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Game Over

Game Over

February 04, 2021
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Stock indexes spent most of January continuing to grind higher before a sell-off over the last few days of the month led to mixed returns by the end. The S&P 500 was up as much as 2.7% on January 25th but finished the month with a 1.0% loss. The Dow Jones Industrial Average (-2.0%) and MSCI EAFE (-1.1%) indexes mirrored these losses. On the positive end, the S&P 400 Mid Cap (1.5%), S&P 600 Small Cap (6.3%), NASDAQ Composite (1.4%), and MSCI Emerging Markets (3.1%) all finished higher despite the sell-off. The sectors were mixed as well with Energy (XLE, 3.7%) leading the way and Industrials (XLI, -4.3%) and Consumer Staples (XLP, -5.0%) at the bottom of the pack. High yield corporate bonds rode the early January equity rally and finished the month with a 0.3% total return while Treasuries (-1.2%), investment-grade corporate bonds (-1.3%), and global bonds (-1.0%) all trended lower. The DJP commodities ETF saw a 2.9% gain that was buoyed by rising oil prices while gold (GLD) maintained its recent inverse correlation to stocks with a -3.2% return for the month.

Reddit, WallStreetBets, and GameStop

The big story of January that spilled out of Wall Street circles and into the social zeitgeist involved the stock of an unloved video game retailer that got caught up in a tug of war between hedge funds and an aggressive group of retail investors from an online forum. For those unaware, Reddit is a social news forum where users coalesce into smaller groups called subreddits that center around a particular topic. Users can post any content that they wish and comment on or like posts made by others. The subreddit of interest in this story is known as Wall Street Bets and the target stock is GameStop.

For the last five years or so, the story of GameStop’s stock has been exactly what you would expect of a brick-and-mortar retailer in 2021, failing to adapt quickly enough to a shifting landscape. While the retail scene in general has migrated online over the last decade or so, GameStop had additional headwinds working against them. Former customers lamented their practice of selling unnecessary warranties and pricing used games for nearly as much as new versions. The stock price had been in a steady decline since the end of 2013 and the company eliminated its dividend in 2019. This made it an easy target for short-sellers who cited mounting net losses and a shift to other digital storefronts among many reasons why the company was destined to fail.

To briefly recap short selling, it involves an attempt to profit from a DECREASE in the price of a specific stock. Normally, you buy a share of stock today at what you think is a low price with the goal of selling at a later date for a higher price. Short sellers reverse that timeline by selling today and buying at a later date. They begin by borrowing shares of stock from someone who already owns them and (because they think the price will go down) sell the shares today at what they believe is a high price. If they are correct and the stock price does indeed fall, they then go back into the market at a later date and repurchase the shares at the lower price so that they can return the borrowed shares to the original owner. Think of it as sell-high-buy-low instead of buy-low-sell-high.

Now enter Wall Street Bets (WSB). A quick glance at the content will likely lead to dropped jaws among the uninitiated. The users are known for posting offensive and politically incorrect content aimed at generating likes from their fellow users. This undoubtedly leads many to assume that this is simply a collection of risk-loving amateurs doing nothing more than gambling with their paltry Robinhood account balances and they wouldn’t be entirely wrong about the majority. The site’s profile increased dramatically during the pandemic as former sports gamblers morphed into retail traders amid global lockdowns. We mentioned the site in our year-end market commentary as one of 2020’s top stories in the market. But all of the immaturity masks some truly good fundamental and technical analysis and detailed investment theses from the more seasoned users.

A True Value Stock

The first pitches for GameStop started to appear as far back as 2019 when the stock was trading in the $10 range. By September 2019, the stock had fallen to around $5 and one user, DeepF---ingValue, started posting about why he thought that GameStop was a good value play. He put his money where his mouth was and began sharing screenshots of his positions in GameStop stock and various call options. Through the end of 2019, the stock traded sideways until it plummeted like everything else amid the Pandemic Plunge. By April 2020 the stock was trading just above $2.50 and it appeared that the shorts had won. Then another user began highlighting the trends working in the company’s favor, at least for the next couple of years; a surge in revenue whenever new video game consoles were released (as was set to happen in 2020), increased video game consumption during the pandemic lockdowns, and most importantly that the shares of the stock that were sold short represented almost 85% of the shares available for trading. Under normal conditions, 50% of shares being short is considered exceptionally high; 85% was unheard of. As we outlined above, whenever a short seller wants to close their short position, they need to go into the market and buy the stock. With the stock around $2.50, all of those shorts could begin closing out their position to realize large profits. With the aggregate short position representing nearly 100% of the shares available, the cumulative buying volume created by this action would create enormous upside price pressure.

Among the WSB users, however, this wasn’t just a short-term play to ride the wave and exit. The user that we mentioned earlier, DeepF---ingValue, again outlined his fundamental case for the stock in an hour-long YouTube video in July of 2020. In it, he dives into massive spreadsheets analyzing almost 20 years of financial statements uncovering hidden value in the balance sheets and pointing to a “margin of safety” a la true value investors like Warren Buffett and Seth Klarman. Items cited for a big price bounce included the already mentioned revenue surge around new console releases, a preference among gamers for physical discs (contrary to the prevailing narrative of a shift to digital), store closings and other restructuring efforts aimed at minimizing costs, overly pessimistic sentiment among the investment community, the pandemic-induced surge in video game demand, and the fact that GameStop was the only brick-and-mortar video game retailer. The company might not have been a lock for the next decade, but the next few years looked much better than $4 per share in his view.

His analysis was just as proficient as reports that you would see from Wall Street investment banks, diving into fundamental reasons for why the stock was undervalued and technical justifications for why he thought $4 was a good entry point with all of it being publicly available to anyone willing to listen. This high quality analysis might surprise some coming from someone with the username DeepF---ingValue and posting videos on the Roaring Kitty YouTube channel but it turns out that the individual behind the keyboard is a 34-yeard-old named Keith Gill who used to work for MassMutual and is also a CFA Charterholder. So much for inexperienced amateurs!

The Bull Case for GameStop Grows

At this point, the stock was back up around $4 per share but the short interest had climbed from 85% to 100%. If it sounds counterintuitive that 100% of a company’s shares can be sold short, you wouldn’t be wrong. Increased oversight in the wake of the Great Recession meant that when anyone wants to sell shares short, the shares in question must be accounted for. Selling short without being able to reference the shares being shorted is considered a “naked short” and it is illegal for most market participants.

As the short interest continued to grow, the more market-savvy users began to see a way to inflict some pain onto what they saw as greedy Wall Street hedge funds. A post from four months ago outlined what promised to be a once-in-a-lifetime opportunity. As the stock began to rise above $4 per share, the short sellers would start to lose money at around $7 per share. The higher the price went, the more the shorts lost and the more likely it became that they would start to close out their short positions by purchasing shares, driving the price higher, forcing more shorts to close, and on and on. This feedback loop is what’s known as a “short squeeze”. The user dives into intricate technical details of the unprecedented short interest, predicting exactly how the squeeze would play out, and specifically going after hedge fund manager Ken Griffin of Citadel. This user predicts the stock going to $400+ (when it was trading around $10...) and a gamma squeeze/delta hedge (we’ll explain this later) that would push prices even higher in a parabolic move. It is important to point out that with short squeezes, there are probably 99 failed predictions for every 1 that does materialize, but it is much harder to discredit the forum when the users can explain their investment thesis with this much technical detail.

The final catalyst came around the end of August when Chewy.com co-founder Ryan Cohen disclosed a massive position in the stock and was named to the company’s board of directors. His stake emboldened the WSB users in thinking that they were on to something. They already knew that Michael Burry of The Big Short fame was also long GameStop, which also bolstered confidence, but Cohen’s experience pointed to the possibility of a true turnaround given his experience with online retail and having taken on giants like Amazon head-to-head. The stock price rose through the end of the year and was trading around $20 at the end of 2020.

The Investment Thesis Becomes a Movement

Success, right? They rode a $4 stock up to $20 and had proven the shorts wrong. The fundamental case seemed to have undeniably worked out in WSB’s favor, but with the stock price now at $20, short-sellers simply saw the opportunity for increased gains to be made from a stock doomed to fail in the long run. Short interest climbed to 120% and WSB sensed that this ride was just getting started. Users who thought they knew the rules around naked short positions were wondering how 120% short interest was even possible without breaking securities laws. The narrative shifted to focus solely on an inevitable short squeeze that would propel the price beyond what the fundamentals themselves justified.

Within two weeks, that is exactly what began to happen. The stock crossed the $40 mark around the middle of January and people in the mainstream financial media began to take note. Surely this was simply another bubble being “memed” into existence by the WSB forum just like Tesla (TSLA), Virgin Galactic (SPCE), and many other stocks that were popular with WSB users in 2020. Momentum on WSB was just starting to pick up steam, however. By the following week, GameStop hit the $75 mark before closing at $65 on Friday the 22nd. Surely it was over now. The stock was up almost 250% in just three weeks and the company’s market cap stood at $4.5 billion after touching as low as $180 million in 2020.

On the forum, however, the narrative had shifted yet again. What started as a solid value stock with good fundamentals and supportive technicals before shifting to a short squeeze narrative had now become something much more personal. Over the weekend of January 23rd, posts started to appear with deeply personal stories of memories from the Great Recession with vindictive anger now being directed toward Wall Street in general. Some recounted friends who would turn ketchup packets into tomato soup for meals, a father with limited income hiring neighbors for odd jobs around the house to give them the dignity of not having to ask for a handout, and pictures of Wall Street bankers on balconies allegedly pouring champagne down on Occupy Wall Street protesters while laughing and taking pictures. More positive posts described individuals paying off student loans, finally being able to buy a home for the first time, and donating gains to various charities often focused on providing video games to children’s hospitals all juxtaposed against lists of hundred million dollar homes and mega yachts that they saw hedge fund managers using their gains for. Now WSB had a clear enemy. Even if the specific firms targeting GameStop weren’t staffed by those responsible for the Great Recession, they were still seen as part of the Wall Street establishment and that was enough for the forum.

Surely, we have reached a nadir at this point in the story? Nope. In the first hour of trading on Monday the 25th, the parabolic move anticipated four months prior had begun. The price rose from $65 to $155 in a 130% move upward. The stock closed the day at $75 but the story had reached the mainstream. Elon Musk tweeted his support for the Reddit users after having experienced a similar short selling attack against Tesla not that long ago. Mark Cuban cheered on the retail crowd after years of them being taken advantage of by high-frequency trading firms. Chamath Palihapitiya, CEO of venture capital firm Social Capital, made another memorable appearance on CNBC in a 45-minute interview and pointed to what he saw as hypocrisy on the part of Wall Street firms. As the interview ended, he urged CNBC host Scott Wapner to “be on the right side of history”.

The Short-Sellers Get Epically Squeezed

The backlash against short-sellers spread to other stocks including AMC Theaters, Blackberry, Nokia, and the clothing retailer Express. Two common themes that any potential target shared was some element of nostalgia and heavy short interest from hedge funds. GameStop was still the biggest component of the story, however, and this is where we will return to the Gamma squeeze mentioned earlier. In another repudiation of the “inexperienced amateurs” label, multiple posts on the forum mentioned this phenomenon. Go ahead and ask the average financial advisor to explain a Gamma squeeze and see what happens to their face. There’s no reason for most advisors to know what this is, but the fact that WSB members were breaking this down in plain English shows just how knowledgeable some members of this community really are. The Gamma squeeze is another version of the short squeeze, this time affecting the people who sold calls on the stock in question. Just like short sellers need to cover their positions by buying shares, as the stock moves exponentially higher, investors who sold calls also have to buy the underlying stock to hedge their losses.

By now, Keith Gill (DeepF---ingValue/Roaring Kitty), who initially invested $53,000 into his GameStop position, had become a hero on WSB as the value of his holdings rocketed to almost $48 million at the close on January 27th. That is NOT a typo. On Thursday the 28th, the stock traded as high as $483 and the brokerage firms began stepping in. Robinhood, TD Ameritrade, and Interactive Brokers restricted buying new shares or calls on GameStop but continued to allow selling. After hitting $483 around 10:00 am, the stock began what looked like a precipitous sell-off. By 11:15 am the price had fallen to $126 before sharply rebounding back above $300 within an hour. The chart had a neat and orderly step pattern during both the fall and rebound, indicating low volume trading. This is not at all unexpected given that retail traders were essentially shut out on multiple trading platforms, but from the perspective of WSB, this was blatant market manipulation since hedge funds were still largely able to execute their orders while retail traders weren’t. This only fanned the flames as the WSB crowd interpreted the move as a way for hedge funds to use the lull in trading to exit some of their short positions at more favorable prices. They pointed to empty order books as evidence of intimidation and vowed to hold onto their positions anyway.

The Brokerage Firms Take Action

While that makes a good story, it doesn’t provide the full picture. Platforms like Vanguard and Fidelity didn’t restrict trading in GameStop, so why did the others? For the brokerages that did place restrictions, this was probably a necessary step to ensure their own survival. The issue for them lay with the collateral requirements of clearinghouses that act as intermediaries for trading between brokerage firms. Whenever securities are bought and sold, these clearinghouses facilitate the transfer of funds and securities between different brokerage firms. Due to this transfer of ownership, stock trades don’t always settle immediately. There is a two-day lag so that clearinghouses can consolidate all of the orders that they receive. To protect their position during this two-day window, the clearinghouses require collateral from brokerages to ensure that each party will make good on their end of the transaction. The amount of this collateral varies based on a formula that takes into consideration the volatility of the stock being bought or sold among other things; higher volatility means higher collateral requirements. This is because, during that two-day lag, large price swings up or down increase the risk that one party or the other won’t be able to settle the trade in a security that is now worth significantly more or less than when the trade was actually executed. When transactions occur on margin, the brokerage firm can be on the hook for the entire balance of the transaction themselves instead of using client funds. When there is a significant amount of buying pressure and no selling activity to offset it, along with huge spikes in price, as was the case with GameStop, the brokerage firms are now looking at enormous amounts of collateral needed to settle these trades.

This is likely why firms halted buy orders but continued to allow sell orders while they sought out emergency capital to use as collateral for these transactions. The rare sell order that was placed could be used by the brokerage to offset the enormous amount of net buy orders already on their books. Vanguard and Fidelity, however, are unique among these brokerage firms because they also act as money managers. Vanguard and Fidelity offer a wide array of ETFs and mutual funds to their clients which means that they also have direct ownership of GameStop shares through these products. When buying volume soared without selling volume to offset it, Vanguard and Fidelity could temporarily match buy orders with their own shares instead of needing to go through clearinghouses and subsequently ante up massive amounts of collateral.

This isn’t to suggest that the brokerages in question are blameless. The biggest question is how these hedge funds were able to cumulatively build up a short position in GameStop that, at its peak, represented more than 140% of the shares available for trading. The Street has a theory that points a finger at brokerages and market makers who looked the other way but also left open the unlikely possibility that the position could have been accumulated legally. The mechanism for how this could have happened lies in something called a Failed to Deliver (FTD) order. This is basically when one of the parties in the clearinghouse process outlined above fails to send shares of stock when they receive the proceeds from the sale. This results in an FTD and the buyer now has what is essentially an IOU or “phantom shares”. If short-sellers thought that GameStop was going out of business, they could have intentionally caused these FTD transactions with the thinking that they would never have to make good on the IOU once the company went bankrupt. The website WhereAreTheShares.com compiled SEC data on FTD orders for GameStop stock going back to 2010 which shows an uptrend in the occurrence since about 2018. In 2020, the percentage of GameStop orders resulting in an FTD regularly crossed the 1.0% threshold and was as high as 4.9% on October 13th, 2020. Finally, this video from a 2006 presentation explains how this whole process works in more detail and, more pertinently, what it looks like when a short squeeze occurs in a stock with a large buildup of FTDs. The presenter explains exactly what WSB users predicted with the parabolic price move resulting from disjointed supply and demand, and how things could have gotten even worse for the hedge funds and the market as a whole. There were rumors floating around of sell orders getting fulfilled at prices as high as $2,600 and $5,000 per share. While these are unsubstantiated, the forum saw this as the anticipated parabolic move upwards that meant they were minutes away from breaking the system.

The Aftermath (So Far…)

Brokerage firms locking out certain transactions was enough to start the legal and political machines into action. Lawsuits started to pop up and lawmakers from Alexandria Ocasio-Cortez to Ted Cruz started calling for investigations into what exactly happened. Josh Holmes, former chief of staff to Mitch McConnell, likened this to a broader populist sentiment and issued a warning to Wall Street about the power behind the WSB crowd saying “welcome to our world” in reference to recent shifts within the Republican party.

At this point, all of the stocks involved in this frenzy are undoubtedly overvalued and there is no shortage of takes on how this is likely to end in pain for many retail investors but they don’t seem to care one bit. For them, this has become a movement about much more than monetary gains and losses. People have bought into GameStop at prices above $300 and accept the likelihood that they will lose money to join what they see as a good cause. Some users have started using their gains to buy billboard space in New York City, Minneapolis, and Oklahoma City. Planes have been spotted in the sky flying banners with the text “Buy GameStop Stock -WSB”. WSB members have also been urging each other to call their brokerage firms directly to let them know that they do not want their shares to be lent out to short-sellers.

As of right now, it is hard to see this having a lasting impact on stock markets as a whole. At the end of 2020, the combined market cap of GameStop, AMC Theaters, BlackBerry, Nokia, Bed Bath & Beyond, and Express was just under $30B and that figure was at just over $65B at the end of January which would have made them just the 114th largest company in the Russell 3000 as of that date. These were mostly companies headed towards bankruptcy or that at least had a long road to recovery which is probably why they were so heavily shorted. There is always the risk of unseen contagions, but right now the biggest risk posed by this event is that the hedge funds that took these short positions continue to hold and are forced to sell other long stock positions to generate much needed liquidity. That selling would put downward pressure on stock prices across the board and could be why we saw such heavy selloffs to end last week. However, that move could have also been related to pandemic developments, the current stimulus stalemate in the US, or just a reversion to the mean and the first week of February is off to a solid rebound so far.

This does point to the continued importance of other larger trends in the markets and society in general. One is the rise of retail traders. We have already covered this topic at length but the way that social media was leveraged to create a massive push into a single stock will likely weigh on technical analysts for the foreseeable future. Social media sentiment could become an important component of predicting short-term moves in stock prices.

We alluded to the second trend earlier with the Josh Holmes quote above, but this event has also been tied to the rise of Donald Trump within the Republican party, Black Lives Matter protests over the summer, and the broader surge in populist sentiment. While the connections sound flimsy at first, the CNBC article on Josh Holmes’ warning points to similarities among the disparate movements that include a feeling of pushing back against the elite, a belief that the rules have been written to benefit insiders at the expense of average people, skepticism of the media, using the internet as a democratization of power, and drawing inspiration from viral memes. WSB posts can be found referring to this moment as a “revolution”. An increased interest in alternative economic models points to dissatisfaction with current theories and that sentiment has only been further fueled by economic suffering and isolation due to pandemic lockdowns.

In my opinion, this story is just beginning to unfold. Attention may fade from the stock itself, but now we get to see if anyone is held accountable (and if so, who) and if any new regulations or restrictions will be put in place going forward. There are already calls for increased regulation to prevent this type of speculation from occurring again. The trade seems to be unraveling in the first days of February with GameStop trading below $100 per share, but remember that this opportunity emerged when the stock was below $10; still a pretty nice profit! GameStop’s corporate slogan has always been “Power to the Players”. As this story continues to unfold, we will get to see whether that remains true or if the theme shifts towards...wait for it...

GAME OVER


Adam Blocki, CFA, CFP®
Sr. Portfolio Manager