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Q&A: The great Gamestop short-squeeze

By: Devan Robinson

Disclaimer:  This post is for educational purposes only.  This article is not investment advice.  Devan Robinson and clients of Fairlead Financial Group may own positions in the securities mentioned.

There's a legendary trader named Stanley Druckenmiller.  At the height of the late 1990's technology bubble he was short tech-stocks.  He was certain technology stocks were in the midst of a bubble.  He knew markets were efficient and in the long-run he would be proven right.  He wasn't wrong.

But being a contrarian is hard, especially when it seems like everyone other than you is getting rich.  He caved.  He covered his shorts and started loading up on tech-stocks.  Here's what he had to say about the situation:

“I bought $6 billion worth of tech stocks and in six weeks I had lost $3 billion in that one play. You asked me what I learned?

I didn’t learn anything.

I already knew that I wasn’t supposed to do that. I was just an emotional basketcase and I couldn’t help myself.  So maybe I learned not to do it again, but I already knew that.”

That Druckenmiller quote left an impression on me.  Bubbles are a natural feature of markets; there's usually one lurking around somewhere.  They have a gravitational pull to them.  Druckenmiller knew he shouldn't join the bubble but he caved anyway.  That animal instinct took over.  Even for the smartest investors this game comes down to those basic human instincts we're all prone to: greed, fear, jealousy, and hubris.

I don't know what I expected for 2021 but clients asking about the epic rally in Gamestop wasn't on the list.  I thought I'd throw together some thoughts on the common questions coming my way:

First off, does this impact me or my portfolio?  

If you're a client of mine: no, not really.  There may be 0.00005% of Gamestop stock deep within a small-cap fund you own, but not enough to make a material impact.  This is really an outlier market event.  Outlier events can be great learning opportunities for investors.

What's going on with Gamestop?

Well, uh...let me just show you Gamestop's chart.  Here's the stock price as far back as I can take it:

Past performance may not be indicative of future results. Indexes are not available for direct investment.

Wait, the video-game retailer?  Yes, this Gamestop:

If you had bought Gamestop on January 1st you are up an incredible 1,200% year-to-date.

Why did this happen?

It's called a short-squeeze.  One of the biggest, if not the biggest, short-squeezes of all time.

What's a short-squeeze?

First, let's review some market basics with an example: 

You believe stock XYZ is going to increase in value over time so you decide to invest $100.  You go to a brokerage, they find you a seller, and you trade.  You give the seller $100 of your cash and you get $100 of stock XYZ in return.  You are now long XYZ stock; you believe XYZ will grow faster than the $100 cash you traded to the seller.

That's the stock market at it's most basic level.  A stock's price at any given moment is where buyers and sellers are transacting.  That's the ticker-price you see on your screen. 

Stocks are a zero-sum game: there is a seller for every buyer and a buyer for every seller.

What if you want to bet XYZ will decline in price?  You are free to place that bet as well: it's called being short

Going long is pretty simple: you just buy.  How does shorting work?  It's a little more complicated.  You borrow shares from another investor and sell those shares at current market price.  You're then hoping to buy them back at a lower price after the stock has declined, pocketing the difference.

Let's say stock XYZ is currently trading at $50/share.  You borrow another investor's XYZ and sell those shares at $50/share.  Some bad news hit and XYZ now trades at $40/share.  The market agrees with your thesis and you now want to capture your profit: you buy back XYZ at $40/share and return those shares to the investor you borrowed from; pocketing $10/share in profit.

But what if your thesis was incorrect?  Let's imagine XYZ grew to $60/share instead.  As the short you're now $10/share in the hole.  You determine you were wrong and want out of the short-trade.  How do you get out of your short-trade?  You now have to buy shares at the higher $60/share price to cover your short.  Remember, you still owe the investor you borrowed from.  You've been squeezed out of your short position as the price moved against you.

Now imagine if thousands of short-investors are all scrambling to get out at the same time.  They are all FORCED to buy shares to get out, driving the price upwards even further.  That's a short-squeeze.

Do short-squeezes happen often?  

Pretty often, but not usually to this magnitude.  A squeeze of Gamestop's size isn't unheard of though, Volkswagen famously had an epic short-squeeze in 2008:

Past performance may not be indicative of future results. Indexes are not available for direct investment.

Is short-selling wrong?

No, I'd argue the opposite: short sellers actually help investors.

Short selling is an incredibly tough business but a necessary one.  You need critical, contrarian voices in markets trying to root out poorly managed companies.  Often shorts are the investors who discover fraud.  Enron, Worldcom, Luckin Coffee, Nikola, etc. were all initially uncovered by short-sellers.

The risk to short-sellers is extremely high; it's not for the faint of heart.  When you're long, your risk is limited to what you pay.  A stock can only decline to $0/share.  On the flip-side, a stock could theoretically rise to infinity.  There is no upper bound to a short-sellers pain.  Markets trend upward over time as the economy and population grows, making shorting a risky endeavor.

I've seen a narrative brewing that shorts bully and undermine businesses.  This isn't true.  I could be wrong, but I don't think there is a single company in history that went out of business because of short-sellers.  Over the long-haul a stock price mirrors the performance of the underlying business.  Competition and poor management kill business, not short-sellers.

Why did Gamestop squeeze so hard?

Prior to the squeeze, Gamestop was one of the most heavily-shorted stocks in the entire stock market. 

A group of investors on the online-forum Reddit banded together to buy Gamestop all-at-once to squeeze out the shorts.  They saw some success and the trade quickly spread through social media like wildfire.  The rest is history.

It's quite the remarkable story. Melvin Capital, an admired hedge-fund and one of the chief Gamestop shorts, suffered a 53% loss in January.  Completely and utterly run-over.

Is Gamestop a bubble?

I don't know.  It could be a bubble.  It could be a classic pump-and-dump scheme.  It could be the start of a great business comeback.

Great businesses appreciate in value over time.  Bad businesses deteriorate over time, like a slowly melting ice-cube.  A bubble happens when price veers away from the true fundamental value of a business.

Could Gamestop make a comeback?  

Anything is possible in capitalism.  I'd love to see it happen.  

I love video games and Gamestop was a staple of my childhood.  I bet most millennials who grew up with video-games have fond memories of Gamestop.

With that said, Gamestop was heavily shorted for a reason.  

For years Gamestop's management failed to adapt to a changing video-game landscape.  They missed the rise of e-Sports.  They missed the rise of streaming.  Management instead doubled-down on a business model of selling overpriced used game-disks in a world rapidly becoming diskless.  Bears would argue Gamestop is the record-store of the 21st century; slowly melting away until finally buried by the iPod.

I understand the emotional attachment to Gamestop but markets are a brutal space for virtue.  There was no honor in holding Blockbuster shares to the end.

What's the Robinhood drama?

Robinhood is brokerage popular with young adults.  It's an incredibly well-designed app that makes trading stocks easy and fun.  More importantly, trading is free on Robinhood which has fueled its incredible growth.

Late last week, Robinhood halted new buying in Gamestop shares.  This led to an uproar from their customers.  It fueled conspiracies that Robinhood was working with hedge-funds and the global-elite to stop the average man from getting rich.  Pundits, politicians, and charlatans of all types crawled out of their caves to throw fuel on the populist fire.

Why did Robinhood halt trading?

I can't say for sure.  I'm sure we will learn in time.  

If I had to guess: it was a plumbing issue, not a grand-conspiracy.  In the world of banking, money transfers take 3-5 business days to settle.  When you open a Robinhood account you are defaulted to a "margin" account (this is a controversial topic).  Margin is a loan; Robinhood is essentially extending you a micro-loan so you can trade right away until your money clears.

Clearly there was a rush of new investors wanting to buy Gamestop all at once.  A percentage of those transfers will bounce, leaving Robinhood on the hook.  It's simple credit-risk.  At a certain point your risk-department will try to slow things down, or halt buying altogether, until the money arrives.  Brokerages are regulated similarly to banks: Robinhood has balance-sheet requirements that ensure all customer deposits are safe.

Why halt Gamestop?  I don't have the data, but I suspect this flurry of new investors weren't rushing to trade Berkshire-Hathaway.

My guess?  This was classic Occam's razor: Robinhood's plumbing was simply clogged.

But wait, why is Robinhood controversial?

Robinhood is controversial in the world of finance for several reasons:

1. Defaulting to a margin account.  Margin is the ability to borrow against your shares to buy more shares.  Margin itself isn't a bad thing if you know what you're doing with it; professionals use it all the time.  The problem, in this instance, is Robinhood markets itself almost exclusively to first-time investors.  It's like giving the recruit a bazooka.

2. Game-ifying investing.  Robinhood is an amazingly well-designed app.  They turn investing into almost a casino-like experience, complete with flashing lights and rewards as you day-trade.  Combining the dopamine rush of gambling with margin loans makes financial planners nervous.

We've all heard the jokes about markets being a casino but they really aren't.  Not for thoughtful, patient, and prudent investors that put in effort or seek quality advice.  A casino is designed so that the longer you stay within their walls the more likely you lose and pay the house.  Markets are the opposite, often the longer the sit the likelier you are to have made money.  

Show me one casino game with odds like the S&P 500:

Past performance may not be indicative of future results. Indexes are not available for direct investment.

At least in a casino you know the rules of the game you're playing.

3. Payment for order-flow.  This is the big one. 

Brokerages make money by charging you a fee to process your trade.  If Robinhood's trading is free, how do they make money?  They sell your order flow to hedge-funds and market-makers who can then front-run your orders.  It's a controversial practice to say the least.

Remember when your parents would say nothing in life is free?

In a sense, Robinhood is the Facebook of brokerages.  It's free because your data is the product.  It's the classic Silicon-Valley "gather and sell data" model applied to Wall Street.

Order-flow payment is definitely worthy of a debate.  If you are a long-term investor though it is essentially a non-issue.  If you're an active-trader (none of my clients are) Robinhood is not your friend.

Enough boring Robinhood stuff, I want to hear more about the conspiracies!  Are markets manipulated?

Truthfully...not really.  Markets have never been more geared toward the success of the small-investor than they are today.  Terrible, one-sided products that have fleeced investors for decades are rapidly dying.  Variable annuities, non-traded REITs, and overpriced active-funds are losing market share to basic, low-cost index funds.  The playing field is more level than its ever been.

It's a harsh reality, but the investor's enemy is usually their own behavior.  Even if you are Stanley Druckenmiller.  We all want to get rich quickly, that's human nature.  Most won't get rich quickly.  The playbook for doing it slowly hasn't changed.  Live within your means and invest in quality assets that will grow over time.

Do manipulations happen?  I'm sure they do in some corners of the market.  It's a vast arena.  There are bad actors in any endeavor.  That's life. 

What happens next with Gamestop?

I have no idea, but I sure can't stop watching.  

When the world gets confusing it can pay to fall back on those basics: for every buyer there is a seller, and for every seller there is a buyer.  

At Gamestop's current price, who is buying and who is selling?

A lot of hedge-funds are selling their Gamestop stakes at incredible profits.  Who's buying?

Thanks for reading,

The foregoing content reflects the opinions of Fairlead Financial Group LLC and is subject to change. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct.

 Past performance may not be indicative of future results. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful, or that markets will recover or react as they have in the past.