In this week’s Market Commentary, I thought I would take a stab at explaining the dramatic volatility in GameStop last week. The topic can get pretty complicated pretty quickly, so I’ll try to keep it at a very high level.
- Hedge funds. Hedge funds are professional investment firms that invest money for individuals and institutions. The difference between a hedge fund and a mutual fund, for example, is that hedge funds basically have carte blanche to employ many different trading strategies and a wider range of investment securities to generate returns for their investors. Hedge funds cater almost exclusively to high-net-worth individuals and institutional investors, like pension funds and municipalities. Their selling point is that they, ostensibly, are able to earn positive returns in any market environment and that their returns are designed to be at least somewhat uncorrelated to the stocks, bonds, commodities and other asset classes. If used properly, this relative lack of correlation can provide both downside protection and higher blended returns with no greater risk.
- Speculative individual “investors” who trade through low- or no-commission online brokers, like Robinhood. I use the word “investors” very loosely here, as these individuals might better be described as traders or simply gamblers. They have no intention of buying stocks for the long term based on fundamentals or intrinsic value, but rather are hoping to earn quick profits made possible through wide price swings. The ranks of these online investors have swelled in the past year for a number of reasons, including continued strong stock-market performance, the elimination of trading commissions, the increased prevalence of working from home, the unavailability of other gambling alternatives during COVID (casinos, sports betting), the stimulus checks sent out by the federal government, and simply boredom.
- Trading apps like Robinhood that cater to small retail investors. Following many years of steady declines in trading commissions, it is now free for most retail investors to make trades in their online accounts or on trading apps like Robinhood. Some of the trading apps even allow their investors to trade fractional shares, which has opened the door to customers with only a very small amount of investable assets. The large online brokers like Schwab can make money in other ways, like earning a spread on investor cash. But the smaller online brokers/apps must rely on payment for order flow, which means the market makers pay the brokers/apps for routing trades to them. There is some concern that payment for order flow can cause a conflict of interest for the brokers/apps.
- WallStreetBets. WallStreetBets is an investment forum that operates within the Reddit community. The forum’s membership reportedly more than doubled in a week to over 7 million as the GameStock price was soaring last week.
- Regulators such as the Federal Reserve, Congress and the Securities Exchange Commission. Though there hasn’t been much of a regulatory response to the volatility and trading halts last week, investigations are likely to result. The online brokers seem to be catching the most flack for their decision to halt trading in certain stocks (we explain further below). But there is also the question of whether or not it should be legal for individual investors to effectively collude in order to manipulate stock prices. And finally, the fees that market makers pay to brokers for order flow may also come under the microscope.
Over the past week or so, individual investors have been piling into a handful of stocks, causing their prices to surge. The sudden interest in these particular stocks, which include GameStop (GME), AMC Entertainment (AMC), Bed, Bath & Beyond (BBBY) and others, was triggered by a widely followed internet forum called WallStreetBets, which promoted the purchase of these stocks as a way to earn big profits in a short period of time. These specific stocks were targeted for a couple of reasons. The first is that the stocks had suffered big declines for one reason or another. In the case of GameStop, investors had soured on the company because its business model of selling video games through a large network of retail stores was at risk as more and more gamers download games over the internet. In the case of AMC Entertainment, investors are understandably worried that movie theatres may suffer lasting damage until and unless the population feels more comfortable that COVID-19 and its variants can be successfully eradicated. In any case, the large declines in these stocks may have been viewed as an opportunity to “buy low.”
Secondly, and perhaps more importantly, these specific stocks were targeted because they were determined to have very high “short interest.” Short interest refers to the amount of shares of a particular stock, usually expressed as a percentage of total outstanding shares, that have been borrowed from their owners by investors who believe they are worth less than the current market value. The investors who borrow the stock, referred to as “short-sellers”, would then sell the stock on the open market, without ever owning the shares, in the hopes that the stock price would drop in the future. Ideally, the short-seller would then buy the shares back at the lower price, closing the trade and earning the difference between the sale price and the subsequent purchase price. This practice is widely employed by hedge funds and other professional investors as a way of earning outsized returns with limited up-front investment. As an example, let’s say I am a hedge fund manager and I don’t like the business prospects for a company, let’s say Example Corporation (XCO). In the hopes of profiting from my bearish investment thesis, I might borrow 1,000 shares of XCO stock and then sell the stock at the current price of $118. If, in the future, the stock price falls to say $100, I can buy the shares back in the open market, return them to the original owner, and earn a profit of $18,000 (1,000 shares times $18). It is important to note that short-sellers must always close the trade by buying the stock back and returning it to the owner. It is also important to understand that short-sellers must put up collateral for the shares they borrow, and that collateral requirement can increase, sometimes dramatically, if the market value or volatility of the stock increase.
In the case of GME, certain enterprising individuals on the WallStreetBets forum had determined that there was heavy short interest in the stock. In fact, we have since learned that shares representing 140% of the total outstanding shares had been sold short at one point. This is highly unusual. It was clear that hedge funds had identified GME as a company that may be going bankrupt, and they were selling the shares short as a way to profit from the company’s demise. Here’s where it gets interesting. Once GME was identified as having a high short interest, the WallStreetBets folks very astutely realized that all those shares that had been sold short by the hedge funds would ultimately have to be bought back in order to close those trades. Armed with that knowledge, they knew that if they could get enough buyers to start the stock moving on an upward trajectory, they could create a situation that’s called a “short squeeze.” A short squeeze is when the price of a heavily shorted stock begins to rise, and that appreciation forces a decision by the short-sellers. They can either ride out the storm and hope that the stock eventually goes back down, or they can cover their short position and take a loss.
But here’s the kicker. Sometimes the decision is forced on the short-seller because, as noted above, he/she must put up collateral based on the market value and volatility of the stock. So as WallStreetBets members started buying in greater and greater numbers and the GME price soared from the $30’s to well into the $100’s in just a few days, the short-sellers had to keep increasing the amount of collateral they were forced to put up. In many cases, the short-sellers were forced to close their short positions (called “short covering”) by buying back the stock because they couldn’t come up with the collateral. The upside pressure on the stock was magnified by the short covering as well as the fact that many small investors started buying call options on the stock. Call options give an investor the right to buy a certain number of shares of any given stock in the future at a fixed price. The allure of call options is that they allow investors to earn higher profits by controlling a greater number of shares for a relatively small investment. In this case, the important point related to GME is that the dealers who sold the call options were also forced to buy the GME stock as it spiked so as to hedge against the risk of further losses as the stock went up. So the use of call options by small investors caused even more upside pressure on GME.
All this cascading upward pressure on the stock culminated in GME finally reaching a peak of nearly $500 on January 28th. Buyers from WallStreetBets had earned huge profits on their newly established positions. We are just now hearing reports that some hedge funds may have joined the attack on the short-sellers, earning huge profits as well. But the hedge funds that were short sustained massive losses as they covered their short positions. A hedge fund called Melvin Capital Management was said to have lost 53% of its investor money in the month of January as a result of losses sustained on its GME short position.
But the story doesn’t end there. As GME climbed higher and higher into the stratosphere and Robinhood investors were reaping huge windfalls, the broker app suddenly restricted trading in GameStop and several other stocks that had recently spiked. Predictably, many of Robinhood’s investors became irate at what they believed was a double standard. Why are hedge funds allowed to do whatever they want but we can’t? It was believed that forces were intervening on behalf of the powerful hedge funds just as the little guy had them on the ropes. As it turns out, there were no nefarious forces at work. Instead, Robinhood was unable to keep up with the collateral requirements of its clearinghouse, the Depository Trust & Clearing Corporation, or DTCC. The DTCC requires collateral because there is a mismatch in timing between execution and settlement for every trade. If any individual broker is unable to deliver cash or securities on the settlement date, the DTCC is on the hook and therefore must have some protection against that risk. An article on Barron’s.com from January 29th entitled “Why Did Robinhood Stop GameStop Trading? Everything to Know”, by Nicholas Jasinsky, put it this way:
“In exchange, the DTCC collects a fee per trade and requires some collateral from the brokers to ensure they have the assets to complete the transaction. It’s like putting a refundable deposit on a purchase that reduces the middleman’s risk while the package is in the mail, with full payment due once it arrives. The DTCC’s collateral requirements for brokers are calculated by a much more complex formula, based on the specific shares’ notional value, volatility, and other variables.”
What factors led to the GME short squeeze?
- The Fed. The situation described above would not have happened without the Fed. Ever since the Global Financial Crisis, the Fed (and other central banks) have been suppressing interest rates and injecting massive amounts of liquidity into the financial system in an effort to support the economy. The goal was to make capital abundant and cheap so that consumers would spend and companies would make investments in new employees and other growth initiatives. The problem, though, is that the liquidity injections did a better job of inflating asset prices than stoking real economic activity. Efforts to generate acceptable investment returns have led to dangerous speculation in some cases, to include certain stocks like GameStop.
- COVID. The onset of the COVID pandemic has led to mass self-quarantine and work-from-home. Many people have been reluctant to spend money because they’re are worried about losing their jobs and incomes. Even if the willingness to spend freely was there, many of the things we all spend money on have been closed. Restaurants, bars, sporting events, flights, cruises and many other service industries shut their doors for a period of time. The result has been a huge spike in the savings rate, and many consumers have decided to use their savings to invest. At the same time, alternative platforms for gambling, like casinos and sports, have been unavailable, to varying extent, due to COVID-related shutdowns.
- The response to COVID. The two COVID relief packages enacted last year, along with another big one in the pipeline, have provided folks with cash. A certain percentage of risk-seeking folks have seen that cash as their opportunity to make a quick buck. The online brokers, with zero commissions, were perfectly situated to pick up these new clients.
- Resentment stemming from economic inequality. It is pretty clear by the postings on forums like WallSteetBets that there are many, many small investors out there that feel like the system is rigged against them. Hedge funds are vilified on these sites in part for their relentless attacks on struggling companies but more so for the widespread perception that they unfairly benefit from government and corporate policies. This latter viewpoint was reinforced when Robinhood halted trading in GME and other highly volatile stocks (even though they were forced to do so) as they were soaring and making small fortunes for WallStreetBets investors. Many of these smaller investors feel a great sense of satisfaction that they have been able to beat the hedge funds at their own game.
- Widespread coordination among smaller retail investors. While it is illegal for institutional investors to collude in order to manipulate stock prices, it is not explicitly illegal for retail investors to do so. Therefore, the increasing popularity of investment forums like WallStreetBets, while not a new phenomenon, has created opportunities to band together and raise the stakes for hedge funds looking to earn big profits by shorting stocks.
Are Farr, Miller & Washington clients at risk? The answer is an emphatic “NO.”
- We don’t short stocks under any circumstances.
- We don’t employ strategies that utilize leverage for our clients, and that includes buying securities using margin loans.*
- We don’t use derivatives, like options and futures, that are typically used to amplify investment returns but many times amplify risk as well.
- We don’t buy stocks in companies with poor fundamentals, like GameStop.
- We don’t engage in any other reckless activity designed to game the systems or amplify returns.
Our preference is to do our gambling at the casino, not the office. Attempts to manipulate the GameStop share price by collectively attacking short sellers may have proven very profitable for some, but there are likely many more suffering from the stock’s decent from almost $500 a few days ago to less than $100 now. This whole experience has nothing to do with investing, and we would recommend not giving it much more thought.
*We don’t use margin loans as a part of any strategy, but some of our clients will borrow on margin in their individual accounts.