In this article we review:
- The background leading up to and dynamics surrounding the Reddit Rebellion and its astronomical impact on GameStop Corp., and other stocks
- What investors might expect in the days and weeks ahead, as this historically anomalous situation continues to play out
- Why the concept of “little guys beating the big guys” will likely wind up as one in which both sides lose
- Why we believe this unexpected market phenomenon could lead to more short-term market disruption but is not a systemic risk to the markets or long-term diversified investors
- We believe these conditions could contribute to more short-term volatility; however, we remain constructive on the longer-term equity markets as we move toward the second half of 2021
There is an old saying, “if you live long enough, you’ll see just about everything.” However, even for those who have been living through numerous changing market environments over the past several decades, it is unlikely anyone could have expected a phenomenon exploding this past week now known as the “Reddit Rebellion.”
In what seemed like the blink of an eye, a virtual army of Millennial investors, organized on social media to take on some of the world’s most prominent and successful hedge funds, effected a squeeze for the ages on several heavily hedge fund-shorted stocks. As a result, these newly ordained “meme stocks” have experienced astronomical price gains over the past week, unimaginable by any historical measure. This has been best exemplified by the video game store company GameStop Corp., (GME), which reached an intraday high of more than $400 per share and a market capitalization of $35 billion on January 28, up from $61 just three days prior and less than $19 when the year began.
On the flip side of these huge stock gains are the hedge funds that originally took short selling positions against those companies and are now nursing financial losses that in some cases are ranging from serious to near fatal. This is most widely known to be the case for the highly acclaimed and respected Melvin Capital, which has reportedly sustained billions of dollars in portfolio losses on its GME short position and has subsequently sought and received capital infusions into the firm.
Now, everyday investors without any involvement with these types of stocks or hedge fund short selling are left to anxiously ponder as to what the impact of all this might have on them.
How It Happened
To fully comprehend this almost surreal chain of events, it is important to recognize the inherent nature of short selling and how it differs in risk from traditional long-only investing. It is the risk profile of substantial short selling that set the stage for panic-like buying of GME and other heavily shorted stocks in recent days.
Short selling is the investment strategy of profiting on the declining share price of a given stock. It involves borrowing the shares of that stock and selling them in the hopes of buying them back in the future at lower prices and banking the difference. Closing out the short sales with the purchase of the same shares is referred to as covering the position. Generally applied by hedge funds and other institutions on a much wider scale than individual investors, short selling maintains a far wider range of risks than long-only investing (the traditional notion of buying and selling stocks as most investors do).
The first differentiating risk is that short selling requires borrowing shares without owning them outright, therefore involving financial leverage. To be profitable on the trade, the short seller must sell and then purchase at a lower price and thus a higher gain than their interest costs. Second and perhaps most importantly, while a long-only investor can only lose at most what they have invested in any given stock, a short seller faces the hypothetical risk of infinite losses as stocks can keep rising indefinitely. Finally, when a long-only investor incurs losses on a stock, that holding falls in dollar and percentage terms within their portfolio, hence self-reducing its future risk. When a short seller loses money, the opposite occurs — the position rises in dollar and percentage terms, therefore increasing in risk.
For these reasons and others, when a shorted stock rises in value it can create what is known as a short squeeze on the investor, resulting in a far more urgent situation to cover the position. This is where the term “squeeze” comes in. The lender is requiring more collateral against the position, the unrealized losses are rising, and the short position is increasing. As others in the market become aware, a pile-on effect often occurs in the price of the stock. It is certainly not a strategy for inexperienced investors or the faint of heart.
Applying this premise to the current environment, a number of hedge funds took substantial short positions in what they believed to be fundamentally challenged companies with stock prices they thought would decline. In addition to GME, these included headphones manufacturer Koss Corp. (KOSS), clothing retailer Express Inc. (EXPR), as well as AMC Entertainment (AMC). In some of these cases, the overall short position across a compilation of hedge funds exceeded 100% of the stock’s outstanding common shares, meaning those short sellers would ultimately have to buy back more shares than were in existence, inferring they would need to buy back some shares more than once.
Enter the Millennial army of retail investors. Organized in large part on a chat room forum entitled “WallStreetBets” within the social media site Reddit, estimates of more than 6 million individual investors (most of them with commission-free brokerage accounts on newer trading platforms such as Robinhood Financial) identified stocks highly shorted by the hedge fund community and bought their shares en masse. In many cases they also bought the stock options of these companies, essentially forcing market makers to also buy the stocks to hedge their trading positions.
This activity has created immense short squeezes on the hedge funds. By driving up the prices of these stocks, through social media and in a herd nature unlike anything the markets have seen before, the Reddit army also induced massive and panic short covering by the hedge funds themselves, who had no alternative but to re-pump their original billions, and far more, back into purchasing those same stocks they had shorted and incurring losses in multiples of their initial investments in the process.
And that, in a nutshell, is how GME shares moved from $61 to more than $400 (intraday) in three days, and how other heavily shorted stocks such as KOSS, EXPR, and AMC saw similar breathtaking moves. It has had nothing to do with the actual business successes or failures of these companies, nor their previous valuations. It is purely a case of short-term supply and demand that will have to end at some point. That point will likely be when the hedge funds and any other short sellers are finished covering, though nobody seems to precisely know when that will be.
While short squeezes have been in the markets for more than a century, they have never occurred with price impacts of this speed and magnitude. To that point, one might deduce this is a perfect storm, constructed of hedge funds shorting too many shares, intersecting with a new generation of younger trading-oriented investors fully utilizing the capacity of exponentially widening social media access and no-commission trading platforms. Throw in historic Federal Reserve-induced market liquidity, zero interest rates, and the great disdain for large hedge funds felt by those younger individual investors — many of whom believe, real or perceived, that those very hedge funds have served to create a financial system tilted against everyday people. So, there is more than just financial gain or loss in the mix here, as a potential motivating force also seems to be one of societal justification, which in many ways has likely exacerbated the explosive nature of this trading activity and its impact on the targeted stock prices.
There is another old saying that “markets can stay irrational longer than investors can stay solvent.” While, in our opinion, there is no fundamental case to support the current share prices of stocks such as GME, KOSS, EXPR, and AMC, they very well could stay at their recently inflated levels or even continue to move higher until their outstanding short positions are close to completely covered. The question then of course is, what happens next? At that point we could see air pockets in these names close to fully representing the moon shots they have recently experienced.
A Wider Story Develops
The Reddit Rebellion, complete with its charging army blasting trades into the market, has quickly gained a large following and allegiance from many corners of society, including not only everyday citizens but also members of Congress and the media. When Robinhood Financial, the preferred trading platform for GME, temporarily halted trading of the stock allegedly for capital-based clearing purposes, it prompted an outrage from customers and breaking news on the airways, as well as the unlikeliest of agreements on Twitter between U.S. Rep. Alexandria Ocasio-Cortez and Sen. Ted Cruz, perhaps emblematic of just how strange this entire sequence of events has become.
Perhaps the most common metaphor used has been that of “David versus Goliath,” with the Reddit-organized retail investors cast as David beating the Goliath hedge funds into submission. Other commentary has been quick to proclaim hedge funds and other large institutions as having been trading with perceived advantages for years and in the process often leaving everyday day investors, or “the little guy,” holding the bag, so to speak. Some have even proclaimed the Reddit Rebellion as a great inflection point in market history and one that has essentially put that bag in the other hand of the “big guys.”
Perhaps so and to be clear, hedge funds and other large institutional short sellers in many ways set themselves up for this disastrous scenario by taking short positions in stocks with extremely high open short interest ratios, such as well above 100% of shares outstanding, as was the case with GME. One might say this was asking for trouble and that is certainly a difficult point to argue against.
However, the problem with shifting who might be “holding the bag” in this changing scenario from the little guy to the big guy is that in doing so, essentially two bags have now been created. The hedge funds and any other large institutional short sellers are incurring great pain and financial loss on the short side. Yet once they finish covering, a painful second bag will likely be waiting to explode in the form of all the individual retail investors who bought GME and the other “meme stocks” at head-shaking type prices that could soon stand to decline perhaps all the way back to their pre-short squeeze levels. For GME, this would be more than a 90% fall from current levels. It is therefore difficult to look at this complete scenario as anything other than a highly probable lose-lose outcome for all involved.
Assessing the Potential Impact To the Broader Market
The Reddit Rebellion and its skyrocketing impact on stocks such as GME and others have clearly created additional market volatility that can be seen in January’s month-end declines on major stock indexes such as the Dow Jones Industrial Index, S&P 500®, and NASDAQ, which have declined approximately 4% from record highs earlier in the month, though there have been other factors influencing the markets. Still, most of this recent downside in the indexes has occurred in the recent days since GME and other heavily shorted stocks have begun reaching stratospheric levels.
Broader market concerns deriving from this trading activity and likely contributing to current or potential future short-term volatility include:
- The prospect of large hedge funds selling a wide array of holdings unrelated to their short positions to compensate for losses, reduce portfolio leverage, shore up capital, or meet redemptions
- Potential indirect short selling loss exposure with large mainstream institutions such as pension funds, foundations, or endowments, that may have allocated capital to hedge funds
- The pending fallout for the millions of retail investors now owning GME and similar Reddit-targeted stocks seemingly destined to incur dramatic losses once the short sellers cover their positions and these stocks potentially revert to their pre-squeeze price levels
- An overall loss of confidence among traditional investors that market prices can serve as true indicators of value for public companies
These factors could continue to pressure markets in the short term as the investment environment also faces ongoing uncertainties such as rising COVID-19 cases, pending vaccine distribution, the passage of additional fiscal stimulus, and potentially slowing economic growth in the current 1Q of 2021.
We view the Reddit Rebellion and GameStop phenomenon as disruptive to markets in the short term but not a longer-term systemic risk.
Putting everything into context, we view the Reddit Rebellion and its resulting impact on hedge funds and a relatively limited number of companies, such as GME, now carrying severely inflated stock prices as being disruptive to short-term market conditions, but at this point not a systemic risk to the markets or longer-term diversified investors.
The anomalous trading in stocks such as GME has been brought about by a perfect storm of market, financial, and social conditions. However, a silver lining of perfect storms is that their conditions cannot remain perfect forever. Hedge funds will eventually cover their short positions. Some may have viability issues, but most will likely nurse their wounds, accept this experience as a new risk to be considered in the future, and move on, hopefully recognizing the playing field has to some extent shifted. The individual investors buying the likes of stocks such as GME will soon either learn a valuable financial lesson or accept their investment losses as a price to pay in what they believe to be a larger cause.
Finally, the great majority of investors uninvolved in either of these two extremes will likely recognize this multibillion-dollar soap opera as one more dynamic impacting short-term market volatility. Yet they will still stand positioned for the next leg in a recovering economy and higher overall stock prices likely beginning in the spring and summer months of the year. With all this in mind, we maintain our year-end 2021 price target on the S&P 500® of 4,200.
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