Redditors, Shorts and Crazy Single-Stock Swings

Editors’ Note: MarketMinder does not make individual security recommendations. The below simply represent a broader theme we wish to highlight.

“Hey are you guys gonna write about GameStop?” That, as you can imagine, is the question we have received about 84 million times this week, give or take. So, to quote that old Toyota commercial, you asked for it, you got it. But first, please let us reiterate that we really don’t make individual security recommendations. We make jokes, occasionally buried in the footnotes. We analyze broad trends. We review financial media and occasionally offer hot takes. But we don’t make individual security recommendations.

What follows is our broad exploration of this week’s chief media story—the battle between a select group of individual investors and hedge funds. Many seem to think this is huge news for markets broadly that investors everywhere must weigh. We see it differently. This story is mostly overdramatized infotainment—not anything the majority of long-term investors need to worry about. Let us take you on a tour of this to show you why.

On the very outside chance you have been living under a rock, some unloved and distressed stocks went haywire this week. This is because investors and speculators who populate a Reddit forum called /r/WallStreetBets decided a viable strategy is to find heavily shorted^[i] stocks and, if they disagree with short sellers’ thesis, buy them. They share their actions with the forum, others mimic the trades and, given it has about 6.4 million users as we write, their actions made some targeted stock prices go vertical.

That peeved short sellers, including some hedge funds, one of which needed a capital infusion from a competitor. Some shorts even felt the need to close (cover) their short by buying shares, driving even more upside. The financial establishment lined up to denounce these alleged charlatans who dared put their money behind a contrarian opinion. Politicians, in a bizarrely bipartisan showing, lined up to support the retail traders. Trading apps temporarily blocked them from buying certain stocks, including the one that started it all—videogame store GameStop. The world went nuts. We all learned Redditors call stocks “stonks.” We learned Blockbuster’s stock still trades. We learned someone who can hold through huge volatility has “diamond hands.” You can read all of that, in great detail, pretty much anywhere.

A Bubble in the Next Blockbuster?

The common take on all of this, likely building on the growing optimism we have seen in markets since November, is that the Redditors are euphoric speculators buying hopeless stocks with terrible fundamentals. Articles abound warning this won’t end well. Some in America’s pre-eminent newspapers draw parallels between GameStop and the 17^th century tulip mania in Holland or the South Seas Bubble that famously sank Sir Isaac Newton’s finances.

They are convinced GameStop—a retail storefront purveyor of video games and accessories—is the next Blockbuster, which we do not mean in the sense that it will be huge. (The other stocks most often featured here like movie theater chain AMC more or less fit this same, distressed theme.) Many are convinced herd mentality is at work, with the Redditors blindly buying stocks while ignoring fundamentals. A bubble in the making. We aren’t convinced by this narrative, mind you, because there are some big nuances and differences here. But this is what pundits have preened about all week, so we would be remiss not to recant it here.

Now, perhaps a way this most resembles euphoria is one most coverage ignores. When euphoria reigns, we expect to see bearish investors mocked in major outlets and coverage. The Redditors are participating in that, to an extent. But it isn’t bleeding into mainstream analysis, so if that is a sign of euphoria, it seems nascent.

The Case Against the Reddit Story as Euphoria

Usually, when euphoria is driving the train, you can see it in the buyers’ rhetoric. Basically, they grasp at increasingly far-fetched reasons the stock will go up—and only up. They project a far-flung future of profits based on pie-in-the-sky plans. After wading into /r/WallStreetBets and (before it disappeared) the related Discord server, we … aren’t seeing much of that? If anything, the most common sentiment seems to be a general hatred of hedge funds, a belief professional investors are too herd-like in ignoring fundamental turnaround potential, and adoration of Elon Musk—a longtime champion of individual investors who buck conventional wisdom.

As a bubble inflates, something called the Greater Fools Theory usually applies—people buy, knowing the move is irrational, but they justify it on the belief they can sell it to some sucker even more foolish than them at a higher price. There probably is some of that with these stocks—particularly in the case of Blockbuster Video. Yes, that Blockbuster, the one that went bankrupt years ago and doesn’t really exist anymore aside from one independently operated outlet using that name in Bend, OR.^[ii] But some of its shares still trade over the counter, and the Redditors sent them for a ride on Tuesday. We can think of literally no fundamental reason to do this.^[iii]

But with some of the other trades, it is less clear cut. Most of the companies targeted by the Redditors are still going concerns. Several institutional investors, mainly hedge funds, have big short positions in them. Many Redditors seem mostly motivated not by anything financial, but a desire to stick it to these short sellers. If they succeed, prove hedgies wrong, and the price rises, those shorts may have to cover their positions by buying—realizing losses. If someone playing around on Robinhood believes they can eventually sell to a hedge fund that needs to cover its caboose, is that euphoria? Or is it a tactical decision based on the knowledge of how markets work? We aren’t trying to argue this either way, but we do think it is important to note that some semblance of logic underpins a lot of these moves, even if you disagree with that logic. (Yes we are aware of the allegations of coordinated market manipulation here, and we are going to stay above that fray.)

Redditors are also taking a fundamental view of some of these companies. In some cases, they believe those struggling under the pandemic have a brighter future than the institutional world believes, and they are willing to put their money behind a turnaround. That was the case with the original people who bought GameStop and took to social media—one of whom posts under a nom de plume including the words, “Deep” and “Value.”^[iv]

Perhaps you have heard of a guy named Ken Fisher, who wrote a hugely influential book on turnaround investing 37 years ago. It was called Super Stocks, and we would say it is great even if we didn’t work for the firm he founded. This is essentially a book on how to identify deep value stocks suffering through temporary problems. There are many, many others who seek out troubled firms in hopes of turning it around—and profiting. Activist investors do this daily! We find it funny that a turnaround thesis is somehow considered rational when an activist investor acts on it—and euphoric or dumb when retail investors do—but we will get to that in a moment.

For now, some rhetorical food for thought: Is it really irrational to believe a certain struggling movie theater chain will make money once we are all vaccinated and finally able to watch that delayed James Bond flick in the theater? AMC’s financiers don’t seem to think so, as the company was able to leverage the Reddit-fueled stock price boom to secure equity financing needed to ride out the pandemic and avoid bankruptcy. Is that euphoria, or is it sort of how markets are supposed to work? Prices send signals, capital gets allocated. As for GameStop, an activist investor took a large stake last year and helped make over its board of directors, prompting chatter about a turnaround plan. Are the retail investors backing a nearish-term turnaround really more euphoric than all those who bought GM Thursday based on its 14-year plan to go all-electric? If you think the latter is rational despite 14 years being far outside the 3 – 30 months markets usually price in (and we are not opining one way or the other), as a lot of the press coverage we encountered did, then you have to accept the former is possibly rational, too. Again, we aren’t backing one view or the other, just stressing the need for intellectual consistency.

Who Is Wearing the White Hats Here?

Also curious: the way the majority of financial news outlets have covered this story. Every good story needs a hero and a villain. Usually, when short sellers are in the news, they are cast as the villains deliberately driving stock prices down. When hedge funds feature, it is also usually in a villainous role, as destabilizers that drive stocks up and down in order to line their own pockets. Meanwhile, the role of hero or innocent victim usually goes to retail investors, frequently (and demeaningly) portrayed as “the little guy” who can’t hope to do well with all those hedge funds and algorithms driving the market and hogging all the profits.

Not so this time. Now, to read all of this week’s coverage, short sellers are innocent, well-meaning, venerable investors who are only trying to make markets more efficient. Many of the articles we have read take time to explain how short interest actually adds liquidity to the market. Which is … correct! And weird to see acknowledged so widely. Similarly, now the hedge funds are the protagonists, just trying to go about their normal business. And the villain? Retail investors! Suddenly they aren’t “the little guy” anymore, but a powerful, cult-like vindictive force capable of moving markets and making life miserable for the poor hedge fund managers. This is Mirror Universe stuff, folks.^[v]

We don’t favor either side here. We don’t paint with broad brush strokes, we don’t split the investment universe into “good” and “evil” camps, and we don’t call people names. (We also know some institutional investors are on the same side as the Redditors.) Our point is simply, you can’t have it both ways. If short selling isn’t a powerful and inherently negative market force now, then guess what, it never is. If hedge funds aren’t evil today, guess what, they never were. If retail investors today are capable of a) making money and b) influencing markets, then, yes, they always were.

So the next time you find yourself bemoaning hedge funds for crowding everyone out or short sellers for driving prices down, step back and remember what happened this week. No transaction, however big or small, is a self-fulfilling prophecy.

Before Dubbing Someone “Dumb” Money, Look in the Mirror

Relatedly, there is a long-running thread in the financial press that labels the little guy “dumb money” while hedge funds and institutions are the “smart money”—the pros, steeped in financial logic, who see what individual investors cannot. We have never bought this thread, considering that in our collective experience following financial pundits, we have seen some pros say some pretty dumb stuff.

In this case, most coverage seems to assume that the hedge funds were smart to be short—until this band of rabble-rousers came to foil them. But that is an assumption. We have seen many shorts foiled over the years by taking dumb positions, like shorting Japanese sovereign debt on the notion its debt-to-GDP ratio—an irrelevant measure saying little about debt’s affordability—was unsustainable.

The grand irony here: It seems to us the allegedly smart money may have forgotten Markets 101: Sufficiently liquid markets are efficient and discount widely known information. Most of the stocks the hedgies shorted were companies well known to be troubled—in some cases before COVID, in some cases due to it. Those troubles were known to basically everyone. Thinking they weren’t baked into the stock price is truly irrational. So unless bears had some new, different reason to short, the biggest risk was that a positive surprise would rock them. Guess what? That happened.

Price Discovery, Outages and Outrage

By Thursday, several investing platforms announced they were restricting trading in Redditors’ favorite stocks. The initial theory pushed by the press was that the firms were trying to inject some sanity into markets, force everyone to take a breather, and protect retail investors from entering trades that could wipe them out. (This theory doesn’t seem correct, as we will explain, but it fed into the story’s frenzied coverage.) Showing how odd this story is, Senator Ted Cruz and Representative Alexandra Ocasio-Cortez both objected to what they deemed an unfair practice.^[vi] We have seen some point to the subsequent drops in GameStop, Nokia and BlackBerry stock prices on Thursday as evidence that this “worked.”

That makes us wonder how those advancing these arguments would define, “worked.” We often note that markets are efficient. This is because they incorporate the opinions of everyone transacting in real time. That includes buyers, sellers, short sellers, people buying short-dated out-of-the-money call options, people buying on margin, you get the drift. The process of all these transactions affecting the price is what economists call “price discovery.” But this can be efficient only if the market is allowed to incorporate all opinions, including the Redditors.

So our general stance on all stuff like this is, let the market decide. This is sacrilege to all those who think valuations and models should determine optimum pricing, but in our experience, the market’s collective wisdom is the best pricing mechanism there is in the long run. Yes, that can lead to big seemingly irrational short-term swings, but that is part of the process. If you don’t believe us, then revisit the saga of JPMorgan’s purchase of Bear Stearns after the latter collapsed in March 2008. JPMorgan initially agreed on a purchase price of $2 per share. Investors then bid the stock up, and the final purchase price was $10 per share. The market was right.

People have long accepted that hedge fund managers blabbing about their short positions on television and all but trying to talk the stock price down are part of the pricing process. Call us crazy, but we don’t see much functional difference between that and Redditors who blab about their long positions and make memes. It is all part of this big, messy, beautiful thing called the market.

The Not-So-Secret and Really Boring Truth Behind the GameStop Lockout

But, perhaps illustrating just how much this story has left reality behind: The reason that seems most plausible for some brokerages limiting trading in GameStop and other hot stocks? The boring mechanics of clearing. Stock trades settle two days after they are placed, with the funds and shares changing hands via a clearinghouse, the Depository Trust Clearing Corporation (DTCC). DTCC requires brokerages to keep cash on deposit at the clearinghouse to serve as collateral during the two-day post trade window. It reportedly upped this requirement on firms like Robinhood on Wednesday, citing a vast increase in volume. Robinhood needed time to raise the cash. Hence, the pause.^[vii] Once they got the cash, the pause lifted.

But don’t worry. We are sure this story has more twists, like possibly Senate or House hearings. Considering those are mostly theater too, with politicians grandstanding in search of popularity, perhaps the Reddit vs. Hedgie saga will then have found its proper home. So our counsel: Tune down the emotions—both fear and greed—that this story may bring. If you are a long-term investor, this is much more noise than news.