Saturday, January 30, 2021

The Gamestop Mania

If you are not involved in the Gamestop mania, you are probably sitting back and enjoying the action. You're awaiting the moment when Tom Brady comes out on the field and saves the day.

Anyway, big, bad hedge funds, having shorted Gamestop to oblivion are suddenly faced with the obligation to buy back the shares that they sold short. Many of them do not have enough cash on hand to do so, and are getting seriously damaged.

By now most of us understand that shorting a stock means selling something you do not own. Through the magic of your brokerage firm, you borrow the stock from someone else and sell it, pocketing the proceeds. The person who owned the stock does not really know that you borrowed it and sold it. He knows that the stock still appears on his account. 

So, you sell a share of XYZ for $100 and you have the cash on your account. Are you feeling rich? Perhaps so. But, you also have a debt, not a debt for $100 but a debt for one share of XYZ. Well and good. Now, if the stock rises to $1000, you now own $1000, against which your $100 cash balance does not look quite so imposing. 

As for how and why the stock can make such a meteoric rise, the current answer seems to lie with small retail investors, people who are market amateurs, but who have banded together to push up the stock. Those who are smart enough to sell out before the madness of crowds takes over will make a lot of money.

If they are market amateurs they are also setting themselves up for some serious losses. They are playing the market as though it is a casino. And I trust you know that a casino operator has one very fond wish-- that the first time you play roulette or craps or whatever, you win big. He knows, as first time investors do not know, that instant success convinces him that he is brilliant and that his gut instincts are infallible. Over time he will lose far more than he won the first time.

The same applies to investors on Robinhood. Since there is no real basis for the current price of the Gamestop stock, it will inevitably, at some point, descend to something resembling fair value. If you bought near the top, in order to teach the hedge funds a lesson, you are going to take a loss. It’s like musical chairs-- if you are the last one standing, you will be taking a considerable loss.

To be more precise, if you have invested your family fortune and your retirement accounts, you are going to be hurting. Hopefully, you have not done so. Yet, if you have merely invested your government issued stimulus check, you can probably afford the loss. You can write it off as entertainment. So now, thanks to the internet, millions of people, people of modest wealth, invest money that they can easily afford to lose. Thus, the normal market psychological mechanisms do not work as well. 

Effectively, if millions of denizens of an internet chat room, or some such, pool their resources, they can compete against hedge funds that have massive pools of money. Or, at least, who had them until a few days ago.

According to the rules of short selling, if the owner of the share you borrowed now wants to sell his share at $1000-- why wouldn’t he?-- you are obliged to buy a share and give it back to him. 

But, the cash you received from selling the stock short is not even close to what you need to buy it back. In fact, you will normally be obliged to have a cash balance sufficient to buy back what you owe-- that is, to cover your short. For the sake of this argument, we will ignore the way that margin lending works here. The principle does not change if you are allowed to buy back the share by putting up about half and by borrowing the rest.

Still, you need cash on hand in order to cover your short, to buy the share you borrowed and to return it to the owner who wants to sell it. 

Here’s where it all becomes fun? What are you going to get the money you need to buy a share of XYZ at $1,000. Of course, you will find it by selling other shares you own in other companies, companies like Google and Facebook and Exxon and Home Depot. You will need to sell enough shares of other company stock in order to cover your short. The more expensive XYZ becomes, the more you will be forced to sell-- that is, to liquidate positions. 

As I understand it, you do not have a choice in this matter. Your broker, operating according to the rules of the investment game, will automatically sell shares of other companies if your cash balance falls below a certain point-- that point being having a sufficient amount of cash to cover the short.

If you do not want to sell out your Tesla, you might also find a cash infusion, as one hedge fund did last week, of billions of dollars. It might have been that the fund did not have sufficient assets to cover its shorts-- but I do not know that for a fact.

Anyway, the waves of forced selling are not all that amusing, even if you are not participating in the game. After all, when funds are obliged to sell massive numbers of shares of stock in Google or Facebook or Exxon or Home Depot, you, individual investor, who owns the stocks or who owns a fund that owns the stocks, are going to take a loss. At times, we saw this week, your holdings can decline significantly.

When you are asking why the social media giants intervened to stop the run on Gamestop, one reason, indirectly, is that they were defending the value of their own stock.

At that point, your own portfolio will be descending, even if you are not short Gamestop. Then, you will cease smirking about the losses that the hedge fund investors are taking will vanish. While we all understand that hedge fund investors can afford to take the losses-- otherwise they would not be allowed to invest in the funds in the first place-- other holders might not be quite so flush.

If things get too bad the markets can suffer more severe declines, and this will impact, not only your retirement account, but the economy as a whole.

As of now, no one is very worried. Everyone seems to believe that the situation is anomalous, and that besides, if worse comes to worse, the Federal Reserve will come in to prop up the markets, perhaps by buying futures, perhaps by bailing out hedge funds by providing liquidity. We might not believe in God, but we believe in the Fed. And therefore, like that great fictional character Alfred E. Newman, we are sitting back saying: What me worry?

If that is not sufficient cause for confidence, we also have the perfectly stupid statement by White House Press Secretary, Jen Psaki-- to the effect that we need not worry, because the Treasury Secretary is a woman.


Unknown said...

Psaki’s reminder that we now have our first female Sec. of the Treasury was really something to behold. We all can see that institutions are failing. Everything seems to be smoldering but we are suppose to lift our eyes to the hills and bask in the glory of the knowledge that we have a woman as the secretary.

The only thing that makes me able to tolerate this is that more people are getting their bellies full of this lunacy.

Unknown said...

And I should add here that I am a woman. I am heartily sick of this. Sick of it all.

Sam L. said...

There are runs in the market, and runs out of the market, and then there are just "the runs".

Webutante said...

These first Redditer investors in GME were no fools and meticulously set this up to beat the professional short guys at their own games. They became the smarter money and made tons of money for real and on paper. Now it's going all Ponzi on us as the smaller, dumber investors pile in. There will be pain and lessons learned. The government will try to save people from themselves with little effect as the smart guy Redditors cash out of GME and move on to the next big shorted stocks to go long on en mass. This is almost better than watching the SuperBowl.

David Foster said...

A woman who worked at the Fed for several years remarked that she had never been discriminated against there for being female, but had been seriously discriminated against because her background was involved with real financial markets rather than academia...also, no PhD.

Anonymous said...

The problem is NOT that some part time investors worked together to make money. The problem is NOT that some hedge funds who essentially do exactly the same thing lost money. The problem is that a company, like Robinhood, picked winners and losers by denying their clients their rights.

IamDevo said...

This episode has exposed the naked Emperor, and the Emperor doesn't like it. The world of hedge fund short sellers, which includes the likes of Soros (remember when he nearly bankrupted the Bank of England? Yeah, most people don't, but look it up? That got him declared a criminal in various European jurisdictions, but hey, he massively funds leftist organizations, which in turn, secure the election of favorable politicians who turn a blind eye to his activities, so Yay, Soros,"Power to the People!") Anyway, the arcane world of securities sales, in all its permutations, has become too complicated for regular investors, who still think that by putting money into their 401k or IRA, they are supporting productive, going companies, whose value is reflected in their stock value. HAH! Confession: I have/had both 401k's and IRA's invested in stocks, bonds and other financial instruments, but where else are you going to put your money with current interest rates? The Fed has manipulated the economy in order to compel this result, in order to keep the merry-go-round spinning, but the gears are grinding and the ride will probably be coming to a sudden, jolting stop in the near future and this episode merely made that eventuality more apparent. Always remember, that which can not go on eventually won't. The only way to avoid the pain is not to play the game. Caveat emptor still applies to life's transactions. Don't know about anyone else, but I plan on liquidating my positions at the most advantageous time in the immediate future, as soon as the rest of you decide to buy into this dip.

Linda Fox said...

I've been investing for some time in stocks (personally, not professionally). I started doing it when I noticed that the mutual funds I'd been investing in were not delivering performance necessary to secure a comfortable retirement.
I'd had little choice about the investments; these were the TSAs - the funds that the school systems had given rights to market to their employees. The number of firms were quite limited, given them a captive market.
So, I took some spare cash, and put them in industries that I had some knowledge of (mostly technology). I focused on core industries (those supplying basic components, such as Corning, which had various glass products used in Smartphones and touchscreens).
Most investments did well, some spectacularly. Over time, I grew my pile, often beating the professional's performance.
In the last year, I put some money in a few stocks - Roku, Michaels, and some pharm companies. I saw the numbers skyrocket.
I recently cashed out on a few stocks. I chose to take the profit, rather than try to ride the bus all the way. This is the most core concept that separates the winners from the losers - the willingness to get out of the market when it's especially volatile. I'll be using some tax strategies to reduce my tax burden on the profits, such as donating stock to charities, rather than cashing in.
This explanation of how stock markets work is the best I've seen in a long time - it beats the experts in business or investing by a considerable margin. Congratulations on making the psychology of investing so comprehensible.
Speaking of margins, I never use them - they are quite risky for amateurs, and easily lead to loss of your entire investment. Unless the RobinHood guys start selling off their stash - quick - I fear that they will find that out.

Callmelennie said...

You're missing the vengeance angle, Stuart. Most of these Redditor predators were millennial, many of whom saw their dreams crushed by the 2008 crash and subsequent Great Recession, much of which can be blamed on hedge fund shenanigans.

I read many of their comments, and came away with the sentiment that they didn't care if they lost money; they just wanted to murder a couple of arrogant hedge funds