Now that GameStop is drifting back to pre-craze valuation levels I would like to step back and suggest that this phenomenon has simply been the confluence of four old investment stories and one great old movie. The stories are, in brief:
- Short selling is not some intrinsic evil, however it does frequently elevate an old ethical dilemma called moral hazard. It did with GameStop in spades. This is the lesson of the 1944 film noir classic Double Indemnity.
- The value of a stock in the near term is often less about “the fundamentals” of valuation than it is about who the marginal investors are.
- Sometimes the valuation of an asset is best determined by the Bigger Fool Theory.
- Hidden in the recesses of that Reddit social media crowd exuberance there was also likely a lot of classic pump-and-dump.
Short selling and moral hazard
In Billy Wilder’s 1944 film Double Indemnity, Barbara Stanwyck’s character takes out a big life insurance policy on her husband and then ropes the insurance salesman, played by Fred MacMurray, into killing him in order to collect on the policy’s double-value payout clause. Moral hazard is the incentive to take on excessive risks when there is some kind of insurance backstopping your risk of loss. This film’s extreme case illustrates why the insurance industry does not let strangers take out large life policies on you; there is just too much economic incentive to want you dead.
Short selling by itself, despite a lot of new critics, is not a bad thing. It is simply the inverse of buying stock on margin. With margin buying, you borrow money at a fixed cost and use the proceeds to purchase stock. Betting that the stock will go up in value, you can nicely leverage your gains. But if the stock goes down in value, you get bigger losses on the downside, having to pay back the loan with money you may no longer have.
In a short sale, on the other hand, you are betting that the price of the stock will go down. You borrow someone else’s shares of stock, sell them now, and bet that later you can buy the shares back at a lower price to replace the borrowed shares. The moral hazard comes in here because, if your bet is large enough, you have a very large incentive to find a way to drive the current price of the stock even lower to magnify your gains. As in Double Indemnity, it may just get too tempting to find a way to “murder the husband.”
GameStop had its start as a software retailer called Babbages, and evolved into a business model similar to Blockbuster Video. The fundamentals of the business have been really bad, as young people increasingly stream their games online rather than purchasing them in stores. The short-sellers were betting that GameStop would follow Blockbuster’s path from an already-low valuation into oblivion, which would give them a large profit.
It was clear that the short sellers wanted the company to die. But were they actively killing it? The problem with moral hazard is that innocent or not, the suspicion never goes away. Fred MacMurray thought he had figured out the perfect crime in Double Indemnity, but even if the insured husband had coincidentally died of natural causes, his death so soon after the insurance policy was written would look forever suspicious. Absent clear evidence of collusion, we may never find a murder weapon, but the “husband” here remains in very ill health. Moral hazard remains.
The marginal investors of Reddit
The plans of the GameStop short-sellers were foiled by an online investment forum on the social media site Reddit.com. Some sharp investors realized that enough new buyers into the market would create a short squeeze. This happens when the most fragile of short-sellers see the price of the stock starting to rise, and so they are forced to buy back shares at the new higher price in order to minimize their losses. But all those new sales just pump the price of the stock higher, further “squeezing” the next-level-fragile set of short sellers, who then buy back their shares at a still higher price, and so on. This helped drive the share price to nearly 200 times its historical low. Losses by the big short-sellers tallied to the billions of dollars.
I have written in the past about picturing the flurry of daily buy-and-sell for many stocks as similar to the Canadian sport of curling, where lots of “sweeping” goes on from both sides, usually with little marginal gain. The marginal investors of a stock are the individuals and computer algorithms furiously “sweeping” for small gains daily while most of us investors in those same companies just sit back and watch the game. For every buyer there is a seller. For every winner, a loser.
In short, the “true value” of a company is often much less than where the sweepers temporarily take it, and we bench-sitters are fantasizing unless we are willing to become marginal investor ourselves. Is Tesla really one of the most valuable companies in the world? My position is that the true value of a company is the point where you will jump into the stock or pull out your investment to realize your gains (or losses). Most of us just sit and cheer, only pretending that we are playing the game.
The bigger fools of Reddit
When asset bubbles start to arise, classic valuation goes out the window. An enduring theory of the value of commodities like gold and silver, and updated to amorphous products like Bitcoin, is that investors often buy in with the expectation that there is “a bigger fool than I” who will buy them out at an even higher price.
This strategy works until it doesn’t. Somebody bought lots of GameStop stock at $483 per share. Barring a dramatic turnaround and that buyer still holding the stock, that person/company was the “biggest fool” in this bubble. But many Reddit-inspired investors were smaller losers on the up-and-down “bigger fool” ride along the way. And most “bigger fool” losers will never admit it was them.
The old pump-and-dump
Call me a cynic, but I did not see some great new social media movement in the GameStop mess. Let me suggest that the Reddit investment forum, as with dozens of other internet investment forums, is home to lots of classic day-traders, many of whom try various low-rent versions of price manipulation. Pump-and-dump has long been a strategy with “penny stocks” trading at small values. If I can buy a lot of small-price shares, and then convince lots of other people to also buy, I can sell my shares for a marginal profit based on nothing but a sudden new interest in the stock.
Robinhood, the newest low-cost investment platform, has brought a lot of new, unschooled day-traders into the market. Fresh meat for pump-and-dumpers, in my read, and this one went way beyond expectations.
What has been is what will be,
and what has been done is what will be done;
there is nothing new under the sun. Ecclesiastes 1:9 NSRV
The math of day-trading has never been attractive to me. If you are going to pit me against thousands of super-fast computers and hundreds of sharks in the water, the only good bet is on whether the computers or the sharks get their dinner first. Oh, and don’t take investment advice from random bloggers.
Here is the trailer for that classic study in moral hazard, the film Double Indemnity (1944):