I’ve been following the GameStop saga with almost manic fascination. GameStop is an American company that runs a chain of stores, where people can buy, sell, and rent video games for their PC, Xbox, PS4, etc. Whenever I go back home for the winter holiday, and my brother is in town, he and I drive a few miles south to the nearest GameStop to pick up a few games to pass the time between Family Guy episodes and my mom’s delicious home-cooked meals.
GameStop has a transparent and largely benign business model. It houses both new and pre-owned games (as well as consoles and merchandise) in a single place, and the people who work there are knowledgeable about the subject matter and helpful with their recommendations. It functions as a sort of for-profit library for this particular niche of entertainment. In recent years, however, it has been hurt by a confluence of factors. Digital platforms allow you to download games directly from the internet, making a trip to a GameStop store seem wasteful. Game accoutrements like controllers, merchandise, etc. can easily be purchased on Amazon. And the pandemic/lockdown has reduced the kind of foot traffic that leads to unexpected purchases (such as when my brother and I are on the hunt for a particular game but find one or two others that catch our eye). Unsurprisingly, GameStop’s financials have plunged in concert. From a peak of ~$10 billion in the early and mid 2010s, GameStop’s annual revenue is now roughly half of that. Its net income is negative, and has been so for the last several years. A stock (code GME) that used to trade at $50/share in 2016 reached a low of $3-$4/share in early 2020.
Now GME is trading at over $300/share. Its market capitalization is over $24 billion. Its price to earnings ratio can’t even be calculated, because its earnings are negative. Given that it is trading at ludicrous levels, its P/E ratio, assuming a return to profitability, would likely be in excess of 100. Bear in mind that typical ratios are between 10 and 30: for reasons that should be intuitive, the stock price of a company should, in theory, be proportional to its earnings. So, clearly, something very weird is happening.
The short explanation is that a bunch of idiots on the internet have managed to drum up the stock price through sheer hubris. Per Bloomberg:
Short sellers have been called a lot of things. Bloodsuckers. Parasites. Other words not fit to print. Now in the vortex engulfing GameStop Corp., they have a new name: the establishment.
It’s a role cast for them with relish by their chat-room usurpers, the tens of thousands of average Joe day-traders whose fervor for a left-for-dead retailer has become a self-fulfilling prophecy in its 245% rally this year. GameStop has become a money geyser for the options-obsessed crowd that gathers in Reddit’s WallStreetBets forum. For those wagering on a decline, it’s been a catastrophe.
Give credit where it’s due. In their frenzy, WSB’s cocky hordes have managed to turn the tables in a game short sellers invented, spinning gold from the complacency of others. Before this year, GameStop was a cash register for bearish traders, who borrowed and sold more shares than the company issued. Hedge funds had been winning so long that they overlooked the tinderbox they were creating should sentiment turn.
Now it has, violently. GameStop, which isn’t expected to turn a profit before 2023, has seen its market value triple to $4.5 billion in three weeks, burning the skeptics whose any attempt to cover is likely to further propel its ascent.
(Note: This article was written two days ago. In the intervening period, GameStop’s valuation has risen several-fold again.)
I had heard about Wall Street Bets years ago from friends who surf Reddit. They regaled me with stories of anonymous traders (self-described “autists”, meaning they were socially inept but pathologically risk-accepting) making enormous leveraged bets using call and put options — and posting the results regardless of whether they won or lost. In one famous example, user “WSBGod” invested $127k in Tesla call options in January 2020 and, some days later, realized a paper profit of over $4 million when Tesla’s stock price ballooned. In another example, “Rando1023” invested in Apple call options in January 2020, doubling or tripling his investment in a few months. But, when the coronavirus hit, and Apple’s stock price reversed, his account balance cratered, leaving him with a 99.7% loss. Wall Street Bets is driven by the usual male machismo, the desire to take incredible risk to reap unfathomable rewards. But there is also a trollish, nihilistic undercurrent. If you lose your entire life savings on a failed option bet but post the screenshot of your Vanguard account to Reddit, you will be rewarded with a level of internet fame that makes the whole experience worth it. Memes matter more than money. It’s an attitude I can’t truly comprehend: it is as if, somehow, they are pretending that it is someone else’s cash that they are gambling with.
Regardless, as Bloomberg explained, the Redditors hit upon a strategy to target the short sellers who were practically printing money from GameStop’s slow decline. Short selling is essentially a loan: you borrow stock from someone with the promise to give it back at a later date. If you sell the borrowed stock immediately and the price declines, you can buy it back and pocket the difference as profit. If, on the other hand, the price rises, you will be forced to buy back at that greater price, generating a loss. To take an example, suppose a stock is trading at $5/share, and you borrow 20000 shares, selling them at $100,000 total. Then, suppose the stock price increases to $10/share. You need to make the lender whole, which means you need to find 20000 shares to return to him. At current market value, this costs $10/share * 20000 shares = $200,000. You have lost $100,000 in this process. But, importantly, your return on investment is infinitely negative: you did not necessarily outlay any money at the outset, as in a typical, “buy and hold” investment. Short selling is a good way to lose boundless amounts of money.
In practice, your lender wants some collateral in case you cannot pay back your loan. And so, in a “short squeeze”, the stock price acquires almost unstoppable momentum: the price increases initially; the lender becomes worried and increases the collateral requirements for short sellers; some of them are unable to pay up and abandon the short, which forces them to buy up shares (remember that they had sold them initially and need to give them back); and this drives up the price even further. In some cases, like GameStop’s, this seeming overvaluation attracts even more short sellers, who are subjected to the same squeeze. These feedback effects can be amplified even more by adding leverage: investors who buy call options instead of the stock itself can, in effect, move the market several times the value of their investment.
If none of that made sense to you, I sympathize. It hardly makes sense to me. The important thing to realize is that some hedge funds have lost billions of dollars because a community of morons decided this would be fun and meme-worthy. (I can’t deny they’ve been right.) And the kinds of things institutional investors are saying now are just astounding.
Michael Burry, an investor profiled in the “Big Short”, called GameStop’s rally “unnatural, insane, and dangerous”. One analyst, Anthony Chukumba, whined that “If you want to gamble, go to the casinos. This is not what the markets are for. This is not investing”. CNBC talking head Andrew Ross Sorkin seemed on the verge of tears when explaining that Melvin Capital, a hedge fund that shorted GME, had exited their position and absorbed billions of dollars in losses. Andrew Left, who lost mounds of money for his firm, Citron Research, in a similar bet, gave an interview attacking the Redditors, saying, “It’s extreme capitalism gone wild. We’re a nation of gamblers.” John Stark, former SEC regulator and current Duke Law lecturer, complained that “There’s a whole group of investors who really don’t care about the inherent value of a company. They just care if there’s someone else who will pay a higher price.” One absurd looking man, with thinning, spiked up hair, white-framed glasses, and a bowtie, appeared on Fox News to proclaim that “social media” should be “banned…from talking about short stocks”. The NASDAQ CEO suggested a trading pause to allow big investors to “recalibrate their positions”. And, to cap it all off, another CNBC reporter relayed that he heard “a number of hedge funds are in similar trouble [to Melvin Capital] and may need to be bailed out”.
Is there any better summary of the American stock market? If you are making money, you are doing so by gambling, ignoring fundamentals, and not recognizing the preternatural power of the market to divine a company’s inherent value. It is basically cheating, and we need timeouts (of you) and bailouts (of me) to fix the situation. But If I am making money, I am doing so with the blessing of the Chicago School and the efficient markets hypothesis. The same people who are complaining about GameStop’s ludicrous valuation didn’t utter a peep about Tesla (worth more than Volkswagen, Toyota, Nissan, Hyundai, GM, Ford, Honda, Fiat Chrysler, and Peugeot combined); Snowflake (a company that no one besides me has heard of, and is somehow worth 80 billion dollars on a few hundred million in revenue and negative earnings); Bitcoin (which can’t be said to have any real value at all); or any of the other companies that have fatally flawed business models but keep plodding along nevertheless.
I appreciate (if that’s the right word) that Reddit is sticking it to hedge funds, at least for now. But even this victory is Pyrrhic. The biggest investors in GameStop include the likes of BlackRock, who made a paper profit of a few billion over the last few days. There has also been speculation that Citadel Capital, a hedge fund that receives “order flow” from Robinhood, a trading platform that became popular during the pandemic, has been using that information in order to front run the Redditors and collect handsomely. Even when the billionaires lose, they win. The game is so fucked that we can no longer unfuck it, at least from within.
Can we dispense with the notion that the stock market has anything to do with valuations or fundamentals? That its rise benefits American society? And, that, conversely, we should listen to its wails with the same attentiveness as we would a newborn’s? The richest 10% of Americans own 84% of the stock market’s wealth. The autists of Reddit are that 90-99th percentile fighting against the top 1. This is not exactly David and Goliath. And so, despite the memes and the lols, we should treat this episode with the disdain we do ordinary gambling. Regulate it heavily, particularly leveraged bets. Don’t bail out the losers. Let them suffer (suck on this, even). Tax the shit out of the winners. And, most importantly, redistribute their ill-gotten gains to the people who rightly don’t have a stake in this nonsense.