Updated: Mar 12
The GameStop Surge Explained
The end of January 2021 was marked by unprecedented events that shook the financial world. Those with deep knowledge and expertise of the matter were replaced by mere amateurs holding on to the 1990s culture.
Analysts of large hedge funds such as Melvin Capital Management, Maplelane Capital, and D1 Capital Partners deemed it time to short sell the stocks of a handful of companies appealing to that very same 1990s culture. But what does it mean to short sell? Literally, it means that you sell something you don’t own by borrowing the securities you need and selling them right away. Analysts undertake this technique whenever they feel like betting on the worsening of a company in the future. This pushes securities’ prices down and allows them to repurchase those same stocks at a much lower price to cover their initial position, gaining from the difference.
Gamestonks!! - Elon Musk, CEO Tesla Inc.
One of the unfortunate companies doomed by this negative forecast was GME, GameStop Corp, a video game, consumer electronics and collectibles retailer. Selling across 14 countries, with 5,500 stores, it reached a turnover of $6.5 billion in 2019 but recorded a net loss of $470.9 million. This red flag is one of the main reasons why it caught hedge funds’ attention. It seemed to promise nothing but further losses in such a fast-evolving digital world.
But something went wrong. And here is where Reddit, a totally unforeseen actor, comes into It is a social platform spreading news and hosting discussions. One of its forums, r\WallStreetBets, groups a very large number of finance amateurs, namely around 2 million affiliates - now more than 9 million. When these people found out that hedge funds were betting on the failure of GameStop and other similar companies, they did something that nobody in the financial world could have thought possible nor reasonable. Pushed by their common interests, they bundled up and pursued a strategy of their own. The idea is that, by being bullish on a highly shorted stock, the Reddit forum can force short sellers into protecting themselves by buying stocks, triggering a temporary upward spiral. However, it is important to bear in mind that this rapid increase in price does not reflect any fundamental value, so it is assumed to be only temporary. As a consequence of this turmoil, prices increased by 1,745% YTY. It goes without saying that hedge funds played the role of the victims in this battlefield, losing huge amounts of money on their initial bet. Just to make some examples, D1 Capital Partners lost around 20% of the value of their investment, and Maplelane Capital shrank around 33%. BlackRock, on the other hand, by holding 9.2 million shares of GME, raised as one of the big winners given the circumstances.
But wouldn’t hedge fund have been better off keeping the shorting position for themselves? Definitely. Nevertheless, US and EU regulators require the disclosure of short positions to competent authorities if the shorting regards over 0.2% of the company’s capitalization, and to the public if more than 0.5%.
We have asserted that establishing all the causes and dynamics of this phenomenon is far from being an easy task, however it appears undeniable that this stunning surge in prices clearly contradicts the Efficient Market Hypothesis (EMH). This hypothesis conveys the ideas of market rationality and arbitrage. According to the former, investors are rational and form their best guess about the future using all the available information. Of course, not everyone needs to be rational. But as long as at least a few are, this guarantees that market prices reflect all available information. Arbitrage, on the other hand, occurs when there are risk-free opportunities to make profits, and in the EMH this cannot happen. It is therefore straightforward to conclude that since GME stock price does not reflect the fundamental value of the company per se, this market cannot be considered efficient. This is one of the reasons why the GameStop surge caused so much distress in the financial world. It should be noted that Reddit’s individual investors were facilitated by the use of zero-commission trading platforms, such as Robinhood Markets, which open the doors to stock trading to commoners, who otherwise would not have the means to participate efficiently in financial markets. As a result of such a large participation rate, the sum of all the individual contributions ends up being more than able to contrast the action of hedge funds. It came as a shocking surprise when those very same platforms closed their gates when the large demand was causing their clearinghouse to ask for higher deposits.
This event underlined for the first time the strong influence that social media can have on financial markets. Policymakers should start taking this factor into account. Many believe that another relevant factor that contributed to this surge in retailer stocks might be seen in the unemployment checks distributed with the stimulus plans enacted by governments in an attempt to restart the shrunk post-pandemic economy.
Maybe it is still too soon to understand whether this turmoil has been the result of a mere fortuity or, on the contrary, if it represents a durable change destined to reshape the rules of the financial game. The odds are hanging more strongly on the side of the latter hypothesis, but for now this is just a speculation.