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Bubbles like GameStop have Happened Before and Will Again

By Jon Aldrich

By now, I am sure you have been made aware of all the commotion surrounding a company called GameStop (GME) and the crazy behavior of its stock the last couple of weeks and similar behavior in a handful of other “troubled” stocks such as AMC Entertainment (AMC) the movie theater chain and Blackberry (BB), remember them?

GameStop is a company that operates stores you often see in strip malls and sells video game consoles and video games (new and used). For years this has been a fairly good business, but similar to Blockbuster video stores years ago, technology and customers tastes change and now many gamers just download the new games instead of having to go buy a disk which has hurt GameStop’s appeal recently.

The stock which traded around $6 a share for most of the year in 2020, gradually creeped up to about $19 a share by the middle of January, rocketed up to $347 a share on Jan 27th, plunged back down to $193 a share (a 44% one day loss) on Jan 28th, and as I am writing this in the morning of Friday, Jan 29th it has exploded up to $336 a share, a modest gain of 74% from the previous day. What in the world is going on with GameStop? For those of you that are trying to wrap your hands around this, I am going to attempt to break this down and explain the forces at work that are causing this craziness.

GameStop StockChart of GameStop stock the last 2 weeks

What is Causing All the Crazy Moves in These Stocks?

2 words, Short Squeeze. Ok, what is a “Short Squeeze”? To understand this, we first need to understand what shorting a stock is. An investor sells short a stock when they borrow shares from a broker and immediately sell them with the hope of re-purchasing these shares in the future at a lower price to make a profit. The short sale is closed once the investor that borrowed the shares buys the shares back  and returns the “borrowed” shares back to the brokerage.

Example: Jimbo Kimble believes the price of ABC stock is overpriced and is due to fall in value. He “borrows” 1 share of ABC from his broker @ the market price of $300 a share, and immediately sells the stock and pockets $300. Remember, though, he is obliged at some point to return these borrowed shares. 10 days later, the price of ABC has fallen to $100 a share. Jimbo purchases 1 share of ABC @ $100 per share to close out his short position, return the share to his brokerage firm and now has a $200 profit. However, if the price of ABC had risen to $500 instead, Jimbo would have to pay $500 to buy the stock and return the shares, but since he “sold the share short” @ $300, he has lost $200.

A Short Squeeze can occur if a large percentage of shares of a stock have been sold short. You can find the companies with the largest short positions online at a site such as www.highshortinterest.com .In the case of GameStop, an extremely large percentage of the available shares have been sold short. (Actually more than those available because of “naked shorting” which is supposed to be illegal but still occurs.)

If a large amount of the company’s shares are sold short, and the price starts to rise for some reason (good news or several coordinated buyers of stock), the investors that have “short” positions will start to buy the shares to close out their positions and stop losing money. However, this can create what is called a “feedback loop” and this demand of more and more “short” sellers having to rush in and buy shares to get out of their losing positions, causes the stock price to soar, as in the case of GameStop. The problem for all those holding GameStop shares though is once most of the “short” sellers have purchased the stock to close their positions, there may not be many buyers left and the stock price will drop like a rock thrown off a cliff.

David vs Goliath – What sparked all the interest in GameStop

Really, this all might not have happened, had a large hedge fund manager named Andrew Left of Citron research not infuriated a significant group of mostly small, individual traders on a Reddit subgroup titled “Wall Street Bets”  Let’s dig into this a bit more.

First, for those of you not familiar with Reddit, it bills itself as a social news aggregator, where registered members submit content such as posts, links or texts to a certain “community” or “subreddit” as it is called. There are areas for virtually everything (news, stocks, pets, politics, cooking, etc.) and you can find a lot of information, both true and untrue, on the site.  There is a large subreddit called “Wall Street Bets” and it is populated with a rather large community of day traders to exchange ideas and offer up recommended stocks to purchase.

Reddit User Rally

In June 2019 one Reddit poster named “DeepF***ingValue” (DFV) started posting trades of his investment via purchasing stock and options on GameStop whose stock had languished for years because of deteriorating fundamentals as mentioned above.  But he understood the potential for a future short squeeze since so many shares were short. He posted a screenshot of his $53,000 investment in GME and for the next year and a half would post updated screenshots on his large position and how it was doing.

The position grew in size and by September 2020, that initial investment had grown to $1.5 million, as GME shares started to rise from $5 up to $15 or so. On the “Wall Street Bets” forum  DFV became a legend for this trade and along the way others in the forum started purchasing shares. Meanwhile some large hedge funds began noticing the increase in GME share price and started putting on even more “Short” positions because the fundamentals of the company did not support a stock price at that level.

One hedge fund manager in particular, Andrew Left of Citron Research, a large hedge fund that over the last 20 years published lots of negative research on companies it was shorting started publishing negative research and making unflattering comments about GameStop whenever he was on TV or in internet posts. This may have worked in the past, but the highly charged environment we live in now, with BLM Protests, Capital Riots, and the blowback against the elitests and One Percenters, combined to really ignite this fire against his company and other large hedge funds that had piled on to short GME. It was a revolution in the stock market.

Many of the Redditors vowed to inflict pain on Citron and other Hedge Funds shorting GameStop. Many also took to some rather unscrupulous methods of publicizing private information of Andrew Left and other hedge fund managers as well as their families and made threatening and harassing posts and calls to them. This has actually caused Citron Research to stop publishing research about shorting companies. Cancel Culture at its finest.

The Redditors on the Wall Street Bets Forum which numbered over 500,000 members when this started and is up to 6 million members now began to organize and championed a move to start buying GME stock and holding it to inflict pain via a “short squeeze” on these Hedge Funds that have always stuck it to the little guy over the years and always seem to get off without any repercussions.

What happened is that this grassroots effort actually worked, not only for GameStop, but other highly shorted companies such as Blackberry and AMC. The rapid rises in these stocks caused the large hedge funds to have to buy stock to close their positions and stem their losses. And we are talking significant losses by a number of Hedge Funds. One firm in particular, Melvin Capital lost a few billion dollars and had to be bailed out by another Hedge Fund. Word is, that several hedge funds lost a lot of money due to the “Davids” on Reddit. It is estimated that Short Seller losses from Gamestop are over $19 billion so far in 2021.

The stock rose rapidly in a matter of days from $19 a share up to $350 a share as other well known people such as Elon Musk and others joined in with the Redditors. (Mr. Musk has his own bone to pick with short sellers at Tesla over the years, so he is loving this). DFV’s investment was now up to $30 million dollars and he was still holding firm and not selling, that we are aware of.

As far as it looks for now, what is occurring on Reddit is not illegal, and the Redditors do have a point that the big hedge funds have their own platform on TV shows such as CNBC and other networks where they go on and promote stocks they are holding or denigrate stocks they are short. They wonder, how is this any different?

This Has All Happened Before

They often say history often repeats itself. Short Squeezes have been around a long time. In 1922 a massive short squeeze of Piggly Wiggly stock occurred. In 1998 as the internet was just taking off, K-Tel records  (who sold compilations of bad 70’s artists) had an infamous short squeeze as well.

GameStop and the other stocks involved in the Wall Street Bets action are the classic definition of a bubble. They always end the same way, with a lot of tears and empty bank accounts except for those that were able to get out early, much like a Ponzi Scheme.

Most of these newbie investors really have no clue about investing and are just jumping on the bandwagon. True, it is great to see so many young people interested in investing, but I worry, this may be teaching the wrong lesson of speculation and excess. Many have even bought the wrong stock ticker symbol and hardly any know what short selling is or why the price of the stock is going up. Of course hardly any have done any research into the stock they are buying. Most of them claim it is all about a bigger battle and many say they will hold on to their shares forever to try to teach the big bad hedge funds a lesson. I guess we will see how long that lasts once reality sets in and the inevitable fall in GME stock occurs.

There are a lot of small investors involved in this and I do hope that everyone is only investing money they can afford to lose, because what is occurring here is no different than putting all your chips on Red or Black at the roulette wheel in Las Vegas. We can only hope that there aren’t a lot of them putting up their mortgage money or money they cannot afford to lose because this will end the way all other bubbles end.

What Can We Expect in the Future?

This has definitely caught the attention of the Securities and Exchange Commission (SEC) and many politicians. When Ted Cruz and Alexandria Ocasio-Cortez agree on something, watch out, as there is a good chance we may get some new regulations to curtail this type of behavior.  In truth, it does de-stabilize the financial markets and destroys confidence and trust which is not a good thing for free markets. So some additional regulation may be a good thing as long as it applies to the Hedge Funds and Big Banks as well as the little guy. In the past this has not been the case.

For now, this may take a few weeks to play out, and if you must partake in the craziness, and do a little gambling in this arena, please only wager small amounts that will not hurt if you lose all the money you invest. I am not advocating doing this, but with the pandemic and the need for some people to have a little excitement in their lives since they cannot travel, go to bars, or head to Las Vegas, please be prudent. Remember, there are no easy “get rich quick” schemes, and the path to long-term prosperity generally lies with good habits such as living within your means and having a solid, diversified long-term plan and investment portfolio.

There is so much more I could write about what we are seeing occur in GameStop, but for now we will save that for future musings. Be careful out there!