Several people have asked me on Facebook to explain the whole dust-up with GameStop, Robinhood, Reddit, and the effect on the market overall. Herewith is that undertaking. I thought it would be useful to lay it out in a Q&A format, somewhat along the lines of the questions I'd expect people to ask me about it.
But first, some introductions are in order. As a friend of mine always said, "You can't tell the players without a program," so here you go.
The Players
GameStop. GameStop is a seller of video games and related merchandise, through more than 5,500 retail outlets across the U.S. and in several other countries. As video games were increasingly downloaded and played online, the brick-and-mortar business model began to falter. In addition, management made some questionable moves to try to counter the decline, including a failed venture into selling mobile phones.
GameStop's stock traded between about $4 and $58 a share from the company's initial public offering in 2002, to its zenith in late 2007. The stock then fell victim to the broader '08-09 market crash and recession, falling below $18 a share. It finally began climbing out of that range in 2012, peaking above $55 a share in 2013 and trading in the $30s and $40s until late 2015, when the fundamental factors and bad business decisions noted above began to drag it down. It declined steadily from 2016 to early 2020, even as the rest of the market soared, and traded as low as $3.32 a share in 2019. GameStop is essentially the Blockbuster Video of the gaming world.
This stock is a dog, and for easily understandable reasons. As a primarily brick-and-mortar retailer, its woes were exacerbated by the pandemic shutdown and supply chain disruptions. It has recently re-structured its board, suspended its dividend, and its earnings per share are $(4.18) - in other words, it was trading around $4 a share, and at the same time it was losing about $4 a share.
Robinhood. Robinhood is a commission-free stock trading app. It was founded in 2013 by two finance entrepreneurs who previously built trading platforms for (drum roll, please) hedge funds. It competes with the big boys, like Schwab, TD Ameritrade (which is being acquired by Schwab), and E*Trade, which all stopped charging commissions in 2019. Robinhood's assets under management (AUM) total about $20 billion, vs. more than $3 trillion for Schwab, more than $1 trillion for TD Ameritrade, about a half-trillion for E*Trade. All that means is that Robinhood has fewer users with smaller balances. And any of its users could open an account with any of the big boys just as easily as with Robinhood.
However, Robinhood differentiates itself by claiming to be the platform for the "little guy." Its interface is designed to appeal to millennials and investment rookies. Its stated mission is to "democratize finance for all." Its founders abandoned hedge funds, which pay next to nothing to trade stocks (more on that to come), believing they could bring that same low- or no-cost trading ability to small investors. Its website throws out tidbits like, "we believe the financial system should be built to work for everyone," and "a more human way to learn ... education resources that are built for today." And its educational materials are, indeed, targeted toward the newbie, with topics like, "What is an investment?" and "What is a stock?" By contrast, TD Ameritrade's education offerings focus on trading strategies, including options trading. (Full disclosure: TD Ameritrade is the platform I use.)
But other than those differences, there is nothing revolutionary about Robinhood at all. It's just another trading platform, and in terms of the way trades are entered and executed, market prices, settlement, etc., it is no different than any other online broker. It is also a FINRA-registered broker/dealer, is registered with the SEC, and is a member of the Securities Investor Protection Corporation, just like any other broker (including the one that I led as CEO).
Reddit. Reddit is described by Wikipedia as "a social news aggregation, web content rating, and discussion website." Reddit is described by Reddit as "the front page of the internet." Feel free to read the full Wikipedia entry. Reddit was acquired by Conde Nast, the magazine publisher, in 2006, and it was subsequently acquired by Conde Nast's parent firm. Other investors include the rapper Snoop Dogg and the Chinese holding conglomerate Tencent (let that sink in).
Reddit holds quirky events for its users. Its user groups, called communities, regularly engage in pranks such as skewing polls on various websites; the pranks are often encouraged by Reddit. Reddit has been marked with numerous controversies, many involving censorship similar to what we've recently seen from Twitter and Facebook. It appears to be the social media platform for people with too much time on their hands.
Some of my own google searches seeking information about various topics have landed me on Reddit pages, and I have generally found the posts there to be less than informative. Their posters seem to me to be uninformed, and mostly juvenile delinquents. Your mileage may vary, however.
The GameStop stock trading action that is the subject of this post was organized on a Reddit topic forum, which are known as subreddits, called r/wallstreetbets. (That's right - bets.) This subreddit is known for aggressive and highly speculative (read: risky) trading strategies. Its members are generally amateur investors who are basically gambling in the markets, rather than investing for some goal, such as retirement, and they ignore (or don't understand) investment fundamentals. As such, they are a perfect subset of the Robinhood target market: generally young investors that don't have a lot of capital, that don't really know what they're doing. Wikipedia says, "The subreddit is also known for its profane and juvenile nature ..." Hardly serious investors looking to improve their lot in life.
Keith Gill. Gill is a member of the r/wallstreetbets subreddit. He is 34 years old and works as an investment rep, at least for now. He is registered as a broker and investment advisor, as well as a Registered Principal (manager). He also holds the Chartered Financial Analyst (CFA) designation, which I also hold, and can personally attest is very difficult to attain. He has a sum total of five years' experience in the industry, with three different firms, over a span of nine years. In other words, there is some question as to whether he can hold a job in the business. I would not have hired a rep with such gaps on his resume, and such short tenure with any one firm.
The normally clean-cut Gill spends his spare time creating youtube videos under a profane username, in which he pushes certain investment trades while wearing a long wig, a wide headband, and sunglasses. One trade he pushed on youtube - and on Reddit - was buying GameStop shares. He claimed that GameStop was worth $50 a share when it was trading at $5 and had negative earnings. He held a significant long position in GameStop, meaning that he stood to profit handsomely if enough of the Reddit crowd - again, inexperienced and unknowledgeable investors - bought the stock and drove its price up.
If Gill were just another Redditer (my own term), this might not be a problem. However, as a FINRA registered rep, he is likely to lose his job, his licenses and his CFA charter, as well as having to disgorge his profits. He may wind up in jail. I certainly hope so, at least. And shame on his employer, Mass Mutual, for not better monitoring his youtube antics. They're probably in for some hefty fines as well.
Hedge funds. Hedge funds are not evil, nor are their managers, generally. (Bernie Madoff was a bad guy, but he was running a Ponzi scheme and calling it a hedge fund.) Hedge funds are generally structured as limited partnerships, and are only open to very high net worth investors. This is because of the risk involved in what they do, which usually involves using leverage (borrowing money) to increase returns for their investors. Unlike the Redditers, who also assume a large amount of risk, hedge fund managers know what they're doing, and so do their investors. Hedge fund investors are often themselves institutions that manage other people's money.
Yes, hedge fund managers make a lot of money. If you handed a million dollars over to someone and they turned it into $1.5 million in one year, wouldn't you be willing to pay them 2% of that $1.5 million, or $30,000? You're still up $470,000. Multiply that by more than 2,000 to reflect a fund whose AUM is over $3 billion, and the hedge fund manager can make $40 million a year, after paying other employees. Too much? Considering the manager added a billion dollars worth of value to his clients' investments, it's not.
In fact, this is the story of a guy I used to work with, who went on to start a hedge fund focused on the mortgage derivatives market, which was the focus of our former employer. (At least two of my former colleagues went on to manage hedge funds. Where did I go wrong?) This guy was a logic professor at KU before joining our firm, and was one of the smartest - and funniest - people I ever knew. (He also went to high school with Paul Simon and Art Garfunkel.) In 2010, his fund returned 50% to its investors, and he was named Hedge Fund Manager of the Year for funds managing $1 billion or more.
Hedge funds often bet against the market, hence the name. Hedging is using one investment with a low correlation to your other investments to protect your profits when those other investments fall in value. It's used to limit your losses. It's basically how I started my career in the capital markets, 33 years ago: trading futures contracts to hedge the value of mortgage derivatives. Remember the example above, in which my former colleague's hedge fund returned 50% in 2010? Remember what was going on with the rest of the market - especially mortgage securities - in 2010? By being uncorrelated with the market, his fund made a lot of money while most investors were losing money.
Oh, and why do hedge funds pay next to nothing to trade stocks? Buying power. They - and other institutional investors - are trading billions of dollars at a time in some cases, and they're using multiple brokers. Every broker is competing for a piece of that billion-dollar trade, no matter how small in percentage terms. Because even a fraction of a percent of a billion dollars is a lot of money.
Now, on to the questions.
What went down with this whole thing?
Gill was pushing his fellow Redditers to buy GameStop. But the motivation wasn't just to drive GameStop to $50 a share. The Redditers wanted to hurt the hedge funds by driving the stock price higher. You see, hedge fund managers, recognizing that GameStop was a dog, were short-selling the stock en masse. More than 100% of the company's stock is held by institutional investors. The short interest in the stock, meaning the number of shares sold short as a percent of the total number of shares outstanding, is over 120%. I'll continue answering this question momentarily, but first - .
How is that possible? And what is short-selling?
The answer to those questions is pretty much one and the same. Selling a stock short is a bet that its value will fall, as opposed to a long position, which is a bet that the value will rise. (That's what most of us do - we buy stocks that we think will increase in value.)
So a short sale involves selling a stock you don't own. To effect that trade, you borrow the shares from your broker and sell them. When the price falls, you buy them back for less than you sold them for, and the difference in price is your profit. Of course, if the price goes up, you have to buy the shares for more than you sold them for, and you lose money. Buying the shares back and delivering them to the broker is known as covering the short position.
When a short seller's position suddenly rises in value significantly, it's known as a short squeeze, hence the title of this post, which combines that term with the excellent film, "The Big Short," which was about the '08-09 crash.
Why would a broker let you borrow those shares, and what if you're unable to pay for the shares you have to buy to cover the short position?
Great question. First, the broker requires you to put up cash, known as margin, to cover potential losses. Generally, the margin requirement for a short sale is 150%. So if you short 100 shares of GameStop when it's trading at $5, you have to put $250 cash in your margin account in addition to the shares you borrowed, which are worth $500 initially. (100 shares at $5 per share equals $500 worth of stock, and the additional 50% cash margin requirement is $250.)
If the stock price goes up, the broker can access the margin account to cover the short position. It can also issue you a margin call, which is a requirement that you put up more margin if you want to maintain the position.
The other reason a broker will do this is that it gets paid to do it. It charges you interest on the borrowed shares, and it earns interest on your cash margin. It also charges you a commission when you short the stock, and another when you cover.
Back to what went down?
Since hedge funds bet against other investments, they make extensive use of short-selling. And since they're using leverage and borrowing stocks, they can drive the short interest in a particularly doggy stock above 100%. Also, since they are institutional investors - not individuals - they can drive the percent held by institutions above 100%, also through leverage. (By contrast, less than 70% of Home Depot stock is held by institutions; I am one of the individual investors that owns Home Depot directly. And the short interest in Home Depot is less than 1%, meaning the vast majority of investors expect the stock to increase in value. At over 120% short interest in GameStop, virtually everybody expected its stock price to fall.)
But the Redditers didn't, right?
Wrong - probably. Some of them may have thought GameStop was legitimately worth more than $5 a share, maybe even the $50 that Gill claimed. If they did, they don't understand the fundamentals of investing. Nobody in their right mind would have thought it was worth the $469 a share it traded at briefly on Jan. 28, nor the $325 a share it closed at on Friday, Jan. 29. Imagine: a stock with negative earnings and no dividends going from less than $20 a share to nearly $500 in a matter of days. (The Redditers were actually already bidding up the stock's value gradually as far back as September, but the huge surge in buying came in recent days.) If a pharmaceutical company announced a definitive and immediate cure for the virus with 100% efficacy, its stock price wouldn't increase that much.
The Redditers are gamblers. So what they did was akin to mortgaging their houses, buying roulette chips, and putting them all on one number. Except the stock market doesn't work that way. A massive number of buyers, in a concerted effort, can actually cause a stock's price to go up, in this case by a large amount by using leverage and stock options. You can't cause the roulette wheel to stop on your number - legally, at least.
They also wanted to hurt the hedge funds, which they saw as the evil Goliaths, and they saw themselves as David. But what goes up must come down, and the fundamental value of GameStop is far nearer $5 a share than it is $325. Most of the Redditers will wind up living under overpasses when GameStop normalizes, if they don't wind up in jail.
What happened to the hedge funds?
When GameStop shot up on January 27, the hedge funds had to cover their shorts at big losses. One false report circulating was that one fund lost over $13 billion and declared bankruptcy. The actual losses sustained by all hedge funds that were short GameStop were about $5 billion, at least for now.
What did Robinhood do that upset everyone from the Redditers to Tucker Carlson?
To cover their losses, hedge funds had to sell large amounts of their long positions, which resulted in the Dow Jones Industrial Average (DJIA) falling by more than 600 points under heavy selling pressure on Jan. 27, even as GameStop rose by 136%. The next day, Robinhood suspended trading in GameStop, meaning the Redditers couldn't keep trying to manipulate the share price.
The Redditers, of course, were furious. They accused Robinhood of acting to protect the hedge funds and limiting the small investor's access to the markets. Carlson and other media pundits - none of whom have the first clue as to what went down, how the markets work, why Robinhood did what it did, or what a hedge fund is - sided with the Redditers and went after Robinhood.
Why did Robinhood suspend trading?
A 150% margin requirement will only protect a broker up to that extent, and in the face of a 135% one-day gain in a heavily-shorted stock, the broker is going to begin to suffer losses. Fortunately, the hedge funds were able to access capital to cover their shorts. But some small speculators who were short GameStop weren't able to, and in some cases Robinhood had to eat their losses. (Brokerage firms take risks, too.)
As a registered entity, Robinhood has to meet a minimum capital requirement, and they have to meet it every day. If a bank's capital falls below its minimum regulatory requirement, it has to file a capital restoration plan with its regulator. If a brokerage firm falls below its requirement, for even one day, FINRA will close its doors.
So Robinhood was protecting itself, but also protecting its investors - including the Redditers - by ensuring that it remained in business. It also has an obligation to attempt to maintain orderly markets. And it's not the only platform that instituted restrictions on trading in GameStop. Schwab, TD Ameritrade, E*Trade, and all the other brokers did, too.
Robinhood did nothing wrong, and everything right. Only people who don't understand the markets would be upset with them.
But hedge funds are just for the rich, right? Didn't Robinhood effectively favor them over the "little guys?"
Remember when I said that hedge fund investors were largely other institutional investors? These are professional money managers who, again, are investing in hedge funds to hedge, or protect the value of, their primary investments. As noted earlier, the hedge funds' investments are largely uncorrelated with those investors' primary investments.
And who do those professional money managers manage money for? Pension funds for companies, government agencies, and labor unions. Sovereign funds for foreign countries. Insurance companies.
So if you're a teacher, or a nurse, or a government employee, or an autoworker, or have a life insurance policy, you can be sure that your pension fund manager is prudently using hedge funds to protect your retirement savings and the insurance benefits for your family against market downturns. In other words: you own hedge funds.
But isn't that incredibly risky?
No. First, those pros know what they're doing. Second, the hedge fund investment is a relatively small percentage of their total holdings. Third, by investing in uncorrelated assets, they're actually reducing their overall risk through diversification. And finally, the hedge funds require them to leave the money in the fund for three months to three years. That adds stability by avoiding the kind of volatility that can result from large amounts of money jumping into and out of an asset in a short amount of time - like what the Redditers did with GameStop.
Weren't there some other stocks involved?
Yes, there were a number of other heavily-shorted stocks, including AMC Entertainment, the Kansas City-based theatre chain. AMC's stock shot up from about $5 a share to over $20 at the opening bell on Jan. 27, and it closed the week above $13. The brokerage firms restricted trading in AMC and a number of other stocks that the Redditers were trying to manipulate.
AMC is another dog of a stock. (As a dog-lover, I should really stop insulting dogs.) When the pandemic shutdown hammered stocks in the entertainment, leisure and travel industries back in March, I calmly looked at a number of affected stocks, and began buying them. I bought airlines, cruise lines, restaurants, and hotels. I sold many of those positions later in the year at more than 100% gains. And I looked closely at AMC, which was trading at about $3. I thought this might be another opportunity to double my money in a stock. However, the company was already heavily in debt, and thanks to competition from streaming, its stock price had already been falling since late 2018. So I passed, and I'm glad I did: by the end of last year, the price had actually fallen further, despite theatres re-opening, to less than $2 a share. So no way should AMC be trading at $13, if not for market manipulation by the Redditers.
What happened with the overall market last week? If this was just related to a handful of stocks, why did the market move so much, and over several days?
As noted above, the hedge funds had to sell long positions in other stocks to cover their shorts in GameStop and other stocks they'd shorted, which drove the Dow down by 600 points on Jan. 27. When the brokerage firms suspended trading in those names the following day, the Dow rebounded, and was up nearly 600 points by mid-day Jan. 28, having almost fully recovered the previous day's loss. After all, the stocks the hedge funds had to sell to cover still had their fundamental value. Effectively, they were just "on sale" after the previous day's decline. So a lot of investors bought back in.
Then, the media and the politicians got involved. There was talk of action against Robinhood. Elizabeth Warren wanted tighter regulations on the stock market overall, which spooked all investors. The media started spreading false rumors about a stock market bubble. By the closing bell on Jan. 28, the Dow had fallen 300 points from its mid-day peak, and the net gain on the day was less than 300 points, roughly half the previous day's drop.
Those concerns fueled by politicians and the media resulted in a nearly 200-point drop in the Dow at the opening bell on Friday, Jan. 29. The selling continued throughout the day, in part as a result of Robinhood and other brokers resuming simple trading in the shorted stocks, including GameStop. They still prohibited some of the riskier options strategies that led to the extreme volatility two days earlier, but the Redditers resumed buying them, and more short positions were closed. The Dow closed out the week below 30,000 for the first time since December, losing another 600 points on the day.
Is there a bubble in stocks?
No. The stocks of airlines, cruise lines, hotels, restaurants, and entertainment venues are still closer to their 52-week lows than their 52-week highs - meaning a large segment of the market is more oversold than overbought. And those stocks still have room to run, as travel continues to pick up, states and countries increasingly re-open, and life after the pandemic emerges. There's probably another round of fiscal stimulus coming, too, which will result in more spending. Mortgage rates remain low and homebuying is still brisk, so housing stocks will continue to show strength. Supply chain disruptions will ease, so manufacturers will be able to satisfy pent-up demand, improving their stocks' performance.
So the Redditers are the bad guys here?
Yes. They're the stock market equivalent of the Capitol rioters or Antifa. They were trying to disrupt legitimate businesses from going about their business in an orderly way. They put a lot of truly small investors - pensioners and retirees - at risk.
Do you think there will be a movie about this?
I have no doubt about that. I only hope that it's a fair and accurate presentation, like The Big Short or Too Big to Fail, and not the usual slanted Hollywood treatment that blames the wrong party, and glorifies the guilty.
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So there you have it. If you're still with me, thank you for reading all of this. I hope it's been informative. If you have additional questions, feel free to message me.
Also, for those of you who initially asked the questions that sparked this post, thank you as well. I had a good general understanding of what went down, but I learned even more through the additional research that went into this post.
**Disclaimer: none of what is written above should be construed as advice to purchase any stock, engage in any trading strategy, invest in any sector, or use any specific trading platform.
