To Infinity And Beyond (or not)
Ok, I’ve got to mention it. People have started asking about it. What’s going on? Do I need to worry? Is it impacting my portfolio?
Yup. Gamestop. Even if you never read the financial news (I mostly recommend people don’t) you will have seen the headlines. They have been everywhere.
Here’s what happened:
Let’s start at the beginning. GameStop (GME) is a struggling retailer. They sell video games in strip-malls. It’s not a high-quality business. Sales have fallen in 10 of the last 11 quarters, and more than 1,000 stores have been closed in the last two years. Due to the dismal prospects the stock was one of the most heavily-shorted stocks on Wall Street.
Let me explain shorting.
There are two main ways you can trade a stock. You can go long or short. When you go long a stock you have bought it and you own it. Presumably you do that because you have an expectation that the price will go up over time. Presumably someone sold you that stock (there’s always someone on the other side) because they either thought the stock would go down or they needed to turn the stock into cash.
If you don’t believe a stock price will go up because you believe it’s overvalued or your analysis says it’s a horrible business, you can ‘short’ the stock.
To short a stock you have to sell a stock that you don’t own.
I know, it sort of gets the brain in a tizz.
To sell the stock you don’t own you have to borrow it temporarily from someone else. The plan is that you sell the stock at say $100, you borrow it from someone else, you pay them a fee to borrow it (like a rent) and then the stock goes down and you buy it back at say $70. You pocket the $30 less what you paid to rent it. So you are selling something you don’t own, but have borrowed, at a price that is higher than the price at which you think you can buy it at some point in the future. Once you buy it you will then return it to the person you borrowed it from. Confused?
The problem with GME was that the hedge fund managers were so convinced that the business was going to fail that they had borrowed more shares than there were outstanding (don’t ask me about how that happens).
It was, in jargon, ‘one of the most heavily shorted stocks on Wall Street.’
Normally this would go mostly unnoticed.
We aren’t living in normal times.
There are hundreds of thousands of bored young people (mostly men) in America (and the world) right now who can’t do what they normally do (drink, party, go to the casino, watch sports games) and they have all been sent stimulus cheques in the post. A large number of them have found their way onto an app called RobinHood where trading is free.
RobinHood is a trading platform that has gamified the whole process. Think free stocks, confetti raining down on your screen, spinning digits, constant nudges to entice you to trade.
The combination of lockdown, stimulus cheques and frictionless trading at Robinhood is like a red rag to a bull.
Oh, and there’s Reddit too. Somewhere in (or on?) Reddit is a community called WallStreetBets. Someone here started talking about GME and rallied the troops to start buying the stock.
Lots of people buying the stock sends the stock price up – it’s simple supply and demand. Remember the hedge funds have shorted the stock, which means they are hoping to buy it back at a lower price than they sold it at so they can return it to whomever they borrowed it from.
This brings me onto the short squeeze. When you short a stock you have limited upside – if you sold it at $100 and it goes to zero you pocket $100, less the rental costs. You can’t make more than $100. However, you can lose a lot more.
If you borrowed the stock at $100 and it goes to $200 and you have to buy it back at $200 to return it to the person you borrowed it from (you always have to return it) you have lost $100, plus the rental costs. If it goes to $300, $400 etc. your losses keep going up and up.
At that point the short sellers start to panic and start scrambling to buy back the shares. The problem with GME was that it was so heavily shorted there were no shares to buy back. The short seller starts bidding for shares at any price to try and ‘close out their position’ before they get totally wiped out.
On it goes.
That’s what sent the price into the stratosphere.
Well, that and Elon Musk’s tweet below. (The share price opened at $88.56 on the 26th January and hit a high of $483 two days later. It’s now $55.2).
Now, as any student of finance knows (or anyone who actually stops to think it through knows) nothing at the company has changed. It isn’t suddenly worth 1000% more than it was the week before. The future cash flows of that company (that’s how you value a company – you value it based on the present value of the future cash flows) haven’t changed because an army of redditers (or are they Reddites?) decided to play a game.
So of course it ends just the way any intelligent market participant knew it would end. With a big crash.
Some people made money (one hedge fund made a reported $700 million) but an awful lot of people who got sucked in on the way up or near the top will have lost money. There will be some sad stories. Very sad stories. The little guy didn’t win.
How does this impact us long-term, patient investors who take a total market index approach?
It really doesn’t.
It was fascinating to watch and it is a reminder that fear and greed will never disappear, despite markets getting more sophisticated. We humans will never change. We have been behaving like this for millennium.
This was different in some ways, in the way the group formed on social media, but the psychology is exactly the same.
I want to assure you that I am always watching these things. So far there is nothing that I have read that causes me to think that we need to change any part of our strategy, that is investing predominantly in low-cost index funds where we benefit from the long-term trajectory of the market without making bets on specific companies.
I am not saying that will always be the case. The world is changing and it is changing rapidly. We have to be ready to adapt. But chasing manias like GME will never be part of the long-term plan.
As always, I am here to answer any questions you might have.
And finally if you are not a Liberty Wealth client and you got caught up in this and now realise your life savings might benefit from a compassionate ‘tough-love’ advisor to stand between you and the next GME, drop me a line!
Georgie
georgie@libertywealth.ky