I have said many times before that I don’t really understand how the stock market works. I mean that I understand in theory about how it should work. Companies sell stock to raise money to grow the business. If the company is well run and makes money, its value, and the price of its stock, goes up. If it is run poorly, then its stock price goes down. For an investor, the goal is to identify companies that show promise of growth and success and buy its stock so that when the price rises, you can sell it at a profit. But the modern stock market has in practice so many layers over that basic idea that the relationship between cause and effect, what causes stocks to go up and what causes them to go down, has become highly opaque.
The problem with the above simple model is that you can only make money as an investor if you can identify a company whose stock is likely to rise in value so that you can buy it in anticipation of the rise. If you think a company’s stock price is likely to go down, there is nothing you can do. If you already own some stock in it, you can sell it quickly to avoid further losses. But if you do not own any stock already, there is no way to make money from your prescience about its future downturn.
Enter the short selling innovation. In this case one borrows that company’s stock with the promise to return that same amount of stock before a set date in the future. One then sells the stock at today’s market price (even though one does not own it) and, when the price drops, buys back that same amount of stock on the market at the lower price and returns it to the lender on the date, making a tidy profit. Since you only borrowed the stock initially and did not buy it, you are not limited by how much money you have to start with. And this is what turns the stock market into a real casino. You can borrow a huge amount of stock and make a huge amount of money. This is what the big hedge funds do.
The catch is that if you bet wrong and the stock price rises, you can suffer massive losses since you now have to buy back the stock at a higher price than what you sold it for. The big hedge funds have huge amounts riding on these things and they have the financial power to drive the companies’ value down by various means, since selling large amounts of stock will tend to reduce its price, and they also usually have access to media where they can bad mouth a company and persuade people to dump its stock. Ideally, for them, the company will go bankrupt so that the stock becomes worthless. Of course, that means that the employees lose their jobs and the investors who had stock in it will also lose. But the hedge funds don’t care as long as they make money. They are willing to drive struggling but still viable companies into the ground in pursuit of their private profits. That’s free market capitalism, baby! This kind of thing happens so routinely that it is hardly worth news mention. We are expected to just suck it up.
So what happened with GameStop? In this case the tables were turned on hedge funds. A Reddit forum known as WallStreetBets consisting of a large number of small investors moved together to shore up the GameStop stock that a massive hedge fund named Melvin Capital had targeted for short selling. As a result, its stock price rose dramatically, threatening Melvin and other short sellers with losses estimated at around $20 billion.
But then a trading app named Robinhood that is used by small investors stepped in and prevented the buying of GameStop shares, thus causing its share price to plunge. This resulted in howls of protest at this development and today comes news that Robinhood has restored trading again, leading GameStop shares to rise rapidly once more. It is possible that Melvin dumped its holdings during that brief period when the stock price plunged in order to limit its losses.
Why did a supposedly neutral player in the market intervene in a way to shield a massive hedge fund? Because the playing field is never level when it comes to the oligarchy and the markets are tilted to favor the wealthy. When hedge funds treat Wall Street as a casino and manipulate the markets and ruin small investors in the process of making vast sums of money, it is hailed as the working of the free market. But when they are hurt after they make a bad bet, they demand protection from the consequences of their acts. It is the same logic as was revealed in the 2008 financial crisis.
How the government responds to this issue is going to be a test of whether we learned anything at all from the 2008 financial crisis, where the government rushed in to save the big banks while doing little for the homeowners who lost their homes. This time, while there is going to be a big fight over passing the stimulus plan to help ordinary people, it will be interesting to see if Congress and the Biden administration come together quickly to help the big hedge funds like Melvin Capital that are, of course, now complaining that they are the poor victims.
One interesting thing to keep in mind during this is that former Fed chair and current treasury secretary Janet Yellen earned $810,000 in ‘speaking fees’ from the Citadel hedge fund which is suspected of being involved in this business.
Citadel does business with Robinhood, the trading app that helped fuel the massive stock activity that hit Melvin Capital. Robinhood said Thursday investors would only be able to sell their positions and not open new ones in some cases, and Robinhood will try to slow the amount of trading using borrowed money.
These huge ‘speaking fees’ are how wealthy firms buy favorable treatment from officials as they rotate in and out of government. It is a form of legalized bribery.
Stephen Colbert spent part of his monologue yesterday discussing the GameStop issue..
Reader Jeff Hess sent me this link to Glenn Greenwald explaining the complexities of what is going on with GameStop stock.
Greenwald says that we should not take at face value the story that this was entirely a battle between small investors against big hedge funds and that there may be other hedge funds betting against Melvin. His video seems to have been made before the trading app Robinhood stepped in to prevent further purchases of Game Stop.
As has been truly said, especially when it comes to politics and high finance, it is not what is illegal that is a scandal but what is legal.
It’s worse than you may realize. Trading with Robnhood is “commission-free,” but that’s not the whole story of course. The first thing you should wonder about when hearing such an odd thing about a profit-making business is how they do manage to make some kind of a profit, when their notional “clients” don’t actually pay them.
Much like Google and its “free” search engine which costs us all more than we can really know, they have another business model that nobody is supposed to think about for too long. In Robinhood’s case, the people who trade using their app are not their real clients….
From Bloomberg last month: Robinhood Financial Hit With Class-Action Suit for Selling Stock Orders
Funny how it still exists and they still have a spokesperson, rather than, say, having to go directly to jail, for example.
And before you tell me it’s one bad apple spoiling the bunch, then look for another place to gamble with stonks….
A short position does not require borrowing shares. What you are talking about is a futures contract where one party will sell X shares on date Y for price Z (normally the share price at the point that the futures contract is initiated but that is not fixed). The selling party is called the short, the buying party is called the long. Shorting is associated with a lower share price at the point where the contract matures due to that being the reason to sell for the price on the futures contract.
Not owning the shares you are shorting is called a naked short. So called due to the exposure of risk when you need to buy the shares on the day you are selling them. You can buy them earlier but usually it happens in the same transaction due to the amount of money involved.
This is usually not a real problem for the big stocks. But once you get to the point where the naked short contracts contain more shares then are typically traded in a day price distortions start to show, which can happen in lower volume stocks like GameStop. GameStops case is even worse since the total amount of shares in the short contracts exceed the total amount of outstanding shares, multiple times.
It is the reason that at least one hedge fund crying foul has already received billions from the parent to cover their position and instead of taking the loss they doubled down and are betting on that they won’t be the one to hold the billion dollar tulip bulb when the stock finally crashes due to shorters not being able to find a counter party wanting to go long.
For this reason I doubt that the Melvin fund managed to unload a significant portion of their GameStop future contracts, not enough parties out there willing to lose their shirt (and more) taking over those short positions.
It is a mistake to think of this as nothing but small investors vs big investors or worse good guys vs bad guys. I have more sympathy for the small guys, particularly when the big guys try to change the rules on the fly to recover from their bad position but the small guys are in it to make money also. Ultimately this is one group of people manipulating the market to out manipulate another group trying to manipulate the market.
Game Stop is currently trading well above any price that can be justified and at some point it is going to come down. The people with short positions will eventually buy enough to cover their borrowing or go bankrupt. At that point a lot of small investors are going to have stock with vastly inflated price. The ones that recognize that point and sell early enough while others are still buying will make a fortune, the ones that are still buying late will get hosed.
There are also other things going on in the Game Stop situation. When this started there was more Game Stop stock shorted then actual Game Stop stock. This sort of trading of more stock then actually exists makes it look like there is more supply then demand. This depresses the price and helps the hedge funds. So most likely they are breaking regulation or found some loophole to slip through.
And even if you DO treat this as ‘small investors vs big investors’… GameStop isn’t one of the players, GameStop is the ball. Given the pressure they’re under (let’s be honest, brick and mortar video game stores weren’t doing well even before the pandemic, because aside from special editions most video game purchases can be done entirely online now) it’s unlikely GameStop will come out of this unscathed no matter who ‘wins’.
This is one case where I really don’t care about either party. Giant hedge funds getting outmaneuvered after making risky bets on the market? Don’t care. A bunch of idiots on an app are wasting money by (temporarily) inflating the value of some stupid store to “own the hedge funds”? Don’t care. I guess you could say this further demonstrates how much the stock market can be divorced from real world value, and how this kind of speculative short term trading is dangerous and stupid, but that’s hardly news.
I strongly suspect that this is just a cunning new variant of pump-and-dump scam… Somebody’s going to make a lot of money out of it, but I’d bet it won’t be the retail “investors”. (Scare quotes because “sticking it to the hedgies” is not an investment strategy.)
Let me start with one point, it would be a mistake to bail anyone out over this farrago. If the government does get involved it should put additional restrictions on the stock market to reduce the illusionary appearance that the stock market has any connection with economic growth.
Then, a little background. I am in the market, mainly in low value dividend-bearing stocks and funds. My goal is not to make a fortune, but get enough cash-generating funds to supplement my retirement. I am not involved with the Game Stop controversy in any fashion. I do know co-workers who have, reputedly, made money by investing in Game Stop. I do not know if they have sold their shares and have the money, or if they are hanging on to them and will be hurt by the inevitable collapse.
Finally, because it does make a difference, the stock market is a secondary, zero-sum, market. Companies do not directly benefit from the sale of their stock on the market (aside from specific and somewhat rare circumstances), and the only money in the stock market is money investors put in. The market generates no money itself, it only grows because more money in put into it.
I think what we are seeing here is inevitable. It is the result of mass communication, combined with relatively small personal risk with the possibility of great reward. As the stock price rises, the risk at entry is greater, but since the reward appears greater, the risk appears more attractive. It is a bubble.
But there are some remarkable things about this bubble. First, it’s a single stock in a relatively small company. It appears that the original motivation was to screw a hedge fund who shorted the stock. At that point the share price was low, and it wasn’t hard to get a few thousand small investors to buy a few shares at $10/share. Screw the hedge fund manager, we like the company.
Once it started, however, some momentum would build. Buyers who didn’t care about the hedge fund would see a stock move 20% in a few days, and a 20% move is a indicator to a lot of investors to buy. With increased buy orders, the stock rises more, attracting more attention, and ends up in a viscous cycle which will continue until it pops. A lot of these trades may even be driven by algorithmic systems without human decision making. Part of the algorithm used by large traders may be to put small amounts of money (relatively, in the hundred thousand dollar ranges), into riskier stocks which are making large moves. Which would trip other algorithms to do the same. I’m not saying this happened, but I consider it a strong possibility.
At this point the original hedge fund is screwed. Whether it really was by small traders willing to risk more and more of their money to invest in a higher and higher priced stock, or whether other hedge fund managers looked at the first one and decided to ravage it to reduce competition, or if the small traders triggered a computer-trading bubble by their initial action, it really doesn’t matter. The original hedge fund is screwed, they cannot meet their obligations and will lose all their other assets.
What will happen to people who invested in that hedge fund? In most cases they will have lost their money. The market is a zero-sum game, if a player in the market loses all their assets, any backers of that player do not get their investments returned.
What will happen to Game Stop? This is a more interesting question. The one thing that the stock share price does for companies is what is called market capitalization. In general, the higher the market capitalization the easier it is for a company to get a loan. The rational is that a company with a high stock price has the respect of investors and thus the risk of loaning money to the company is low. A high share price also makes it easier for a company to sell stock to a primary investor (banks or investment firms) who will then sell the stock to the public. Again, the stock exchange is a secondary market, even when you purchase stock as an IPO that money does not go to the company but to the investment banks which purchased the original stock shares from the company.
So, in a normal situation, Game Stop would be able to negotiate more loans, or issue more stock, to re-invest in the company. Can Game Stop do that in this situation? I don’t really know. Maybe. Maybe not. Banks may not be willing to lend money to a company which appears to be only surviving because of a bubble.
If the Game Stop board is really interesting in keeping the business afloat, they should be looking for opportunities to grow. Maybe trying to partner with someone like Netflix or another streaming service. I doubt they have many physical assets, it seemed to me like Game Stop was more of a franchise operation and their franchise owners rented the physical space. But they must have purchasing agreements with the game creators, and maybe they can leverage those agreements into operating in another area of the entertainment landscape. There are opportunities, even for a small company with limited assets.
But they have to work fast. If they wait until after the bubble bursts, it’s even more likely that they will go under. And when the bubble bursts, like it will, all those paper profits will be wiped out no matter who holds the stock. I can’t predict when the bubble will burst. I expect soon, but that’s not guaranteed. The Mississippi Bubble and the Internet Bubble both lasted for ten years. This bubble appears to be a single stock, and it’s likely to have a much shorter duration. Bubbles are another example of how economics activity is often better explained by psychology than as rational behavior (regardless of your personal definition of rational).
As a final comment, while I enjoyed Greenwald’s take on it, I fear that he may be shoehorning this event into one of his pet conceits: The Oligarchy is destroying everything and the public should band together to stop them. I don’t doubt that his interviews with people on Reddit elicited the responses he reported, but depending on how he asked his questions the responders may have responded in the ‘stick-it-to-the-man’ fashion as a way both to appease Greenwald and to feel better about their own actions. Not that they need to be ashamed of their purchasing of stock and even getting rich off it, but we all want as much affirmation that our actions are noble and good as we can. By sticking-it-to-the-man, they are alleviating any guilt they may might feel about their greed. I’m not saying greed is necessarily bad, but it’s generally thought in our culture that greed isn’t the most attractive of emotions.
This issue isn’t even specific to the finance industry. The executives of film studios and publishers love copyright, until someone who isn’t a giant corporation owns copyright and then suddenly those same publisher executives area ll about fair use and free speech.
The original small investors may not be screwed depending on their motivation for buying the shares, if their prime motivation was to screw the hedge funds, and they only invested money they could afford to lose, they have already ‘won’ because making money wasn’t the point of the excercise.
“The problem with the above simple model is ….”
that only the first part is correct: “Companies sell stock to raise money to grow the business.”
After that it’s just the Law of Supply and Demand. The reasons why supplies and demands increase or decrease do not matter. The rest is baked air.
Short selling is a way of gambling; that group of small investors decided to rig the system and succeeded. They took consderable financial risk.
Well, not just supply and demand.
It’s structured in such a way that it creates positive feedback, and wild swings, instead of negative feedback, and stable price signals. It may be inherent in capitalist firm structure, it may not be, I don’t know. But wild swings and sudden rule changes definitely give an edge to those who are better-connected to the stock exchanges.
Or, a form of gambling.
@12
Short selling is not necessarily gambling except in the loosest possible sense of the word. And at that loose of a definition of gambling then most things you do are gambling because your wagering your time and effort on some potential pay off. Going to a store to buy something is a gamble that the store is open and you time and gas money are not wasted.
If an investor is short selling a company because they think the company is currently over valued and will go down that is a rational investment. It’s healthy for the market in that it gives people a way to poke bubbles and deflate them.
If an investor is short selling a company because their market tracking system shows that a big investment firm is about to sell a big chunk of that company’s stock to cover other losses that is gambling on the quality of their model. This sort of movement is not particularly good or bad for the market. It is unrelated to the value of the company but is extraction of money based on who has the best information about the market.
If an investor is short selling a company because they plan to over short sell the company and drive the price down to make a profit they are gambling on their ability to manipulate the market. This sort of gambling is bad for the market because it magnifies swings up or down and is based on manipulating the market not understanding the market.
It’s not “gambling” when they just arbitrarily change the rules of the game to suit themselves.
If you play blackjack at a casino, they don’t get to change the cards whenever they feel like the house isn’t winning enough. Or if it’s roulette, they don’t have you place a bet, spin the wheel and throw the ball, check where the ball lands, then move it to another spot whenever they don’t like the outcome. And so forth.
Why not? Because they could be charged with a crime and the whole place could be shut down.