Recently, we saw a significant increase in volatility. A few individual stocks had great fluctuations, due in part to a new wave of investors.  These young traders are opening stock accounts in record numbers and organizing trading campaigns through on-line messaging boards. We wanted to get the perspective of a young 20-year-old to look at this new phenomenon.  We asked Quentin Rickey to compose a guest blog post.  Quentin is not an employee of Leonard Rickey Investment Advisors, and this article is informational, not advice, but we appreciate his perspective and informative article. Normally, we don’t write about individual stocks but the events over the last few weeks have been remarkable. Although a lot of attention has been paid to this story, there hasn’t been a large effect on a portfolio that’s diversified across different asset classes, regions, styles, and sectors.  -Ben Rickey 

This was originally written on February 1st when GameStop’s stock price closed at $225 per share. So far in February, GameStop is lower and has continued to be extremely volatile. 

In the month of January, GameStop’s (GME) stock was up over 1700% (Source: Koyfin). The last week of January alone it was up over 400%. Does this mean that GameStop has revitalized itself and Wall Street buyers have taken notice? No, GameStop hasn’t made any large-scale changes. The reason GameStop stock rose so much and so fast had little to do with company attributes. It’s not Wall Street who took notice of them; it was retail investors. Everyday people who are not financial professionals organized a short squeeze via the on-line chat room Reddit. 

Short sells are a strategy utilized by hedge funds. To short a stock, you have to have a special type of account called a margin account. The process is quite simple in theory, a company borrows shares of a stock, sells it, and buys it back. If the company drops value between borrowing the stock and selling it, the hedge fund makes the difference. The party short selling is then betting that the company will decrease in value. For example, if Company A is trading at $10 a share, I may borrow that share and sell it to someone for $10. Now I have $10 and negative 1 shares of Company A. To complete the transaction, at some point, I must buy a share of Company A. Let’s say Company A is now trading at $1 a share so I buy a share. Now I have 0 shares in Company A and made a net profit of $9. This is the way hedge funds fundamentally short sell, only with much larger dollars and often with leverage involved. This decline in value of a company may be at least partially attributed to the hedge fund’s influence on the market.  

In the instance of GameStop, the hedge fund Melvin Capital Management bet against GameStop. With GameStop’s dismal financials and inability to revamp itself into the 21st century – the mall retailer seemed to be a good bet to turn a large profit. And it probably would have quietly put GameStop out of business and collected a neat sum of money if it wasn’t for the Reddit board r/WallStreetBets. Reddit is an on-line discussion website that allows members to post content on different “boards”, much like predecessor 4chan. The community of Redditors took notice of the short-selling going on with GameStop and a movement began to form. They wanted to hit the hedge fund and its billionaires where it hurt – their pockets. So, members of the community started a stock squeeze. 

Utilizing a stock squeeze is how GME boosted from a $19 stock on January 19th to a $396 stock on the 28th, only nine days later. Melvin Capital Management had negative stocks of GameStop, a result of the short sell. That means that at some point, they need to buy them all back. So, knowing that Melvin Capital Management had to buy back GME, retail investors started purchasing. Many of these retail investors were using Robinhood, a mobile stock trading app directed to young entry-level investors. As people bought up the remaining GME shares, it drove the price up. In theory, if people kept buying and held their stock – because the hedge fund had to buy back, the stock price could rise indefinitely. The result? By the end of January, Melvin Capital Management lost 53% of their roughly $12.5 billion of assets under management (Source: Wall Street Journal, 1/31/2021). The GameStop frenzy has caused the stock to be grossly overvalued. What should be a $10 stock was trading at $400. This creates a stock bubble and as people start to pull out, a lot of the investors in GameStop may also be looking at financial losses. 

Although the losses won’t actually be infinite for Melvin Capital Management, it certainly hurt them and their clients and will continue to do so. GameStop fell 30% to $225 on Feb 1st showing signs of the stock squeeze slightly dissipating. Some of this alleviated tension is credited to the controversial move made by Robinhood to prevent the buying of GameStop and only allow the selling. It is very unprecedented for a broker-dealer to restrict the capabilities of their users and this allowed the hedge fund to get some relief from the intense squeeze. Robinhood is currently being investigated by the SEC for interfering with the market. 

Stock squeezing isn’t new, but there are a couple of things that make this situation unique. First, the sheer size, with this being the biggest short squeeze over a three-month period in 25 years (Source: CNBC, Goldman Sachs). The next, and perhaps most interesting aspect is how the short squeeze got so large. Robinhood and other app-based broker-dealers have made retail investors much more involved in the market. These are the people who are not professionals in the finance world and are just looking to do some day trading. With the ability to buy fractional shares a student could invest in a $800 stock for twenty bucks. The access people had to the market is what allowed for the hive-like mentality generated on-line to buy GameStop and so aggressively squeeze the stock. Generally, stock squeezes are done by individual corporations with pools of money, who are prohibited from doing anything that drastically impacts the market. But in this case, the squeeze was a loose-knit group of people on-line buying and holding the stock.  

The GameStop stock squeeze is unlike anything we have seen before, and we may not see it happen again as the SEC looks into regulations to prevent further market volatility. If this event has taught us anything, it reinforces that the stock market is ever-changing. Hedge funds have been able to short sell with little consequence in the past, but as access to the stock market is expanding, retail investors can keep these large hedge funds in check, and if they get caught unprepared again there will be financial consequences. The army of Reddit investors wants to send GME stock “to the moon” and seem to want to continue to try and squeeze the hedge funds short sell. Even if GME doesn’t make it to the moon, the historic and unprecedented situation is sure to land among the stars. 

Thank you for sharing your opinion Quentin.  The continued outcome of these boards is fascinating.  I wonder if some of the users who organized the Reddit Boards’ short squeeze may face prosecution for market manipulation.  It is also interesting to look at the new capital available to companies like GameStop.  The increase in value can open access to capital that might not have been available otherwise.  If you have any questions or would like to discuss the ideas in this post, please contact your advisors.  Thank you – Benjamin Rickey, CFP®