On 8 January GameStop shares closed at $17.69. They hit $40 the following week, then $60 on 22 January and reached an all time high of $483 on 28 January. Now one week later they closed at $53.38. You might have seen a few news reports and be wondering what is going on there.
The TV show ‘Billions’ portrays the glamorous lifestyle of highly intelligent and villainous hedge fund traders. They always manage to make huge amounts of money from their devious and brilliant schemes. All the while, staying one step ahead of the dedicated Federal Attorneys of the Southern District of NY. Interestingly, one of their favourite tricks is the ‘Short Squeeze’.
Short selling is when a trader enters into a contract to borrow shares from a fund manager in order to sell them now with the aim of buying them back at a later date and a lower price. The trader then returns the shares to the original owner, whilst pocketing the profits. Clearly a trader will only do this if they expect that the share price will fall during this window of time.
A short squeeze occurs when someone buys up all of the freely traded shares of a company that is being shorted such that there are insufficient shares available to purchase when the short seller needs to buy them. As a result, the share price increases massively and the short seller suffer enormous losses.
A pump & dump is when existing shareholders of a company hype up the prospects up that company with the intention of selling their shares after the price rises. This is an illegal act of market manipulation.
The reality is that some hedge fund traders are either not too bright or they’re not paying enough attention to the risks that they are taking with other people’s money.
The combined losses by large hedge funds are reportedly nearly $20 billion dollars as a result of short selling GameStop, a company that had a market capitalisation of only $400 million last year. When day-traders found out that hedge funds were heavily shorting the stock of their favourite retail gaming store, they began buying it in large numbers. It was a thinly traded illiquid stock so it didn’t take a huge amount of effort to create massive upward momentum.
There has been a lot of hand wringing about market manipulation and instability. Fund managers in the press decrying the “madness” etc. When Wall Street turns the sharemarket into a giant poker machine nobody bats an eyelid, but when retail investors do it, everyone screams blue murder.
It’s unlikely that a scenario of this scale will be repeated in the near future and it’s expected that the normal rules of investing will resume. GameStop might be able to reinvent their business and survive, otherwise they will continue down their path of a slow and steady decline. They probably wont be able to sustain the current $4 billion market capitalisation though. Most of the people who bought the shares in the last week are never going to make a profit from them.
The hedge fund companies should have known better because this scenario has occurred before.
In 2008, hedge funds lost $30 billion short selling shares in Volkswagen. At that time, 30% of shares were held by Porsche, 20% by the government of Lower Saxony and 5% by various index funds. When hedge funds short sold 12.8% of their Volkswagen shares, Porsche exploited weak German takeover laws and increased their holdings by 44%. This left only 1% of shares available to trade and subsequently, the hedge funds were not able to fulfil their short sale contracts.
Porsche made a profit of $10 billion but could have easily gone bankrupt if this strategy had failed. The CEO was thanked with a bonus of €130 million though he was fired not long after.
Hedge funds will now be on guard for a repeat of these episodes but eventually they will forget and get caught out again.
The lesson for us is that other people can treat the market like a poker machine and hopefully they only lose money they can afford to lose but we don’t have to get caught up in it.
It is my belief that investing for your financial goals, like a comfortable retirement, is a long-term strategy. Having a long-term financial plan is like sitting in the eye of a storm. Long term investors can ride through these shenanigans with barely noticeable ripples.