There was a time when a billion dollars was a lot of money on Wall Street. A big hedge fund would bet a billion and small-time investors would step back because they knew they could not fight it. These days, with Reddit, Twitter, Facebook and other social media, it is possible to organise millions of traders. The collective power of 20 million young connected retail investors with an average US$1,000 ($1,330) to US$5,000 in their account, is far bigger than most large hedge funds. Rookie investors making big, audacious bets and willing to organise themselves on social media are taking on well-known hedge funds and winning.
Last week, Melvin Capital, a New York-based hedge fund with US$12.5 billion under management, collapsed because it had built a huge short position on video game retailer GameStop whose shares were ups 1,700% last month and 8,000% over the past year. Melvin, which lost US$6.3 billion, or 53% of its assets, in January, was bailed out by two large hedge funds who injected US$2.75 billion. Short-sellers betting against GameStop have so far lost US$20 billion.
GameStop’s stock became one of the heavily shorted stocks on Wall Street in 2020 as hedge funds bet that the bricks-and-mortar retailer would soon go broke. A bunch of young traders noticed that short interest in the stock was 100% of GameStop’s available shares, or free float. So, they began placing contrarian bets that it would soon be revived. Last August, pet supplier Chewy’s co-founder, Ryan Cohen, emerged as a white knight. The stock surged and suddenly, there was a short squeeze as hedge funds rushed to cover their short positions by buying more shares.
Short selling involves borrowing a stock and immediately selling it. If the stock falls, investors make money by buying it back at a lower price. A squeeze follows a big gain in a stock when short sellers are forced to cover their positions. In October 2008, Volkswagen briefly became the largest company in the world before its stock fell 93%. Short-sellers, who bet against Volkswagen found out that Porsche, a key shareholder, was aggressively accumulating shares. They got squeezed as the price climbed. Eventually, Porsche took over VW.
By itself, a short squeeze could not have catapulted GameStop. Blame that rocket-like ride on the Gamma Squeeze. Young investors weren’t buying actual shares but call options which gave them the right to buy shares in future. When you buy options, there is a market maker helping make that trade happen. They end up buying the stock as the price rises close to where they have to pay out on the options contract which pushes the stock higher. A Gamma Squeeze on top of a short squeeze can be a self-reinforcing cycle forcing price to go up and up.
The frenzy over GameStop has been months in the making. Last year, the world saw a growing number of first-time investors, mostly young, enter the market. Forced to work from home and stay indoors, Americans had more time and extra cash on their hands as they were no longer spending money at bars, restaurants or other recreation. Washington sent Americans three stimulus cheques to cope with the pandemic lockdown, adding to their cash pile.
The newbie investors flooded internet chat rooms and social media forums to share trading or ideas with their peers. The advent of commission-free stock trading and fractional shares at online brokerages such as Robinhood that use confetti showers to celebrate transactions helped gamify and democratise investing. Individual investors in the US opened 10 million new brokerage accounts last year.
Reddit — a social news aggregation and discussion website co-founded by Alex Ohanian, husband of tennis star Serena Williams — has a popular forum, or subreddit, called WallStreetBets where three million investors gather to comment on headlines, sports, entertainment and, the direction of markets and stocks. Stock tip on the forum were turned to a meme or an emoji, hence the monicker “meme stock”. YOLO, or You Only Live Once, is a common reference to a risky investing bet on the forum.
Recently, a lot of chatter has been about old firms like smartphone pioneer BlackBerry, cinema chain operator AMC Entertainment Holdings and, of course, GameStop, which has struggled over the move to e-commerce as people download games rather than buy cartridges or DVDs from retail stores. Though the launch of new consoles such as Sony Corp’s PlayStation 5 and Microsoft Corp’s Xbox Series X increased foot traffic, its revenues have been steadily declining. Analysts have likened GameStop to Blockbuster, the video rental chain that went bust a few years ago as streaming giant Netflix gained traction.
Righting a historical wrong
GameStop phenomenon is nothing like a classic bubble, which almost always is driven by greed. Indeed, as Bloomberg columnist John Authers argued in a recent podcast, the mania has been fuelled by anger. Young investors believe that establishment-run Wall Street is unfair. As such, their attack on hedge funds is really about earning back the money that Americans paid to bail out troubled banks such as AIG through the Troubled Asset Relief Program, or TARP, in the aftermath of the global financial crisis. Comments like “all of the gains from GameStop short squeeze are going to people who have never been rich or powerful and losses accrued by hedge funds or their wealthy investor clients” dominate WallStreetBets forum.
Angry young investors see the squeeze as righting a historical wrong and themselves as latter day Robin Hoods robbing the rich hedge funds to pay back the poor. After the 2008 financial crisis, angry young Americans gathered near Zuccotti Park in New York, not far from the New York Stock Exchange, to protest that no banker, hedge fund manager or derivative trader who profited from the subprime boom was ever put on trial. The protests dubbed “Occupy Wall Street” fizzled out within weeks
On Jan 6, social media helped hundreds of angry right-wing supporters of president Donald Trump attempt a coup of sorts to stop Joe Biden from taking the helm of the world’s largest economy. Now, social media is helping Robinhood traders take on short sellers amid a passing of batons of sorts on Wall Street. Among the people who weighed in sympathy with Redditors were Tesla CEO Elon Musk, tech billionaire Chamath Palihapitiya as well as Dr Michael Burry, an early GameStop investor, whose mortgage trade was featured in the book and movie, The Big Short.
On one level, the battle is between the little guy or the retail trader who is just trying to keep Wall Street honest, and billionaire hedge fund managers, or people like the fictional cigar-chomping trader Gordon Gecko in Oliver Stone’s 1987 movie, Wall Street. What is different this time is that there is a decentralised or distributed network of investors using technology to level the playing field for themselves. On another level, the battle is akin to outsiders trying to shake up an entrenched establishment the way Trump took on Washington’s swamp four years ago.
GameStop is not the first stock that a band of “outsiders” have sent skywards. Tesla defied gravity for years because a core group of tech-savvy investors believed that electric vehicles time had come. Tesla was one of the most heavily shorted stock for years and hedge fund lost billions betting against it. Tesla used its inflated currency to raise US$12 billion last year. Bitcoin’s huge recent rally has been fuelled by the same decentralized network of investors.
An unsustainable phenomenon
As Warren Buffett is fond of saying, you almost never find just one cockroach. There are probably a lot of hedge funds in distress that are facing a short squeeze and margin calls, some of which will fold or have to be rescued the way Melvin was last week. Others would have to deleverage, selling some of their good stocks to meet margin calls and pay creditor prime banks.
Clearly, the GameStop phenomenon is unsustainable. Yet, it is unlikely to spread over to other parts of the market and lead to a crash as short sellers and Redditors are confined to a small corner of the market. If the standoff between the two groups drags on and engulfs other hedge funds, things could turn messy with a cascade of selling. There is a concern that the mania could morph into a larger socioeconomic populist movement that is hard to control. However, there will be a bigger political outrage if regulators just let the frenzy continue which leads to a spectacular market collapse. Congressional hearings on the market turmoil in the wake of the GameStop squeeze are expected to begin soon and regulators have reportedly begun investigations.
Will it end in tears? Yes, for a handful of late investors most of whom put in small amounts of money. Redditors have shown remarkable discipline and coordinating their actions in the wake of mounting short selling. Some of the early investors in GameStop have made tens of millions and indeed cashed out big portions of their winnings. Moreover, behind the surge was an algorithm that can and will be used to discover the next big GameStop, may be not next week but months from now. That will bring the next bunch of traders eager to fight new battles.
The game has changed. It is unlikely that short selling will ever be the same again. Sure, there will always be investors taking a contrarian short positions but the US$ 3.6 trillion global hedge fund industry, which just had its worst decade ever, will be more wary of making big bets as crowdsourcing ideas thrive. Dedicated short selling funds were down 48% last year after falling 22% in 2019. But short selling provides benefits, like liquidity, and the ability to hedge portfolios though it has been taken too far by too many who don’t fully understand the balance of risk and rewards.
Wall Street now has to reckon with the social media that has harnessed and empowered huge swathe of investors. Melvin Capital, the hedge fund, was driven to the wall because a bunch of rookie investors found out through Google search that it had built huge short positions, so they cornered it and destroyed it.
Young Reddit members who trade on Robinhood have been galvanised by a Wall Street establishment that sees them as dumb investors, who do not understand how financial markets really work and whose trades will eventually blow up. For their part, Redditors see themselves as underdogs in overdrive who are just enjoying their new-found influence.
Wall Street is not going to take all lying down. It is now playing victim, claiming that Robinhood traders made a coordinated effort to corner the market, which is illegal. It is unlikely that the Securities and Exchange Commission whose primary goal is protecting retail investors will succumb to the lobbying of the big well-connected hedge funds.
“Redditors are doing exactly what billion-dollar hedge funds do every day — colluding to move a stock for fun and profit — the notion that this should be the subject of a federal investigation is preposterous,” notes columnist Matt Taibbi, famous for a scathing piece in Rolling Stone which described investment banking giant Goldman Sachs as a “great vampire squid wrapped around the face of humanity,” during the financial crisis. He believes America, as a society, will in the end “unite” to denounce GameStop as some form of “financial Trumpism.” Reddit hordes, he notes, are convinced that “the stock market, like the ballot box, remains one of the only places where sheer numbers still matter more than capital or connections.” How they use their numbers, newfound clout and money they make battling the hedge funds, to effect real change remains to be seen.
Assif Shameen is a technology and business writer based in North America
