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GameStop Stock Price (Jan 12-Jan 29)
GameStop (GME) was trading at about $19 per share until January 12 or so. Then something changed. Trading volume increased dramatically and the price started going up. So much so that it more than doubled in less than two days, causing a lot of hype, more interest, and finally closing at $328 per share on January 29. That’s 17 times more than on January 12! How can it be? And what does it mean for long term investors?
Shares of stocks represent claims on the future profits of the firms that issue them. Wall Street professionals spend a lot of time and effort gathering information about the profitability of companies and trade on this information. Different professionals may have different opinions about the future profitability of a company and trade based on their beliefs. Because of the trading, we expect the price of a share to reflect the diversity of opinions. As new information is acquired, market prices quickly change to incorporate it. But how can we explain the huge change in GME price with the arrival of new information? In this case, we can’t.
Most of the time we expect market prices to reflect a company’s ability to generate profits in the future, the so-called “fundamental” view of company valuation. Occasionally however, prices may deviate from this view of a company’s valuation. GME’s spectacular rise is likely to end soon, and you may wonder what this all means for long term investors.
What is a bubble?
It may be puzzling why someone would buy a stock at $100 or more when it was trading at $10 just a couple of days before. This intuition may make sense if you are a long term investor. But if you are a speculator trying to gain from short term bets in the stock market, that’s not how you operate. If you think the price will reach $150 in the next few days, you are more than happy to pay $100. You are not looking at the fundamental value of a company, but at whether you can sell it at a higher price.
In normal times trading by speculative investors can help keep prices closer to the fundamental value of a company. But we are not in normal times. In periods of high uncertainty and high divergence of opinions about the economy and the future profitability of a company, prices of individual stocks can become disconnected from measures of fundamentals. That’s where we are now. A situation where the price depends mainly on speculative motives is referred to as a speculative bubble (see Harrison and Kreps, 1978). How did we get there?
The Hedge Funds vs. the Redditors
The story is that a chat group on Reddit named Wallstreetbets started collecting buyer interest on GME, apparently not so much on fundamentals but on the possibility to squeeze a number of hedge funds that were shorting the stocks. The squeeze could generate enough of a price increase to make money quickly. Let’s see how that may work.
In a “short”, hedge funds sell shares of a company they don’t actually own, in this case, GME. To short GME, the hedge funds borrowed shares from a banking institution. Why do that? The hedge funds in question believe GME stock price is overpriced and will fall. If and when it does, they can buy the shares back at a lower price, return them to the institution, and pocket the difference between their initial sale and the later purchase (minus some borrowing costs).
So the hedge funds benefit from a decline in the price while the Redditors buyers of GME benefit from an increase in the price. So far the hedge funds are on the losing side.
The GME Bubble
While shorting a stock may sound complicated, it’s a fairly simple concept for hedge funds. However, there is risk in the strategy. Hedge funds write contracts when they borrow shares, and they have to return the shares when their contracts expire. Even if they are right about the price going down, their contracts may expire before the drop in price. If their contracts expire when the price is higher than when they sold the shares, they lose money on the trade. And as they do that, their buying activity can cause the price to go up even more, at least temporarily.
The reddiors figured that if they could somehow generate positive momentum in the price of the stocks, this would force hedge funds to close their positions, at increasingly higher prices. The redditors would step in then, and sell at a gain. In fact, contracts don’t necessarily need to expire to force a hedge fund to close the position. A hedge fund’s risk management strategy may force them to sell after a certain amount of losses have been accumulated (called a “stop loss strategy”).
Robinhood and the pandemic
Speculative trading by individual investors has been on the rise, particularly during the Covid pandemic. That may be in part due to the fact that people have fewer entertainment options and it’s harder to get to places like Vegas. Apps like Robinhood make it easy and free to trade single stocks. A study by Brad Barber of the University of California, Davis, and colleagues conclude that activity on Robinhood Markets Inc.’s platform accounts for roughly one-third of all retail trading volume in the stocks that are most popular among Robinhood users.
And buying shares isn’t the only way to speculate on stock price movements. In recent years, options trading by individual investors has become more and more popular. If you believe a stock price is about to rise, you can buy a call option, which gives you the right to buy the stock at a pre-specified price at some time in the future. Call options can give you higher potential profit per dollar invested than buying shares, but you may lose it all. So they are like stock investing on steroids. The last couple of weeks have seen a surge in call options trading. And this increase in turn fueled additional demand in GME shares by the sellers of call options trying to hedge their bets.
Why aren’t more people selling?
You’d think someone would step in to sell at the high prices in large quantities, make huge profits, and help the price get back to down to earth. One of the lessons we can draw from this event is that similar to many many sectors of the economy, financial markets operate with very tight inventories. Regulations and technology have changed the role of traditional market makers that could have alleviated demand and supply imbalances. In fact, more short selling would be one way for GME prices to come back down. So, while we may balk at the idea of Robinhood limiting trading among the Redditors, we should also ask why more people aren’t able to short the stock.
Lessons for long term investors
The first lesson is that yes, it would be great if we could be the guy that bought on Jan 12 at $19 and sold at $468 on January 28. But remember for anyone that made money on this trade there must be someone else on the other side that has lost it, since no real value has been created. GME may be getting some publicity, but its sales aren’t going up 17 times. So if that wasn’t you, don’t even try now. There is always some stock that with hindsight may look great; Tesla gained 600% last year.
We are undeniably in a period of higher uncertainty, so it is natural to see imbalances in some areas of the markets, real or financial (remember the toilet paper shortage?). The low interest rate environment and the slow economy don’t make it easy for investors seeking returns greater than 0%. But high trading in individual stocks (or ETFs) with your savings should be avoided. One of the results from the Barber and others study is that more trading, particularly on the stocks that receive more attention, is associated with lower investor returns.
The good news is that if you are a long term investor, you probably have a plan in place that will withstand temporary market imbalances. First, you have a diversified portfolio that holds thousands of stocks, so no single one will unduly influence your performance. Second, you are invested for the long-term, so short term movements, even wide ones, will have very little or no impact on your ability to meet goals. Finally, remember that the higher returns of equity markets are earned on average and over time, precisely for being willing to bear the short term volatility. So stay invested, and don’t try to time the market by staying on the sidelines.
If the uncertainty about financial markets and some hyped up news make you nervous, consider revising your investment plan, and turn off the news for a while!
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
