The current “stick it to the man” fracas over GameStop is a sideshow in small corner of the market
In the 1989 song Fight the Power, rap group Public Enemy said, “We have to fight the power that be.” Americans have a long history of wanting to stick it to the proverbial man, going back to the band of revolutionaries that dumped English tea in Boston Harbor on a cold December night in 1773 as a show of defiance to King George III.
Over the past several days, millions of retail investors have banded together in an effort to teach “big bad hedge fund short sellers” a lesson. I am not going to comment on who is right and who is wrong, but when my 19-year-old college freshman son, a Finance major, started texting me frantically yesterday morning and then later in the afternoon one of my clients asked about GameStop, I knew this was an issue worth discussing. So here are a few thoughts that I hope people can use to keep things in perspective.
Going long and shorting a position both have their place in the market
First, there are many ways to make money on an investment. When most investors analyze a potential stock investment, they’re usually looking to determine whether they think the value of the stock will go up over time. Historically, there are two primary strategies that determine future price appreciation – earnings growth and value. Growth investors believe that a company’s future earnings will increase, thus driving the price of the stock higher as the company becomes more profitable. Value investors believe that if you buy a stock at a discounted price relative to the company’s intrinsic value, you have a good chance to make money as the markets recognize that value. What is happening today with the buying frenzy in companies like GameStop, AMC, etc. has nothing to do with either. It’s pure speculation and gambling.
Second, most investors make money when the price of a stock goes up in value over time. They make a determination as to a company’s future prospects, buy the stock, and hope it appreciates. But a small number of investors play the game differently. After determining that a particular company has dismal future prospects, these short sellers borrow stock from a broker, sell it in a “short sale,” at the current price, then sit back and hope the stock price goes down. At some point, they have to return the stock – by buying the shares they had borrowed and sold – to the lending broker. If the stock has declined in value and they can buy it more cheaply, they make a profit.
This is not an easy game to play, as short sellers need to get two decisions correct: Is the stock going to drop in value? and Will it do so during the time period I’m shorting the stock? They can get the thesis correct, but if their timing is wrong they lose. And while the potential loss of owning a stock “long” is what one paid for the stock, the potential loss of a short position is infinite. Most humans are not psychologically hard-wired to root for a negative outcome, and shorting is difficult. Many people think shorting a stock is “un-American,” but others believe it provides a useful check against runaway upward price movement of lousy companies. I am not commenting on either side’s argument, but they are fairly strong opinions in many cases, especially among many young investors today.
And no, this doesn’t mean we’re back to The Big Short and the Recession of 2008/2009
Finally, many people seem to be confusing the crazy trading activity in a small number of companies with the notion that the entire stock market is a bubble and overvalued. In reality, they have nothing to do with each other. What’s transpiring is the intersection of populism meets technology meets investing. Scores of “ordinary” investors, many of whom are new to investing during the pandemic, have opened accounts at Robinhood and other trading platforms. They can connect through message boards, such as Reddit, and share information. The current “stick it to the man” sentiment seems to revolve around “Wall Street fat-cat hedge fund managers” who short stocks.
Each trade needs two sides by definition – a buyer and a seller – and the investors leading the current charge have identified a very small number of stocks the short-sellers are targeting. They equate the hedge fund managers with elites and want them to suffer. Who will win this game of high-stakes investment chicken? Nobody knows, but investors should keep in mind that the U.S. stock market is comprised of thousands of publicly traded companies, many of which are seeing earnings growth as we slowly make progress against Covid-19 with vaccines, etc.
The tug of war between these populist investors and short-selling hedge fund managers is confined to small corner of the market. It is not indicative of the market writ large. Remember that as you listen to endless television interviews with politicians, investment gurus, and regulators over the next several days and weeks. Don’t lose sight of the forest for a couple of small trees.
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