The GameStop controversy has become far more than a fascinating story of David and Goliath, with small investors beating the big hedge funds at their own game using the power of technology. Now, fundamental questions about our free market system are being discussed — and not only by market participants, but by regulators and politicians!
Rumors and half truths have been circulating about collusion between hedge funds and the big market intermediaries. And while there’s some truth to those stories, there are also many distortions.
When Robinhood stopped new purchases of targeted stocks, saying they were protecting their investors, it created a furor. Those individual investors didn’t WANT to be protected from their own greed! But Robinhood was only telling part of the story. Far more significant was the fact that as those big stock positions ballooned in value, Robinhood was required to put up more capital to stay in business, and avoid bringing down the entire clearing system. In fact, overnight Robinhood used a $500 million line of credit — and got another $1 BILLION worth of capital by giving up some ownership benefits in their company.
Good thing they were saved. BUT, the issue was over who did the saving. The money came from large hedge funds, and market intermediaries — who were quickly accused of trying to save their hedge fund friends. More “incriminating” was the fact that Citadel (whose name is on both a large hedge fund and the market intermediary that pays Robinhood most of its income in exchange for directing transactions to Citadel) was also a part owner of Robinhood. Can you spell incestuous?
Meanwhile, stressed hedge funds sold other positions, stocks they owned and had expected to go higher. But the hedge funds needed the cash, and a wave of selling hit the markets, leading to the worst week for the S&P 500 since last October. This whole situation is creating a huge negative impact on the entire market.
So markets are faltering, and the “machinery” of market transactions is stressed and raising capital. But, if there’s anything worse than a problem with our financial system, it’s politicians deciding they have the answers! And that’s what’s coming next — hearings and investigations, for sure.
IN THE MEANTIME, here are some important facts about WHAT COMES NEXT:
Hedge funds have lost $20 Billion — on paper — but have maintained most of their short positions in GameStop and other stocks. Only about 8% of the short interest has been covered in GameStop. And those target companies are still in a very weak financial position. So if reality ever sets in, it’s very possible — actually, likely — that those stocks will ultimately collapse dramatically.
The big losers will be the amateurs who have rushed in to buy at high prices, believing someone will follow them to push prices even higher!
If you have profits in this trade, please take them and pay off your mortgage or student loans! If you haven’t participated, please don’t get involved now. The last line of my original column (below) still applies. And that’s The Savage Truth.
JANUARY 29, 2021:
It’s with a bit of detached amusement that I have been watching the outrageous price gyrations of some stocks that many had written off as almost total losers.
Whether GameStop’s collection of dated retail stores playing in an industry that is totally online, or AMC movie theatres standing empty for nearly a year, or Tootsie Roll candies not selling with no Halloween parties, the “smart money” in hedge funds decided to bet big on their demise.
What’s a Short Sale?
To understand how this is done, you need to comprehend the simple process of a “short sale.” That’s what it is called when you – legally – sell shares you don’t own, hoping to buy them back at a much lower price.
It turns the old concept of “buy low, sell high” on its head. With a short sale you sell high and then buy low!
Of course, there are rules to be followed. You can’t simply “dump” unlimited shares of stock. In most cases, you can only execute a short sale on an “uptick” – after the stock trades slightly higher, not when it is cascading lower. And you must put up margin money – just in case the stock goes up instead of down. You might need to buy the stock (cover your short) at a nigher price if that happens, so the brokerage firm wants to make sure you have cash to do so.
So What Happened with GameStop?
For months the so-called smart money hedge funds had been short- selling shares of GameStop and other similar companies – betting they would file for bankruptcy and the shares would become worthless. Then the short-sellers could “cover their shorts” – buy the stock for just pennies to complete their transaction. They planned to book huge profits!
Hedge funds have a lot of power in the financial markets. They can be offered only to “accredited investors” – those with a lot of money and sophistication. And hedge funds can use a lot of leverage – borrowed money to make bigger bets than ordinary investors are allowed to do. Plus, unlike the mutual funds and ETFs offered to individual investors, they are not obligated to publish their investment positions.
Hedge funds swagger with their power. Yes, they may make buying and selling mistakes, but they have quite an edge – and few dare to stand in their way –especially when they decide to “short a stock.” Until now!
Revenge of the Nerds
Imagine a schoolyard bully who is always taking the little kids cookies and lunch money. Individually the kids can’t do much. But suppose they are suddenly equipped with cell phones, and come up with a plan to attack all at once. Suddenly the bully isn’t so brave any more. In fact, he turns tail and runs when faced with a concerted effort to turn the tables.
And that’s what happened on Wall Street this week. Small investors, gathering together on online message boards like Reddit, decided to start buying the stock – and pushing the price up sharply.
They knew the hedge fund short-sellers would have to put up more margin money – or buy back their short-sale stock at higher prices. It’s a classic squeeze. Shares of the companies involved soared as the amateur investors – the playground nerds – jumped in to buy, and profit as the stock went up.
The hedge fund bullies lost a fortune, running into the billions. Some were indeed forced to buy back stock at higher prices, booking huge losses. Some hedge funds might simply fold and close their operations.
So Who is Right and What Went Wrong?
Critics say there is no real reason for those stocks to trade at such high prices. But “the market is always right.” The price is set at the level where buyers and sellers agree to transact. Likely the stock prices won’t stay so high, because the business fundamental don’t justify that level on a traditional basis of earnings prospects.
There’s been a lot of complaint about “Robinhood” a trading platform for smaller investors, with the pros wondering if the amateurs know what they are doing, the risk they are taking. The latest short squeeze, — whether these individual traders bought stock through their own brokerage accounts at Schwab, Fidelity, or Robinhood — made Wall Street pros a bit queasy. It’s as if the old fable came to life.
Like Robinhood, they robbed the rich hedge funds – and many booked profits to pay down student loans or make a down payment on a home. Yes – if they sold – the profits were real. Real money. But before your greedy dreams get you involved, remember that just as the stocks soared higher, they can turn on a dime (your dime) and collapse equally quickly.
It’s an old saying: The bigger they come the harder they fall. And that’s The Savage Truth.