Those who possess the intestinal fortitude to board Wonderland’s monster roller coaster, the Leviathan, will experience the singular pleasure of parking their stomachs nearly 100 metres in the air, accelerating to a top speed of 148 kph, and (hopefully) renewing their acquaintance with terra firma (and sanity) about 2 minutes later. A quick canvass of Gamestop’s recent share price reveals a strikingly similar profile (and likely a similar effect on many of its investors). The only difference is that in the Gamestop case, for many the return to terra firma and sanity are not likely to be either as smooth or as welcome.
What’s going on? Gamestop is widely regarded as a declining asset. The core of its business – bricks and mortar gaming shops – seems destined to fall prey to its digital competitors. It is not entirely surprisingly, therefore, that from US $33 at the end of April 2016, its share price declined to an anemic US $4 on July 31, 2020. In early September of 2020, however, a potential saviour showed up in the person of Ryan Cohen, former CEO of online pet-food retailer Chewy. Cohen revealed that he had acquired a substantial investment in Gamestop. On the hope that Cohen might play a key role in transforming Gamestop’s hard assets into a lower cost digital platform, a steady rise in price occurred. This rise accelerated when, on January 11, the company announced that Cohen and two of his cohort would become directors.
This is when things really started to get interesting. Gamestop’s price did more than simply shoot upwards faster than a ballistic missile. It became manifestly unglued from even the most euphoric view of its investment fundamentals. By January 22, it was US$65. By the close of trading on Friday January 29, it rested at US $325. Amazingly, that was substantially down from a staggering high of US $483. As of the close of market on Friday February 5th, it was quoted at about $64.
What drove this spectacular rise (and equally dramatic fall) appears to have been a loosely organized gaggle of reddit provocateurs riding shotgun on the r/WallStreetBets forum. Their main aim seems to have been to deep six a number of behemoth U.S. hedge funds, institutions, and rich Wall Street traders that had aggressively shorted Gamestop’s shares when investment fundamentals and share price parted company. In this the provocateurs succeeded. According to S3 Partners, Gamestop short-sellers lost a whopping US $19.75 billion in January alone.
This has given rise to much crowing along the lines of “David and Goliath” and “putting it to the man”. In this there should be no surprise. The economic havoc and destruction of the 2008 credit crisis doesn’t just linger on. It marches on. While millions of Americans lost their homes, their jobs, and very often their dignity, Wall Street bankers got rich off selling subprime toxic sludge to institutions and governments around the world, which ultimately suffered huge losses when the true nature of these assets became apparent. The resulting popular perception of inequality was only exacerbated by generous bailouts to banks, hedge funds, and other institutions. On top of this, no market actors were ever prosecuted for their misdeeds in connection with the credit crisis, even though some appear to have been demonstrably guilty of fraud. In short, the reddit crew are not an anomaly; they reflect the same sort of bitter resentment that helped Donald Trump successfully masquerade as a populist and an anti-establishment/anti-corruption mensch while putting the boots to the very crowd that elected him.
Regrettably, however, it’s not just “the man” who is getting it in the neck. Even the most inexperienced Swami will tell you that gravity-defying levitation is at best a short-term affair, and the Gamestop saga does nothing to contradict this view. Already, the price pressure exerted by the reddit crowd has mostly stalled out and the Gamestop price is settling (crashing?) back to earth. Those who purchased at nosebleed prices are losing big time. Many of these folks are likely to be the very same retail investors whose purchases were designed to punish perceived Wall Street excess (or who naively thought that Gamestop shares would continue their upward trajectory forever).
Many of these folks are likely unaware that, as a general matter, retail investors tend not to do very well in financial markets. Indeed, financial economists often divide the market into two types of traders; “informed traders”, and “noise traders”. Informed traders tend to be professionally managed institutional traders. Noise traders, on the other hand, are mostly retail traders (i.e. individuals). These retail traders often trade with the belief that they have valuable information that will allow them to identify overvalued and undervalued companies. Mostly, however, they are trading on air.
The identification of retail traders as noise traders is not mere snobbery. It is based on a rich empirical record. There is abundant evidence that many retail traders do not actually look at investment fundamentals, preferring to make bets on whatever company happens to be the flavour of the day (e.g. as touted in the press or on social media). Retail investors also tend to herd in and to herd out of particular stocks, sometimes causing prices to depart from investment fundamentals for weeks or months. The Gamestop case is an extreme (although time-compressed) example, but hardly unique.
Those who don’t believe that institutional traders are quite so smart might point to the fact that, on average, institutional traders such as pension and mutual funds do not “beat the market”; that is, earn better risk-adjusted returns than a pertinent market index. So how is it that we can identify them as “informed” traders? This is where we run into the ‘paradox of market efficiency’. It is only by virtue of the activities of informed traders that securities markets are efficient. But if the market is truly efficient, then the “alpha” earned by any given trader (that is, return over and above the index) has an expected value of zero. So why would any institution (or anyone else) spend time, money, and effort to identify overvalued and undervalued securities?
The empirically supported solution seems to be that institutional traders do in fact beat the market before transaction costs. This gives them an incentive to keep doing what they are doing (although it raises the deeper question of why clients, who bear those transaction costs, would pay them to do it).
It is also worth noting that not all public companies trade in an efficient market. Many of the studies concluding that securities markets are efficient are based on a sample of very large U.S. companies. For “small cap” public companies (which in the U.S. is defined to mean any public corporation having between $300 million and $2 billion in market capitalization) market inefficiencies are far from unknown. Canadian companies are, on average, much smaller than their U.S. counterparts, and the vast majority fall into the “small cap” category. Thus, there is probably a significant amount of “alpha” lurking in Canadian capital markets.
But in any case, the dichotomy between informed and uninformed traders supplies some insight into the Gamestop affair. Once the value of Gamestop travelled substantially north of what could be justified on the basis of fundamentals, the informed money engaged in aggressive shorting. It looked pretty much like a sure bet. But then the reddit folk came crowding in with what was not merely a monetary, but a political agenda. ‘Sure’ was transformed to ‘manure’ in the blink of an eye.
This exposes a potentially serious weakness in our capital markets that can be exploited by the unscrupulous. There is a danger that deliberate misinformation will be distributed on social media with a view to causing a frenzy of trading designed to artificially puff up or deflate a given company’s share price. While “pump and dump” and other manipulative schemes are as old as securities markets themselves, the advent of the internet and the proliferation and power of social media have greatly multiplied the opportunities for securities market misdeeds. Moreover, such misdeeds are very difficult to prevent, or to root out and punish. Take the Gamestop situation. The reddit crowd seems to have been more a flock of starlings on the wing than a pack of roving hyenas. But suppose there was in fact a manipulative agenda on the part of one or more participants. Would we ever find out?
The Gamestop saga is also a cautionary tale for retail investors. When just-plain-folks who have never, or only lightly dabbled in securities markets before find out that a reddit trader self-christened “DeepF---ingValue” turned a $53,000 investment in Gamestop into $26 million, some will cast aside due caution and leap into the fray. There may well be a not-inconsequential number of such newbies in the Gamestop affair. Many will buy high and sell low, and possibly never return to the stock market. Indeed, even the lucky reddit trader just adverted to failed to bail when he ought to have done and ended up losing about three-quarters of his spectacular gain.
If you’re going to tackle securities markets on your own, get to know how the market works and limit your bets to what you can afford to lose. Alternatively, invest in a mutual fund or an index fund, or seek professional advice. Most of all, don’t get caught up in an irrational market frenzy in which you’re as likely to be a big time loser as a big time winner.
