HB Perspective on the GameStop Short Squeeze Headlines

By: Ross Bramwell, CFA

02/02/2021

As the company GameStop and the term “short-squeeze” have become the center of headlines in the media recently, we wanted to give a little background on the recent events. Below is a Q&A style format that explains some of the basics of the story. Overall, the actions have increased market volatility in the short term as speculative day-trading has dominated headlines, but over the long term we believe markets will continue to focus on economic fundamentals dependent upon future corporate earnings, the vaccine rollout, the continued economic recovery from the pandemic, and fiscal policy. There is certainly a lot of noise right now from these small stocks, and we’ll continue to focus on any larger impact to the markets in the short term and long term. If you have any further questions, please contact a member of your service team.

What is GameStop? GameStop is a video game retailer. Like most stores that still sell products in person, it has had a difficult time lately as video game sales have moved online and as the Covid-19 pandemic keeps people away from stores. GameStop is still in business, but the perception is that it will struggle to grow again.

Why GameStop? Like many companies that are struggling, GameStop was the subject of what’s called short selling, in which investors borrow shares of stock to sell and then buy back later so they can return them, which lets them pocket a profit if the stock price goes down. Short selling is a bet that the price will go down. GameStop was one of the most shorted of all publicly traded companies. Other companies on the list include AMC Theatres, Bed Bath & Beyond, and Blockbuster.

What is a Short-Squeeze? For the most part, investors follow the “buy low, sell high” theme when buying stocks. Short sellers do the opposite — they borrow and sell a stock when it is high and bet that it will continue to fall. If that does not happen and the stock price rises, short sellers are forced to cover their positions or buy more stocks to minimize their losses. Because short sellers (frequently hedge funds in this case) are betting against a company’s success, there is quite a bit of risk involved. Any positive news or enthusiasm for the stock will push up the stock’s valuation, which is going against a short seller. For GameStop, chatter on massive online trading forums drove interest in buying the stock, pushing up the price, which in turn fueled more interest. The speculative trading left short sellers with no more shares to buy to cover their positions, creating a short squeeze and leaving them with millions of dollars in stocks they had to buy at a higher price, creating huge losses in some cases.

What are Reddit’s and Robinhood’s Roles In This? The internet has been used previously to prognosticate about stocks, but the recent message board involved has been on the Reddit community called wallstreetbets, also known as WSB. Investors on WSB have discussed GameStop for years, but things changed early this year. As the price of the shares rose, more WSB posters jumped on board. WSB temporarily made the community private recently and said they were experiencing technical difficulties based on unprecedented scale because of the newfound interest in WSB. There’s also Robinhood, the app that is the unofficial stock trading platform of choice for WSB. Robinhood lets people trade stocks and options for little or no charge. Robinhood, and several other brokerage firms, made headlines because they restricted trading as trading volume became so large.

Why is this a big deal now? Shares in GameStop ticked up on January 11 after it named three people to its board of directors as part of a deal with shareholders who had been pushing for a change. That caused some short sellers to abandon their positions, helping to drive the stock up more in the following days. The stock traded about even for the next few days, but then things began to change as increased volume indicated a short squeeze, meaning people who had bet against the stock either chose or were forced to give up and take losses. And while WSB had gotten some media attention in recent days for its GameStop chatter, an increase in coverage of GameStop and WSB helped bring the story out of the financial world and more into the mainstream. GameStop shares would go from trading at around $43 to as much as $380, becoming one of the most traded stocks on the market along the way.

Will the markets change because of this? In the short term, the impact has been increased volatility and the volume of trading has strained the computer infrastructure of online brokerages. But the larger and longer-lasting impact may be on how the market itself operates. The battle over GameStop has taken on something of a David vs. Goliath feel, with some people outside of finance painting it as a reckoning for parts of Wall Street. There is some belief that WSB signals the arrival of a powerful new force as large numbers of retail investors find influence by acting together in a big trade. That may serve as a check or balance on other large forces, such as hedge funds, which are used to throwing their weight around without ordinary investors affecting a price. Right now, the activity is only around a few companies, which is not that uncommon. But the broader concern comes when retail investors become overly exuberant and inflate stock prices, as that may be considered evidence that the stock market has reached a dangerous level of enthusiasm and speculation.

How can this end? A short squeeze often ends in the stock price falling back to where it was before the drama started. History suggests that these meteoric rises cannot go on forever, and over time, stock prices generally reflect the expected future earnings of corporations. But these can go on for extended periods if the players have enough resources to risk.