Courtesy of Matt Sauer, MFSWNB Investments:

Wall Street watches ideas that begin as contrarian evolve into the norm and finish by being the conventional wisdom. Buying stocks that have business models being disrupted, modest to significant debt levels and projecting losses can certainly be contrarian, how did it end up as conventional wisdom?

The path taken from unpopular to popular requires a greater crowd believing the idea along the way. Sometimes it takes years to go through the pipeline, now with social media it can only require a few days.

One of the hallmarks of an idea going from contrarian to conventional is the perception that the risk is being reduced. In a stock it is often a fresh analysis of the potential outcomes or a change in the economic environment over months or years. Junk bonds have long lost the pejorative name in favor of High Yield as the returns produced favorable results. Both examples are based on a reduction is risk which leaves investor behavior well within the Gaussian behavior of outcomes, it is simply reversion to the mean.

However, when investors begin to believe that the risk is gone (or transferred to another party) there can be reversion to the tail. In the absence of conventional risk parameters, a stock that doubled in the first hour of trading will be on the path to a higher price. Once the tethers of valuation are gone, it is all greed and no fear.

Robinhood’s business model depended on reversion to the mean. One client sells a stock, the other buys and the business model is intact. However, the ability for social media to aggregate investor pools provided trading situations that for a moment appeared riskless and profitable. Robinhood’s risk controls were dependent on normal investor behavior not being aggregated and the opposite became a painful experience.

When the investors continued buying GameStop in the appearance of a coordinated effort, their perceived risk reduction was transferred to Robinhood in terms of collateral required. Robin Hood was required to finance their behavior. The notion that this was an attack on the elites can be discussed another time, but the speculation of the investors was putting their own beloved broker at risk as well as others. Biting the hand that feeds you? Yes, until it is gone.

Was the risk gone, transferred or temporarily forgotten? All three, but it was not eliminated and continued to grow as GameStop price was quickly reverting to the tail. Every trade higher increased the chance that the next trade would be higher. Participants in musical chairs see the chairs disappearing, there was no telling when the game would end (or should we say when the game would stop?) but the reversion to the tail was going to blow up the risk models of the participants down the line and someone was going to be left holding the bag.

No one seemed too hurt, you state. Robinhood shareholders may beg to differ. We cannot measure the dilutive impact of an immediate capital raise, but it certainly was not as anti-dilutive to selling shares to the public.

Buyer beware, seller beware, and broker be wary.