As online trading lifts a sinking ship, should long-term investors care?
GameStop’s stock, by all accounts, was on its last legs.
The video game business’ stock price had basically flatlined through much of 2020 as more and more games went digital, especially throughout the pandemic. On April 3, 2020, it closed at $2.80.
Then, a group of retail investors [i.e., day traders] took note in a Reddit forum called WallStreetBets, and through a flurry of activity on Reddit and other social media sites, they proceeded to purchase shares and options of GameStop, astronomically driving up the flailing company’s stock price.
Why did they game up on GameStop? At the time, GameStop’s stock was the most shorted stock on the U.S. stock market (as a percentage of its shares outstanding), and some large hedge fund managers were among the biggest investors short on the stock.
Some retail investors may also have wanted to disrupt the market and perhaps stick it to those wealthy hedge fund managers. What does all this mean, you might ask?
The answer is, it’s complicated.
Shorting is when investors bet that a company’s stock price will decrease for any number of reasons, including a failing business or fraud. A short seller borrows shares and sells them on the open market at the current price with the intent of repurchasing them at a lower price. It’s a risky business. If the company’s share price goes down, the upside is capped when the stock price reaches zero. If the share price goes up, they are forced to cover their short bets.
Several hedge funds (higher risk pools of investment funds that can go long and short) shorted GameStop and ended up having to buy back the shares to cover their short sale. Had they not, their losses could have become infinite.
Melvin Capital, one such investment firm, had to raise additional capital to close out its short GameStop position and reportedly lost 53% on its investments.
At one point, 130% of GameStop’s public float was shorted. As word got out on social media, trading platforms like Robinhood, which prides itself on no trading commissions for the small investor, fueled the fire by enabling trading of GameStop stock and options. Within a few days, no one really knew who owned what.
Robinhood, which claims to have over 13 million traders, suddenly stopped allowing purchases of GameStop stock and certain types of options, angering traders who could sell but not buy. Robinhood claims it saved less-savvy investors from taking a financial hit, but it later rescinded its decision.
The last week of January saw GameStop shares skyrocketing 400%, WallStreetBets’ members tripling to 6.5 million, and the flailing retailer closing the month with a 1,625% gain to the delight of many retail investors. Late-to-the-game GameStop investors, however, were likely licking financial wounds.
Things have evened out since then. GameStop fell back to $40 per share but as of March 12, it had climbed to $264.50. Many still view the stock as overvalued.
Whether this was a one-off event or the awakening of a sleeping giant — retail investors accounted for roughly 20% of stock-market activity in July — will long be debated in Congress and financial institutions.
Three local wealth advisors weighed in on the matter: Eric Raether, president, Canopy Wealth Management; Sharon Brantmeier, principal/private wealth advisor, Eventus Wealth Advisors, a private wealth advisor of Ameriprise Financial Services LLC; and Aaron Hager, president/registered principal, Harbour Investments Inc.
The long and short of it
What happened with GameStop — and others like Blackberry, AMC, and Best Buy — continues to be an interesting side story that this panel doesn’t expect will impact long-term investment strategies, but it certainly has piqued curiosity.
Hedge funds play a key role because they can make speculative bets in the market rather than taking a long-term investment view, explains Raether. Shorting a stock is a way to get wins. “You can bet on a stock going up or down. If it goes down, you borrow the shares, sell them up front, and then buy them later at a lower price,” he explains.
However, there’s a big difference between speculative and long-term investing, Raether cautions. “When you’re playing the speculative markets like the subreddit folks and many hedge funds are doing, it’s a zero-sum game,” he notes. “There’s a winner and a loser on every trade, not unlike Las Vegas, where the house has the advantage. In speculative investing, the house may not have as much of an edge per se, but it may be 50-50.”
The opposite is true, he adds, for clients focusing on the long haul, and that’s where investment advisors can help clients gain the edge through strategic planning.
Melvin Capital made some significant bets on GameStop knowing it wouldn’t be a sound investment and decided to profit on its demise. “That’s part of the deal,” Raether says.
That millions of social media investors got involved, mainly through Reddit and WallStreetBets to decide which stocks to invest in, is a relatively new phenomenon, however. Hedge funds, Raether says, got caught in a short squeeze and had to cover their positions, “so if the hedge funds sold it short at maybe $10 or $17, now they had to cover their shorts at $200 or $300.”
The end result was that Melvin Capital was hurt badly, but other investors and a lot of Reddit folks lost money too. “People may not be feeling bad for the hedge funds, but sometimes public pensions or teachers’ unions invest in hedge funds too, not just the wealthy fat cats. People tend to want to make it into a David vs. Goliath or good vs. evil story, but it’s not that simple,” notes Raether.
Sharon Brantmeier (Eventus Wealth Advisors) says advisors constantly study all market activity, and her team certainly had been watching GameStop for a while.
“It was like a side show,” she says, “with people trying to speculate on a single stock.” During that same time period, the price of other corporate stocks also were rising by leaps and bounds, like AMC, Blackberry, and Best Buy.
“For a stock to double in a short period of time is unheard of, and then to go up 10-fold or more without any material change like a fantastic earnings report, a business closure, or a head executive resigning or passing away, is crazy,” Brantmeier states.
The differences between retail investors and long-term investing couldn’t be more pronounced, Brantmeier says. The latter requires research, due diligence, and studying long-term trends. “You have to look at the fundamentals of a company and not buy into the hype,” she says.
That said, shorting is a legal part of the investment market. “Anyone can do it so long as you know what you’re doing. It’s not just for hedgers. Hedgers do more shorting because they’re investing bigger dollars.”
Aaron Hager (Harbour Investments) agrees. “Taking short positions, or betting against a stock, is actually pretty common.” In fact, in January there were more GameStop shares sold than were available in the public float.
“As the underlying stock price rose and option expiration dates neared, this fueled what is known in the options market as a gamma squeeze,” Hager explains.
A gamma squeeze is a forced market action of a security (the decision to purchase GME, for example) by dealers hedging risk. “The gamma squeeze, on top of having more shares sold than were available, caused an imbalance in the market in that security,” Hager adds.
Squeezes are normal and will continue to happen, he says. While the GameStop frenzy was unexpected, Hager found the speed at which information spread through public forums most surprising.
In a relatively short amount of time, many people made thousands, but many inexperienced traders lost a lot, and at least one person, a 20-year-old man from Illinois, took his life, believing he was on the hook for $730,000.
Congress got involved. The House Financial Services Committee, led by U.S. Rep. Maxine Waters, D-California, pressed the CEOs of Robinhood, Reddit, Citadel, Melvin Capital, and others for answers. Two more hearings are scheduled.
So, will any of this impact the strategy of local investors? Not likely.
The Securities and Exchange Commission (SEC) could investigate Regulation SHO, its 2005 rule on short sales, but Hager doesn’t anticipate strategies to change for most long-term investors.
It also may be too soon to tell if any lessons have been learned. “We certainly hope retail investors who engage in speculation are aware of both the upside and the downside risks of participating in rapidly moving markets,” Hager adds.
Brantmeier says her company’s long-term portfolio strategy hasn’t changed. “We work long term based on due diligence and fundamental research before we can recommend anything. If clients want to speculate on a certain stock and have some faster gains, it may be fun, but that’s not what we do.”
Online trading platforms are not new, she reminds, but this one made a lot of money very quickly. “You have to follow the trends. It’s so easy nowadays to trade and get information out than it ever was.”
Raether draws some parallels to the 1990s internet tech bubble when all the rage was in tech stocks. “A young, perhaps uninformed retail investor buying stocks on Robinhood from home or on their cellphone may think it’s easy, but at some point, stock prices will drop.”
That said, Raether says shorting serves an important function to keep liquidity in the market because it provides a check and balance “and that goes for hedge funds as well. People like to have a villain, but the truth is always more nuanced.”
Looking ahead, could this be a sign of things to come? “That’s a question for the SEC and Congress,” Raether imparts. “If hedge funds got together and decided to buy certain stocks, it would be illegal and spark an SEC investigation, but because millions of individual investors on social media did this, it’s not collusion and there’s no law against it.
“That’s something the securities laws never envisioned. It will be a footnote, I believe. I’m still not convinced it will impact the overall market, but I could be wrong.”
A retail investor’s view
Zach Westrick, 41, owns Westrick Family Chiropractic in Madison. A year ago, with business temporarily slow and the stock market declining due to COVID-19, the chiropractor signed up as a retail investor [i.e., day trader] online through E-Trade. He’d always been intrigued by the notion of buying and selling stocks, and now he spends about an hour a day online. “I’m certainly not an expert yet,” he admits.
Westrick did not purchase shares of GameStop, but he has been profitable on similarly affected stocks, like AMC. “When I became aware of what was happening with GameStop, it was already up 80%,” he says.
In his opinion, the disruption began in the Reddit forum WallStreetBets to send a message to Wall Street to prove smaller investors knew what they were doing. “They wanted to get a bunch of people to force the price up so the hedge funds that short companies would have to scramble, and they did that with just one stock.”
Last May, Westrick moved some money into an IRA and a small cash account and hasn’t had to regularly inject more because his investments have worked. “It’s grown by a fair amount, so I just use what I have.”
As a rule, he also does not withdraw money from the account. Instead, he buys stocks and reinvests profits into the purchase of other stock, getting his ideas from social media, primarily Twitter and Reddit.
His strategy? If a stock he purchases goes up 10% or more, he might sell half of it. “Then I’m using house money,” he says.
Westrick, married with four children, never trades outside of the accounts he has set aside. “My wife doesn’t get nervous,” he says. “She knows anything I lose wouldn’t sink our family.”
His advice for the curious: Practice first with apps that set up a fake account using fake money. If you lose, no harm no foul, “but if you win, you don’t get anything but you’ve learned a great deal.”
And when it comes to live trading, “Start small,” he cautions, and don’t think in terms of dollars lost or gained.
“People get caught up in stories about others making thousands in a day, but it’s all based on percentages. If I put $100 in and the stock goes up 100%, I made $100 that day. If I put $100,000 into a stock and it goes up by 100%, I make $100,000 that day. That’s why I almost never look at dollar amounts anymore.”
Westrick was frustrated by the first Congressional hearing. “They kept referencing a guy who lost a lot of money, but nothing would have kept that guy from mortgaging his house and then walking into a casino and putting all his money on red or buying Powerball tickets,” he explains.
When Robinhood stopped the ability to sell certain stocks and options, prices tanked. “The hedge funds were standing to lose billions more if the stocks kept rising in price. Conveniently, prices suddenly dropped,” Westrick comments. “Then Reddit says they want to protect the little guy who lost $20,000 from himself. Come on!
“It’s bittersweet for me too,” he adds. “That was the most successful day I’d ever had in the market. I had sold a portion of my AMC stock for a pretty good profit, but I was holding on to some shares to see how high it would go. I still did well, but it could have been so much more.”
Westrick believes social media will continue to be influential, but he doesn’t foresee another scenario where so many investors put their money behind one stock.
“It was the perfect storm,” he says of the GameStop frenzy. “I’m new to this, but it seems to me like the industry got burned.”
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