shorted stocks like AMC Entertainment and Blackberry.

What It Means for Investors

The meteoric rise in the price of GameStop this week was accompanied by a decline of about 3% in the S&P 500 Index over the same period. That begs the question of whether this activity was the cause of the decline in the broader market. There is a logical argument that it might have had some impact but it is tough to know for sure. Many large hedge funds that have short positions were probably rethinking the strategy this week. Reducing a short position means you need cash to buy the shorted stock, which might have led to some selling in the broader market.

The bigger question is what does it mean for markets going forward?  This is an ongoing story and an unprecedented situation so it is difficult to come to any strong conclusions about the long term impacts at this time. Most major brokers have begun to limit the trading in these stocks, which has been a very unpopular move with investors but seems consistent with trading limits in other markets when volatility is extreme. There is some debate about whether the action of the retail investors was legal and there are questions about whether shorting stock should even exist. It is important to point out that it is not unheard of for large hedge funds to try and accomplish the same thing retail investors have accomplished here (‘squeezing the shorts’).  It will be interesting to see whether the SEC or Congress decides to do anything about this. Both Republicans and Democrats have expressed concerns, so Congressional hearings are likely.

Should long-term investors be concerned about this activity? The total market value of GameStop and other stocks that have been impacted is a very small portion of the overall market, so diversified investors may not notice much impact. That said, there is no question that this is just another example of a major increase in speculative behavior that has been building for the last few years. Valuations for risky assets are at, or near, all-time highs and options trading and margin balances are also at record levels. A correction in equity markets is more likely when these things occur but no one knows when it will happen or how deep the pullback will be. As long as you have thoughtfully considered your risk tolerance and asset allocation this does not appear to be a reason to rethink your long-term strategy.

Filed under: Investing

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