There is a very important dynamic happening on Wall Street. Regardless of how it plays out, we expect valuable lessons will be learned. We may be seeing a “democratization” of stock trading power, and Wall Street does not seem to like it. By the time you read this, much will likely have happened…
Our main purpose in telling this story is to define and reinforce the distinction we draw between investing and speculating (gambling) in the trading of stocks and other investments. We see this as two sides of the same coin. Many clients have asked us about what they are hearing in the news and for those who do not know or understand yet: In a seemingly modern David vs. Goliath sort of story, a large and well-coordinated group of individuals organized on a social media app called Reddit, within a subgroup called “WallStreetBets,” has been disrupting and shining light on a type of financial attack often perpetrated by large Wall Street firms called a “bear raid.” This is typically directed towards financially vulnerable companies. The first noteworthy names in this story involve shares of GameStop and AMC Theatres. As of this writing, the “little guys” are winning and have created literally billions of dollars in losses for several large hedge fund firms, but the story is nowhere near finished. Nokia may be in the mix as well, and other names are coming up. It looks like there may be interest in targeting silver metal, too, the price of which has reportedly been heavily manipulated for generations. Let’s try to understand what is happening, why it is important, and what it means for you. Most importantly, let us discuss what we think you should take from it.
By the way, before we explain, it must be said that this is simply an explanation of what we see happening; it is not in any way advice to take any specific action or purchase or sell any securities.
Did you know that you can sell shares of stock before you buy them? For people who have not heard of this before, it is called “short” selling and may make your brain hurt a little trying to understand it. Instead of trying to profit from a rise in the price of a stock, the reason someone would sell short is to profit from a future share price decline. The way this seemingly impossible trade can occur is that Wall Street will lend shares of stock to those who don’t own them within a special type of account called a “margin” account. A margin account grants credit, so the owner may borrow cash or stock against other investments they own within the account. Think of it as a Home Equity Line of Credit where a homeowner could borrow against their home up to a certain limit. Margin accounts have credit limits, too, and this will become important to this story.
A margin account will allow the account owner to borrow shares of stock and sell them. For instance, imagine a margin account owner named Mr. Lupo sold 1,000 shares of BigCo, Incorporated stock he did not yet own in his margin account for $100 per share. As long as Mr. Lupo had enough cash or other investments in the account to act as collateral, he is allowed to do this. The account would now be “short” 1,000 shares and, as a result, would show a balance of negative 1,000 shares. There would also be $100,000 in cash in the account from the sale. Mr. Lupo must eventually replace the borrowed shares and will be charged interest on the negative share balance until he does so. Mr. Lupo is now set up to profit if the stock price declines.
Imagine that a month goes by and the share price of BigCo drops to $40. Mr. Lupo could then buy 1,000 shares of BigCo in his margin account to replace the short amount that he had borrowed. The newly purchased shares would cancel out the negative 1,000 shares, and the share balance would become zero. Mr. Lupo would have spent only $40,000 out of the $100,000 he received for his prior sale of the stock and would be able to keep the other $60,000 less any interest charges and trading costs. While buying demand pushes prices up, selling demand pushes prices down. So, if a group of large firms coordinates lots of short selling at the same time, the price of the stock would have to drop – making the short selling a self-fulfilling prophecy. And if they attack companies that are financially questionable that buyers are afraid to commit to, there is little buying to offset their selling attack. This is one of two parts of what the hedge funds attempt to do in order to prey on financially troubled companies (more on the second later). If they can drive the price to as low as zero, they profit from the short sale cash they get to keep and move on to the next victim. How did the “little guys” turn this game back on the hedge funds?
In the case of GameStop, there were small investors who were fans of the company and loved how they could save money by trading in old video games for newer ones and buy refurbished gaming equipment at lower prices. They were unhappy with the idea that big Wall Street hedge fund firms were trying to
crush their beloved video game retailer. As a result, a seemingly organic movement started among GameStop aficionados, some of whom also happened to be stock day traders. This movement grew to a group of people who collectively in large numbers had enough economic power to mount a counterattack against the hedge funds, called a “short squeeze,” using access to a virtual trading platform called Robinhood (the name of which is not ironic; its publicly stated mission is well described by its name). We need to understand here that buying demand pushes stock prices up while selling demand pushes prices down. So aggressive short selling is supposed to overwhelm the buying pressure and push stocks lower, making the short selling bear raid a powerful strategy.
In the GameStop short squeeze, large new buying pressure from a huge number of Robinhood traders pushed against and turned the tide on the downward price pressure of the short sellers who by then had already spent most or all of their ammo, not expecting any counter punch. This action then started raising the price of GameStop stock. Now here is where it gets interesting.
Remember that margin accounts have credit limits? Well, when a stock is held short, it represents a debt tied to the price of the shares. So, if the share price rises, the account’s debt balance rises. At some point, that debt balance exceeds the margin account’s preset debt limit. When that happens, the account holder receives a “margin call” from their brokerage firm saying they are over their credit limit and must do one of two things to rectify the situation: 1) Put more cash or other assets into the account, which may be hard to do since they are likely fully invested everywhere else and are not sitting on a lot of cash, or 2) BUY back the shares they have shorted until they have met the margin limit. At that point, like a dam breaking with so many shares shorted, the stock now dramatically rises when both the short sellers and the little guys are buying, and nobody is selling, thereby “squeezing out” the short sellers who are panic buying back the short shares at prices potentially much higher than they shorted them at; in the process, creating losses, potentially huge losses. But there is even more to this story.
There is a second part to what the hedge funds can do in all of this, and it may have as much or more impact on pushing stock prices down as short selling. The large Wall Street firms can create even more leverage for that purpose by using another financial tool called stock options in a certain way. We will not explain how this complex financial tool works here. The parameters around options risk are typically defined using Greek letters, and the actions of those on the other side trying to turn it around on them cause a “gamma” squeeze. A gamma squeeze on the options combined with a short squeeze on the stock can compound the loss potential faced by the hedge funds who possibly never expected to be contested. This looks like what just happened in GameStop stock and made all the news. Reports of losses on short positions in U.S. firms of $70 BILLION dollars have been reported[1].
While this has not fully played out yet, the large collection of individuals attempting to profit from squeezing the hedge fund(s) probably has financial limitations that are likely dwarfed by the deep pockets of the large firms who not only have access to vast capital but also have friends in high places that may back them up. As interesting and significant as all of this may be, it is still essentially large-scale gambling on artificial pricing pressures that have little to do with the actual businesses behind the stocks in play.
As the sun sets one day, unless they can find a new approach, GameStop and AMC Theatres will still have dated and non-competitive business models, making their prospects for the long-term still questionable. Because of this large stock rise, the companies may be able to sell new shares to raise money and give them a longer lifeline – but doing so would actually help the short sellers and could scare away the buyers who understand that this waters down their ability to push the stock price up. In the long run, unless GameStop and AMC Theatres can figure out how to make a viable business out of their high cost, old-fashioned, brick and mortar storefront businesses in the changing digital world, they may still be headed for the trash heap of history. Most importantly, though, note that essentially everyone involved here appears to be focused almost exclusively on short-term stock price moves instead of on the long-term fundamentals of the businesses themselves – and this is where we want to shine a light.
In the place of participating in all of this high-stakes gamesmanship, the kind of investor we are in business to serve is instead trying to benefit from the day-to-day business operations of the hundreds or even thousands of companies they likely own pieces of within their broadly diversified portfolios. This is a stark distinction against “playing” short-term stock price moves, hoping it goes one’s way. We can make a strong historical case that this approach has been consistently successful with a low risk of failure over retirement length periods of time, while the speculators have resided in high-risk territory. Again, past performance cannot guarantee future results. So, in a world where the only guide we may have is the historical record of well over a hundred years, what it clearly shows gives us a strong basis to make this case.
The profit earned by these businesses is called earnings in Wall Street speak and comes to shareholders in two possible ways. It is either paid out as a dividend or kept within the business as retained earnings to grow the underlying value of each share by deploying that money to grow and improve the business itself. Over time, the collective dividend and share price of large American businesses has grown significantly around a constantly rising trend. How reliable has this been? Since 1871 the collection of businesses that now make up the S&P 500 index and its predecessors have never recorded a single year of profit loss. There has been not even one year of negative earnings, including the years of the Great Depression itself and any other difficult period within the data back to 18712.
In case it is not clear, we advocate what we call “investing” over “speculation” for handling our client’s important money that needs to support a lifetime of retirement income and possibly pass to the next generation. Not to say that speculation can’t work, but our study of history indicates that the inherent risks from speculation have been historically much higher than would be acceptable for critical investment funds needed to sustain bill paying income. In the data, we see that speculators have experienced a historical high probability of creating real losses as opposed to what the data shows for lifetime investing, which has been a historical high probability of success over longer periods of time.3 One sad aspect is the many stories of failure that litter the path of history are seldom told, while the few stories of success become legend4. In any case, it must be said once again that past performance does not guarantee future results in any case. As students of economic and market history, we strongly believe the battle will continually be won or lost on how well the lessons of history can be learned and employed.
Wishing you a much better 2021!
The Team at Compass Point Retirement Planning
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1 Sujata Rio – Reuters.com: “Losses on short positions in U.S. firms top $70 billion – Ortex data” https://www.reuters.com/article/us-retail-trading-shortbets/losses-on-short-positions-in-u-s-firms-top-70-billion-ortex-data-idUSKBN29X1SW
2 Dr. Robert Shiller: http://www.econ.yale.edu/~shiller/data.htm: Dec 1871 through Dec 2020.
3 “Stocks for the Long Run” Dr. Jeremy Siegel, McGraw-Hill Educational Books 2014
4 “A Short History of Financial Euphoria” John Kenneth Galbraith, Penguin Press 1990