I vividly remember being picked up in a stretch limousine for a job interview with the now defunct Lehman Brothers.
It was the fall of 1999, and as I sat in that ridiculous vehicle, I thought to myself, “I have absolutely no discernible skill to offer other than the ability to work hard.” I would have been happy with a reimbursed subway fair and overjoyed with a taxi voucher.
Instinctually, I knew the tech-bubble party was inherently unsustainable, even if at the time I couldn’t necessarily pinpoint the root causes.
“The market can stay irrational longer than you can remain solvent,” the iconic John Maynard Keynes once said.
This is true. But the corollary is equally true: chickens always come home to roost. Sure enough, peak-to-trough the S&P 500 declined 48 percent, the Nasdaq fell an even greater 78 percent, thousands of people lost their jobs, and frauds like Enron and WorldCom were exposed.
Fast-forward to current day. We have a different flavor of crazy in the market, the poster child of which is GameStop. GameStop is a middling, primarily brick-and-mortar retailer of video games and other consumer electronics. Like most brick-and-mortar retailers, GameStop faces severe pressures from online competition. The company has closed 800 stores since 2019 alone, with plans to close more. Sales declined more than 28 percent between 2015 and 2019, and earnings went from $3.55 per share to a loss of $5.33 per share.
Six month ago, GameStop’s equity was valued at approximately $260 million, or about four dollars per share. A month ago, the same figures were $1.2 billion and $19, respectively. As of Friday’s close, they were $23 billion and $325.
What’s caused this meteoric rise? A comprehensive explanation is beyond the scope of this article, but one might summarize it as a large-scale, broad-based, coordinated financial attack against the short sellers of GameStop.
To “short” a stock means to borrow the stock, sell it in the market, buy it back at some point in the future, and return the stock to whomever it was borrowed from. Investors short a stock when they believe the price will decline – that’s how a short seller makes money. Conversely, if the price of the stock appreciates, the short seller may be forced to “cover” his short and, in turn, lose money.
GameStop was one of the most highly-shorted companies in the market. In fact, it is estimated that approximately 140 percent of its shares outstanding were being shorted as of year-end. This can happen due to a practice called “naked shorting” (where one doesn’t actually borrow the underlying shares) and also through something called “synthetic shorting” that involves the use of options. Occasionally, a heavily-shorted stock will appreciate and force short sellers to go into the market and buy the stock in order to close out their short position. This is known as a “short squeeze.” This is a healthy market development if the squeeze is initiated by legitimate factors – an earnings development, a potential buy-out scenario, etc.
In the case of GameStop, the now famous Reddit community r/wallstreetbets is manufacturing the single greatest short squeeze in financial history. In something reminiscent of a financial Arab Spring, a small group of retail investors started a movement that has caught fire. Social media facilitated the exponential growth in followers of this movement, and their collective buying power has grown to an astounding level. Reddit is playing the role of Hannibal to the short sellers’ Rome.
While this has been hailed by some as “sticking it to the man” and “sending a message to Wall Street,” we shun history at our peril: whenever we have large-scale inefficiencies in the market, inevitably the most vulnerable end up holding the bag.
What the wise do at the beginning, the foolish do at the end. The financial media that is lauding the Reddit users should keep this in mind.
No Reddit revolution is going to usurp the laws of financial gravity — at least not forever. To offer up (yet) another Wall Street cliché, Ben Graham, “the father of value investing,” long ago warned, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”
My hope is that not too many unwitting and vulnerable people end up getting hurt by the current craziness, but my knowledge and experience leads me to conclude that this hope is unfounded.
Court Dignan is a retired portfolio manager.