It seems these days that there are a number of battles being waged out in the world. And, in our information society news travels fast and from many different directions. Fast and prolific enough that it can oftentimes be confusing. When my 13-year-old neighbor asked me about buying a stock he learned about from a meme on the internet, I knew we had reached that state of confusion about a financial battle playing out on Wall Street. So, to help explain things beyond the headlines I reached out to Nick Juhle, our Director of Research — someone we at Greenleaf Trust rely on for his ability to thoughtfully give us the real story. Here’s what he had to say.
What is going on?
GameStop has become the poster child for what amounts to a very interesting clash between retail day traders coordinating on internet message boards and short-selling hedge funds. Here’s what is happening. GameStop is a declining business, not unlike Blockbuster Video circa 10 years ago. The pandemic has accelerated the long-term trends that could be the eventual demise of this brick and mortar video game retailer. Several large hedge funds held short positions on GameStop (they profit if the shares decline in value, so they are betting the stock will fall). In many cases, they were using derivatives (options etc.) to amplify their bets further, which resulted in more than 100% of the GameStop shares being sold short. If the stock were to fall, the short sellers would make money, but in the event it were to spike higher, their potential losses would be literally unlimited. A public message board on Reddit encouraged people to buy shares of GameStop. The idea was that if enough people took action, the share price would rise, which would work against the short sellers. The only way to close out a short position in a stock is to buy the shares, so as day traders pushed the stock up, short sellers were also forced to buy shares in order to close their positions, which in turn drove the price even higher — much higher.
Hedge funds were betting GameStop shares would fall from a price of $4 back in June. Having briefly touched $500, shares were trading at $325 at the end of January. Hedge fund managers are unhappy because they have lost untold billions on what they believed to be a sure thing – enough, in some cases, to threaten their solvency. Soon, every retail investor on the planet (whether they understood what was going on or not) wanted to get a piece of the action, so the buying continued. To be clear, the share prices we are seeing are completely divorced from any underlying fundamentals for GameStop, and are purely reflective of extreme levels of demand for the shares. The same narrative has played out for shares of other struggling companies like AMC Theatres, Nokia, Blackberry, and Koss Corporation, though not to the same extreme levels observed with GameStop.
What are the implications?
A few things come to mind. First of all, hedge funds have been hurt so badly that in many cases they have been forced to sell higher quality investments to buy the shares necessary to cover their short positions. I suspect we have recently seen evidence of that in the market in the form of broader downward pressure and increased volatility. On Thursday, January 28, several retail brokers (Robinhood, TD Ameritrade, etc.) restricted additional purchases of GameStop and other targeted companies. It was rumored that they were pressured to do so by big hedge funds that actually drive significant revenue for them. As a result, there was some market relief. GameStop shares fell and the broader market rallied, but there was also outcry from retail investors who felt they were being unfairly restricted, not because they were doing anything wrong, but because the hedge funds were losing the game. Once those restrictions were lifted, GameStop rallied again and the broader market pulled back.
I expect this noise to work itself out in the short-term as short positions are covered and the retail excitement subsides. That said, there are plenty of other “GameStops” (small companies with high short interests) out there, so we could easily see additional short squeeze dynamics play out. If that’s the case, long-short hedge funds would need to continue to unwind their short sales and would finance the trades by deleveraging their long holdings. This deleveraging process (on the long and short side) could drive additional volatility in the weeks ahead. Longer-term, I think (hope) we will see better risk controls in place with large money managers, and option pricing that more accurately accounts for risks that have now been illuminated. I also hope that inexperienced day-traders understand the risks they are taking by continuing to buy shares that are artificially inflated.
Greenleaf portfolio considerations?
Fortunately, Greenleaf Trust and our clients are largely bystanders as this narrative unfolds. We are not a hedge fund. We do not take short positions. The companies being impacted are generally smaller and, even if represented in a fund or ETF that we hold, any performance impact will likely not be material. Our investment philosophy depends on fundamental research which would preclude any prospect of purchasing GameStop (for example) in an attempt to profit from this situation, and our long-term orientation enables us to look through shorter-term volatility or market dislocations. Disciplined application of our philosophy served us well in an eventful 2020, as we expect it to in these interesting early days of 2021. Please contact any member of our team if you have questions.