The roiling of the equity market by individuals using Reddit to act collusively in stocks like GameStop, AMC Entertainment, Blackberry, and numerous others is likely to continue for the near-term. Many hedge funds that are short these stocks will be forced to cover their shorts and will suffer large losses, which implies sizable profits for the individuals buying these stocks. But the last individuals joining this party will likely also suffer large losses when valuations return to earth. This is sheer speculation, but being done collusively by a wolf pack and it is unsustainable. As some individuals seek to realize their paper gains, a collapse in the valuations of these companies could occur at any time. We have zero exposure to these machinations from either the long side, or the short side (which we never do anyway). We urge any clients to minimize any involvement in these stocks, if they must get involved at all, and to make sure they limit the dollars they can lose.
What is happening?
Hedge funds commonly short stocks of companies they think are significantly overvalued or headed towards bankruptcy. GameStop is one of those, since its business was built on game cartridges, which are becoming obsolete as more games move online. It’s been losing money and shrinking, with bankruptcy seemingly inevitable, so it attracted a very large number of hedge funds, which went short. At the maximum, almost 150% of the shares outstanding were short, which is clearly unsustainable. Enter Reddit and the wolf pack. They started buying, hoping to drive the stock price up to impose large losses on those hedge funds. Surprisingly, they succeeded and forced a large hedge fund, Melvin, to realize a more than 50% loss, according to news reports. As GameStop shares rose in price, Melvin had to post ever more capital until they ran out, which forced them to cover their short position and realize those losses. But this is much wider than just one fund. Numerous funds are in a similar predicament. As losses in these short positions increase, many of these hedge funds are also forced to sell off long positions to be able to apply more capital against their short positions. That’s why the overall market tended to move inversely to the movements of these short position targets much of last week. More such activity will continue, as the mob smells blood in the water, until a new equilibrium is found between the shorts and the longs.
What Happens Next?
Most likely, the volatility in the short targets will continue to roil markets until the short positions are reduced to a level that can be sustained for a much longer time period by hedge funds. At that point, the wolf pack longs will have a tougher time driving up the price any further and some of those individuals may wish to sell off some of their holdings to convert paper profits into cash. That could happen at any time, and it could well trigger a collapse in the price of these shares, since their valuations make little sense. So, we consider this activity nothing short of pure speculation, which is why we strongly recommend clients do not get involved.
The effects more broadly are likely to be minor. The companies in the crosshairs of the short squeeze are typically small, with significant business challenges. That’s why they attracted the hedge funds, which went short and also why the wolf pack is able to squeeze them. So, whether they survive or fail has little significance for the broader economy.
How will regulators deal with this?
Other than the possibility that the regulators can find clear evidence of collusion among the individuals buying these stocks, there is nothing illegal about what’s happening. There’s nothing illegal about individuals buying or selling what they wish or in posting about their stock trades on a public website. Nor is it illegal for individuals to recommend or exhort that others follow their trades. Moreover, it is the man in the street earning profits, while the “rich” hedge funds are taking the losses. No politician will stand up to protect those hedge funds. Some politicians may rant about the system, the financial markets or the stock market. Those are the same ones who rant against capitalism anyway. Regulators will be far more circumspect.
As has already happened, brokerage firms and custodians should increase the margin requirements on trading activity by individuals and hedge funds in these volatile names. That’s normal operating procedure. And for the extremely volatile names, some brokerage firms have limited trading in order to be confident they have enough capital to meet all the regulatory requirements. We suspect this far more stringent constraint will become unnecessary within short order. Robinhood has already raised $1 billion in additional capital and limited trading in GameStop, which reduces their need for capital. So, we think it is unlikely that Robinhood will fail as a consequence of the market volatility.
What will the consequences more broadly for the economy?
In our judgment, the consequences will be minor. The targets caught in the crosshairs are typically smaller companies. (That’s useful or even necessary to be able to move their stock prices.) If GameStop survives or disappears matters little to the broad economy. A few of the companies in question will actually gain a lifeline as a result of this turmoil. For example, AMC was able to issue debt and (hopefully) some equity to shore up their financial position and now has a better chance to survive until the economy returns to a more normal post-Covid world. But for a GameStop with a business that is melting away, the longer-term unfavorable prognosis has not changed much.
Does any of this matter to ACM or our clients?
Overwhelmingly, this activity increases market volatility, but otherwise makes little difference to ACM or our portfolios. As longer-term investors, we hold stocks of companies we expect to grow and perform well. We did own shares in Nokia, Penumbra and Cinemark, which attracted some attention from the wolf pack. Both stocks rallied sharply and we happily sold out of these positions last week since they reached full or more than full valuations. If these stocks fall back sharply when this wave of speculation ends, we could well go back into those stocks. Otherwise, we have zero exposure to the real basket cases that are severely harming the hedge funds and we have zero short positions. We are simply observers to these activities.