(Veteran tech columnist Jon D. Markman publishes Strategic Advantage, a lively guide to investing in the digital transformation of business and society. Click here for a trial.)
A generation of new traders is taking on the establishment. In the process, organized online short-squeeze mobs are pushing the shares of flawed companies into the stratosphere.
At one point Monday, shares of GameStop ( (GME) - Get Report), a company professional investors have been betting against, more than doubled, pushing the market capitalization to $10.3 billion. Veteran market watchers began to cry foul.
Everyone needs to just chill out. Let the markets work.
Short squeezes occur when bullish traders target the companies that professional investors are betting against. This phenomena is not new in any way. As long as there have been markets, there have been short squeezes. I’m reminded of a passage in Reminiscences of Stock Operator, a book that loosely chronicles the exploits of Jesse Livermore, a famous trader in the early 1900s.
Livermore earned and lost millions trading the markets. He came to understand that the same market forces that cause learned investors to bet against companies by borrowing and selling shares in the open market can sometimes be exploited for extraordinary gains.
During the summer of 1923, Livermore began buying up the shares of Piggly Wiggly, a pioneering retail chain that had run into financial trouble. He understood bears were aggressively short and he saw an opportunity. Livermore amassed more than 75% of the available stock float. In the end short sellers had no choice but to buy back shares in the open market for huge losses.
Short sellers play a game that is fundamentally stacked against them. They borrow shares from brokers to sell in the open market. The idea is to buy back those shares later at a lower price when the prospects of the business sour. Unfortunately for bears, the broker can ask for the shares to be returned at any time, no questions asked.
Traders on Reddit believe they have discovered a flaw in the system. In the thread WallSteetBets, online traders are organizing full attack plans to deplete share floats of heavily shorted companies. The strategy involves option contracts, stock buying and lots of populist hyperbole about taking the markets back from the establishment of professional investors.
The choice of GameStop as the weapon to blow up the professional class is ironic. In an era where the gaming infrastructure has moved online, the Grapevine, Texas-based chain is decidedly old school. It operates 5,510 brick and mortar stores United States, Canada, Australia, New Zealand, and Europe. Sales declined sharply in during 2020 and operating losses swelled to $464 million. Business is bad and getting worse as e-commerce overwhelms physical world distribution channels.
A Bloomberg report Tuesday noted that the average price target for GameStop by Wall Street analysts is $13.93. At the current price of $97.15 shares are trading at 7x that level.
None of this is stopping the Reddit mob from pushing prices higher. They’re taking glee and pulling every lever to push GameStop shares into the heavens. Wall Street establishment be damned. More than 175 million shares traded Monday. It was the third time in a week where volume exceeded 100 million shares.
At one point during Monday’s frenzy GameStop shares surged to $159.16, up 146% from Friday’s close. The stock did eventually settle at $76.79.
Some veteran market watchers have suggested that the system is broken. They complain that several hedge funds that bet against GameStop may be bankrupted given the huge price surge.
The price activity is disconcerting to be sure. However short squeezes are not explicitly illegal. As Matt Levine notes at Bloomberg, if the Securities and Exchange Commission did investigate WallStreetBets it would be breaking all sorts of new ground in terms of enforcement.
I approach all of this from a different angle. I’m not bothered that some online traders believe they have discovered a loophole in the system. They certainly have not. I’m also not bothered that short sellers are losing money. Bears play an important role in markets. They provide liquidity. That said, short-selling is supposed to be dangerous.
This will all pass. It always does. Online traders will learn, one way or another that they are not as smart as they believe. Short sellers will develop synthetic securities to get companies like GameStop. Everyone needs to take a deep breath. Markets self-correct.
In the interim I have no position either way. Most traders and investors should stand aside.
Final comment on this from Livermore character in in the last chapter of “Reminiscences”: Speculation in stocks will never disappear. It isn’t desirable that it should. It cannot be checked by warnings as to its dangers. You cannot prevent people from guessing wrong no matter how able or how experienced they may be. Carefully laid plans will miscarry because the unexpected and even the unexpectable will happen. Disaster may come from a convulsion of nature or from the weather, from your own greed or from some man’s vanity; from fear or from uncontrolled hope. But apart from what one might call his natural foes, a speculator in stocks has to contend with certain practices or abuses that are indefensible morally as well as commercially.”