Your Money: The Gamestop Saga Part 3 – How it played out in the market

The wild ride in Gamestop stock was caused by a market phenomenon known as a short squeeze. We explain here how the squeeze on Gamestop played out.

Finally that brings us to Gamestop

The explanation of short-selling ( in Part 1 ) and short squeezes ( in Part 2 ) so far has been generic and hopefully straightforward. When we get to the story of the recent Gamestop (NYSE: GME ) short squeeze, things start to become decidedly less logical. The whole event was artificially “manufactured” by a group of traders who, for some reason, decided they wanted to punish the many short-sellers who were betting against the stock. Whether manufactured or organic, the mechanics we’ve learned still serve us well in understanding how this event played out, with the stock price rising abruptly and violently, putting a deadly squeeze on the vast number of shorts in the stock.

Returning to where we started, we find Gamestop, the aging chain of video game stores. Now that you know more about how to bet on a stock to decline in price by selling it short, GME might start to look like a very good short candidate. Remember its dying business model and its vast amount of overhead due to the bricks and mortar stores and the army of retail employees manning them? And don’t forget about the fact that gamers these days mostly play online and eschew purchasing games from physical stores like Gamestop. If you’re thinking there’s money to be made betting against its stock, you’re not alone.

In fact, a large number of professional investors – mostly hedge funds – also saw Gamestop as a good short bet, so they had been establishing large short positions in the stock leading up to the early days of 2021. The short positions were so large that the number of shares that had been sold short was actually 40% more than the total number of shares in existence! While this 140% “short interest” is not an unprecedented level, it is certainly very high relative to what is typically seen in even the most popular targets of short-sellers.

You may wonder how it’s possible to sell short more shares than are in existence. It’s somewhat complicated and not really relevant to this discussion, so we’ll leave it to the curious to google “140% short interest in Gamestop” for explanations. Suffice to say, it’s possible, and it’s not necessarily an indication that anyone has done anything illegal. But with this huge collective short position in the stock, a sustained increase in the stock price could cause a deluge of buying from short-sellers needing to cover their positions and stem their mounting losses. But this could easily create a self-fulfilling prophesy that causes the stock to rise ever higher, forcing more shorts to buy, and so on – as we know. The classic short squeeze.

Because many traders are familiar with this concept, there can be an incentive to identify stocks with massive short interest like Gamestop…and try to generate enough buying interest to move the price up and kick-start this chain reaction. In the case of Gamestop, if such an effort were successful, and with such a huge short position to be unwound, there was a very good chance of igniting a massive short squeeze that could potentially take the stock price to dizzying heights.

It just so happened that there were a number of people who were hatching a scheme to do exactly this.

WallStreetBets Reddit board

Most people may not be aware, but there are countless message boards on the internet where people discuss stocks, trading, investing, etc. They compare opinions on the stocks they own or are considering trading; they try to convince one another that some stock they like is the next big thing and thus everyone should jump in and buy it now before it takes off; and they write just about anything else they feel like making other people read.

The merits of these message boards are debatable, but there is no doubt that they tend to gather large numbers of smaller retail traders. There is clearly an element of gambling mentality present among many members of the boards. And in the past few years, with the advent of trading apps like RobinHood that are targeted at very young, internet-savvy individuals, the message boards have become particularly active. You can think of them as social media for stocks, and young people have taken to trading stocks like it’s a new video game, or a trip to Vegas. The RobinHoods of the trading business have effectively turned it into a video game, except a game with real money on the line, zero commissions, and no minimum amount of capital required to get into the game.

Given the seemingly endless upward surge in the stock market that has been induced by the massive amount of government and Federal Reserve stimulus of the past dozen years (a topic for future articles), many of these new, young traders have actually made money in the game. Of course, if your main trading strategy is to buy stocks hoping they will go up, it’s not too hard to make money in a market that has done nothing but go up. It’s also not too hard to convince yourself that you’re a brilliant trader with a real skill for knowing how to make the right trades.

If you’re old enough, perhaps you remember the dot com boom of 1999, when it seemed like everyone was an expert on making money in the stock market. Well, those days are back, but the crowd has skewed even younger, as access to the markets has become even easier. And they love chattering with one another about it all on the trading message boards.

One of the most popular of those boards is called WallStreetBets (WSB), a board with over 2 million members on the website Reddit. And it’s there that the Gamestop scheme was hatched. When on January 11th Gamestop announced that it was bringing on a few new Directors who had some background in the digital marketplace, WSB and other boards became ablaze with positive comments and memes for Gamestop stock. Presumably the idea was that the company had a plan to move beyond its bricks and mortar roots and enter the modern video game sales market, giving it new life and a brighter future. People began encouraging others to buy the stock, and indeed, some members of these boards did begin buying the stock.

The domino effect began, in both the amount of internet chatter about GME stock and the amount of actual buying of GME stock. A huge portion of that buying took place through RobinHood accounts, because many of the WSB members trade on that platform. A big part of the theme that was behind the messaging and the buying was that the little guys of WSB and RobinHood would finally take their revenge on the Wall Street hedge fund establishment and the evil short-sellers by pushing the price ever higher and forcing these sordid characters to cover their positions in a short squeeze that would cost them billions – likely bankrupting them. Finally, it would be one for the little guys!

It was all very allegorical, scripted like something straight out of a pro wrestling storyline of the good guy versus the bad guy. But regardless of how cartoonish one may regard the situation, there are enough of these “little guys” on the message boards that they were able to make the plan successful. The way it played out is that, once the stock started moving up on January 12th and 13th, some of the smaller hedge funds with less capital to sit through temporary losses were forced to cover their shorts, which created the first turbo boost to enhance the WSB buying, and that’s when things started to really take off.

As small traders of the stock (and the options on the stock) started showing screenshots of their unbelievable gains on the WSB message board, it brought more and more traders from the sidelines, all piling in and buying GME in hopes of sharing some of the big gains as it shot skyward. And of course, as the price continued to surge, ever more short-sellers from larger institutions chose (or were forced via margin calls) to cover their short positions…and the massive short squeeze took on a life of its own.

Interestingly, while all this was taking place, the fundamental business prospects of Gamestop hadn’t really changed, and it still looked like a strong candidate to circle the drain and eventually declare bankruptcy. i.e., it still looked like a good stock to sell short. Especially if you hadn’t already been in a short position and been forced to cover and take a big loss. So new short-sellers entered the stock, now entering short positions from much higher initial selling prices, thinking that the upward surge had to subside soon, allowing them to make even larger gains when the mania inevitably passed and the stock dropped to zero.

The new short-sellers misjudged the ability of the GME buyers to keep the upward pressure on, and soon they too were showing massive losses and had to buy to cover their positions, thus keeping the stock price moving ever higher. In the end, from January 12th to the 28th, GME stock gained over 2,300%, going from below $20 a share to a high of $483, in one of the biggest short squeezes in history, catalyzed and sustained by the unified activity of the retail traders on WallStreetBets.

Consider that if you had sold 1,000 GME shares short at $20 on January 12 th ($20,000 value) and held on through the peak of the short squeeze, you would have been on the hook to buy back those same 1,000 shares for $483,000, or a loss of $463,000. But few shorts held on that long, of course.

As is usually the case, eventually the squeeze ends when there’s not another buyer left to buy, and the stock falls precipitously from its dizzying heights. As we write this, GME is back down around $50 a share. That’s still a 150% gain from where it started. But check the price by mid-2021 and it’s possible you will see that the shorts were right all along, and the gains were irrational. But as we’ve stated previously,

“The market can stay irrational a lot longer than you can stay solvent.”

In this case, the market only had to stay irrational for about 2 weeks to drive lots of short-sellers into insolvency. If there’s ever a lesson to be learned about the dangers of certain types of market risks, the Gamestop short squeeze has to be it.

Beside this lesson, you might ask what all this means for you. It can mean many things, depending on your situation. But if we assume you’re not a stock market expert, or even a trader, we at Plutigo believe that a good takeaway is that in today’s financial world, you can’t afford to be complacent. You can’t afford to be completely clueless about what is going on, and how it works.

You may think the Gamestop short squeeze had nothing to do with you, but it might not be true. Do you know who invests in hedge funds? Maybe you think it’s a bunch of rich people. And to an extent, it is. But do you know who else invests in hedge funds? Institutions. Do you know what “institutions” means? It means pension funds, like the one you may be invested in through your work. So maybe, indirectly, you were invested in one of the short-selling hedge funds that lost big in the Gamestop short squeeze.

These kinds of sonic booms in the markets have the potential to echo through the lives of the average person, not just the hotshot risk-takers on Wall Street. In a major sense, we are all risk-takers just by being alive, especially in the United States. The financial decisions the government and the Federal Reserve have made for the past several decades, and especially since the 2008 financial crisis, have ramped up the federal debt level to unprecedented – and extremely dangerous – levels.

The Covid-19 pandemic has given the government even more of what it considers to be valid justification to print untold trillions of new dollars, and all this money-printing, which none of us were given a realistic chance to say Aye or Nay to, has one primary effect on the money you already have – making it worth less in terms of purchasing power. That’s the definition of inflation. Things are changing. And while you may not be able to control what the government does, you at least need to be aware of it to some extent.

The “little guys” on WallStreetBets are in reality a creation of the government’s fiscal policies, because regardless of what you hear from politicians, all the actions they have taken to supposedly help average and below-average Americans (in the form of new money printing, zero interest rates, etc.) have helped do one thing above all others: increase the divide between rich and poor. These policies, regardless of how they are presented, or even how they may have been intended, have allowed the rich to get richer at an incredible rate, while leaving the little guy in the dust.

The average American feels more powerless than ever, which we have seen manifest over and over in the streets as social and political strife. When the people on WallStreetBets saw a chance to take some of that power back from the Wall Street establishment, they jumped on it, and the movement was violent. This time that frustration showed up as the violent movement of a stock’s price. The time before that was the storming of the US Capitol in early January, 2021. What kind of violent movement will it be next time?

While we can’t predict it, we do think it’s important to be aware that it can, and likely will, happen again. We encourage you to be as prepared as you possibly can be through education, minding your own finances, and thinking for yourself rather than following along with the crowd. You don’t want your life, let alone the future of the United States, to be the next Gamestop short squeeze.

In fact, if one looks dispassionately at the financial policies of the US government and central bank since 2008 (and possibly earlier), it seems to have had one objective – to keep the stock market rising at all costs. While huge stock market crashes are generally not good for a country, we at Plutigo do not view market boosting, at the expense of prudent fiscal policy, to be the primary objective of the federal government. Especially when it involves taking massive risks with the future of 350 million Americans.

It’s easy to say that all’s well that ends well. And indeed, at this point the policies have not only kept the market up, but pushed it much higher (almost like a short squeeze….) But at what cost? Do we expect that all the government’s heavy-handed actions to disrupt the natural balance of supply and demand in the US stock market will have zero consequences, ever? It’s a logical fallacy to argue that the fact that the policies don’t appear to have caused a major problem yet means they never will in the future.

From our perspective, artificially forcing interest rates to zero in order to fuel the stock market can – and almost certainly will – have dire consequences. Consider just this one side-effect of the zero interest rate policy (ZIRP): even widows and orphans (an age-old market expression used to indicate the most risk-averse category of investors) have been given no choice but to put their money at risk in a very richly valued stock market to have any chance at getting a return to keep up with inflation.

Of course, the side-effect of this situation, what economists call an “externality,” has thus far looked like a positive one. The market has gone up, taking the widows’ and orphans’ investments along with it. But if the market should happen to turn around, and do so sharply (like when NASDAQ fell by 77% during the dot com collapse), what will be the fate of these widows and orphans? Or the tens of millions of senior citizens who have scrimped and saved all their lives to have a decent nest egg that they would be happy to invest in fixed income investments paying them a very low risk 5% a year, but who don’t have that option because of the artificially low interest rates forced by government policy? In a hauntingly real way, the senior citizens who should be passing their days in the casino at the penny slot machines, where even on a cold streak they can’t lose money fast enough to get hurt, are being forced to belly up to the $500 minimum craps table and play with the sharks. This month’s living expenses – and a lot more – can be gone in the blink of an eye. And unlike the MGM Grand or Caesars Palace, the government casino won’t even give them a free pass to the lunch buffet as a consolation prize.

Risk is easy to live with when it’s hidden and you don’t have to sit around worrying about it constantly. Unfortunately, this comfort doesn’t mean the risk cannot and will not cause you harm at some point. And the fact that you may not realize just how much risk you are taking means that you will likely not be prepared to deal with the adverse effects when they hit you.

We certainly hope that all the risks hidden under the last 12 years of reckless government policies and the resulting stock market advance will never turn into the kind of financial mayhem that the NASDAQ suffered in the dot com bust. Nor the kind of absolute disaster that has plagued the Japanese markets, and the entire economy, since their massive stock and real estate bubbles burst in 1989. (Yes, this is a real thing. Most Americans have no idea what has been going on in Japan, one of the most prosperous countries in the world, for over 30 years. If it could happen to them, it could happen to us.)

While we hope nothing like that happens, we fear that the probability of it is much, much higher than anyone in the media, the financial world, or the government is willing to admit. Time will tell what the outcome is for our financial system.

But beyond the risk of total financial destruction, we must look at the real effects. The average American feels more powerless than ever, which we have seen manifest over and over in the streets as social and political strife. When the people on WallStreetBets saw a chance to take some of that power back from the Wall Street establishment, they jumped on it, and the movement was violent. This time that frustration showed up as the violent movement of a stock’s price. What kind of violent movement will it be next time?

While we can’t predict it, we do think it’s important to be aware that it can, and likely will, happen again. We encourage you to be as prepared as you possibly can be through education, minding your own finances, and thinking for yourself rather than following along with the crowd. We don’t want our lives and the future of our country to be the next Gamestop short squeeze.