Understanding the GameStop Saga
In January 2021, GameStop saw its stock price whiplash from around $17 to $500 caused by a short-squeeze engineered by a group of small amateur investors. Other names, so called meme stocks, also saw violent price action during this period. The unusual high price and volatility is tapering off but continues to this day. The short-squeeze caused substantial losses to Wall Street firms on the other side of the trade. The episode sent shockwaves through the financial and investment world and left many scratching their heads looking for explanations. Congress was called upon to investigate allegations of collusion and corruption.
Are markets broken? Is there fraud and manipulation going on? Who are the good guys and who are the bad guys in this story? Why did this happen and how?
The purpose of this article series is to shed some light into the GameStop saga. However, its significance goes far beyond any of these meme stocks — they are just incidental. We will lay out the main parts to the puzzle which can help us understand what this is all about.
Let’s dig into it.
PART I: Brick-and-Mortar Meltdown
But first let us rewind a bit.
Established in 1984, Blockbuster — a movie rental store — quickly dominated the 90’s and early 2000’s, through the rise and fall of VHS then DVD’s, as people started enjoying movie nights at home. At its peak in 2004 the company operated 9,000 stores across the US before suffering a brisk decline culminating in bankruptcy in 2010.
Along the way, Blockbuster made a host of mistakes including charging exorbitant late fees and passing out the chance to acquire a tiny new competitor. Rising from its shadow in 1997, Netflix leveraged online ordering to deliver movies by mail to become the company it is today.
But more than any managerial pitfall, the causes of the Blockbuster’s demise were structural. On the one hand, Blockbuster was incurring high fixed costs of owning and maintaining physical stores as well as the employee overhead to operate them. On the other hand, new technological innovations and changing consumer trends made the whole physical movie rental business model obsolete: Cable, pay-per-view and high-speed internet streaming changed the market dramatically. Recently, with movie theatres closed due to the lockdowns, Disney studios ramped up its own online platform to stream new movies directly on Disney+.
Which brings us to our second example. While movie production pace increased worldwide, movie theatre foot traffic saw a steady decline over the past 2 decades. This was not due to people spending less time in front of a screen — quite the opposite. The switch was in the consumption channel: away from big and small screens and towards electronic and handheld devices in private settings. Consumers were increasingly looking to control the freedom and quality of their time. Movie theatres (and other entertainment venues) were forced to close during the pandemic, exposing their vulnerabilities. Movie theatre operators — such as AMC — suffered as a result.
Technological advances, high speed internet, global supply chain streamlining, and changing consumer preferences and behaviours caused slow but major shifts in how and where consumers shopped, browsed, got entertained and spent their money: away from physical retail stores and entertainment venues in favor of digital and online convenience.
This is what has been commonly referred to as the brick-and-mortar retail meltdown. The phenomenon is far-reaching, widespread and ongoing. Books, electronics, clothing, cosmetics, household items, even furniture, appliances and food… the list is long: only few product categories remain immune for now (e.g. gas stations.) And the pandemic just seems to supercharge this trend: packing years of meltdown into months. And there have been many high profile casualties over the years. From flagship department stores to toy stores to mall operators. Even traditionally large retailers that still dominate have done so in part thanks to a successfully managed ecommerce presence in parallel (e.g. Wal-Mart)
Video gaming is another highly profitable and rapidly growing category of the entertainment industry. It recently became the biggest sector surpassing TV — and triple the size of Box Office revenues. It is set to quadruple in the space of just 10 years. Notably, this growth was driven mainly by a change in the nature and distribution channels. Gaming digitization more than offset the shrinking contribution of physical games and platforms. Just like for movies, the most popular gaming console is probably in your hand (or your pocket or purse).
So, stop me if you heard this story before: a previously successful retail store with a big physical footprint in a booming market that did not see the future coming got swept away by not only e-commerce but digitization of both the products it sells and the distribution channels of those products.
In this context, quite predictably, GameStop’s sales quickly eroded from their peak in 2015, losing up to 50% by the end of 2019. And this is even before the pandemic hit.
It is therefore easy to conclude, absent some dramatic transformation, that it is just a question of time before GameStop pulls a Blockbuster.
And it showed on the share price. Both GameStop and AMC lost more than 90% of their value going into 2020. WallStreet was betting the company’s stock is likely tending towards 0. A pretty unremarkable story in and of itself (unless you are an investor)
PART II: Anatomy of a Short Squeeze
There are many reasons why people buy and sell anything, but the most fundamental motivation to be on either side of a trade is this:
- Buyers are betting that the stock will rise in value in the future.
- Sellers are betting on a falling price in the future.
As opposed to a regular selling where an investor owns a number of shares of a stock and then decides to sell them, short selling (or just shorting for — uhm — short) happens when the seller does not actually own the shares. The shares are first borrowed (from a broker) and sold immediately, with a promise to buy back (and deliver) the share at some time in the future. But why would anyone want to do that?
Picture this. It is summer of 2015. Myanmar became a democracy and Adele is still singing Hello. You are enjoying your vacation by the beach, wiggling your toes in the sand and patiently waiting for your cocktail as you perceive something shining in the sand two feet away. As you unearth it, you realize it’s your luckiest day! An oracle ball. You brush and shake your precious future-predicting device and, lo and behold, words appear:
August 2020: GME @ $1.000
Being a savvy investor, you hurriedly reach out for the other device in your backpack to check the stock market:
Today: GME @ $20
What shall you do?
If the oracle told you that GME will be $100 by 2020 that would have been easy. Why of course you would buy as many shares of GME as you can and hold them until 2020. Multiplying your investment 50 times in the process.
However, as the predicted price is significantly lower than today’s, how can you benefit from this information? If you already owned the stock, you want to get rid of it as soon as possible. Otherwise, you can’t do much to profit from your oracle prediction, can you? Well, with short selling you can. Remember, it allows you to bet and profit from falling market prices. You short sell the stock today for $20 and buy it back in 2020 for $1, if the oracle prediction materializes, making a good and certain $19 profit on each share. Not bad!
And just as in our oracle ball example, many professional investors who have appetite for risk and access to short selling strategies (hedge funds) piled up on GameStop and others: It was evident that GME constituted an ideal target (given the problems and structural issues discussed in Part I) — no need for an oracle ball (just some research.) However, direct short selling comes with many risks — especially when investors get complacent as happened in this case.
- Borrowing costs: when shares are borrowed, the broker may charge interest and fees on the amount borrowed, especially when a stock is in short supply.
- Asymmetrical loss potential: In an ordinary buy transaction, the worst an investor can lose is 100% of their initial investment. You may ask, what is worse than losing all of my investment? Potentially, much more. Let’s assume the oracle ball is infallible and you trusted its prediction:
Suppose you are a European. You read the predicted price to be a thousand dollars (separator.) You went out and bought 100 GME stocks in 2015 for $20 (total value of $2,000.) To your horror, it turns out the ball is American (Made in China.) In 2020, at a $1 a share, you lost $1,900 (95% of your investment). Shortly after, the company goes bankrupt: you have just lost all your investment: the maximum you can lose any case (because a price can’t be negative.)
Now suppose you are an American and thought the prediction said $1 because, well, it’s just precise to the 3rd decimal point. You shorted 100 shares of GME stock in 2015 for $20 (at $2,000). However, the damned ball was actually predicting a thousand price tag but you only find this out too late. Fearing the stock will just keep on rising, you buy back the 100 shares at $1,000 (spending $100,000) you have just lost $98,000. Same initial number of shares as in the first scenario but with an outsized loss potential. Worse, there is no upper limit to how much you can lose — theoretically, infinite. This is not exactly how the profit-and-loss works but it illustrates the two defining risk characteristics of short selling: asymmetry and infinite potential loss.
- Margin costs: In a regular buy transaction: while an investor is holding a stock, the value may fluctuate, sometime wildly, but they are not impacted as long as they are holding the stock. No additional cash is tied to the transaction beyond the initial investment. In short selling however, to compensate the broker for the risks of lending the shares, the short seller must post some collateral: a sum of money, referred to as margin account — like a deposit. As long as the stock price is dropping or stable, the short seller is ok. However, if the stock starts to rise, to compensate the shares lender for the increased risk, the short seller will have to pledge more cash as collateral. We are talking about one of the most dreaded words on Wall Street: A Margin Call. Liquidity is a very important component of markets and is a big source of instability when it is restricted as it has potential to cause domino effect.
And this is why direct short selling can sometimes be a source and accelerator of instability in markets not just for the stock in question but the overall market.
In a short supply situation, a small price increase (for whatever reason) leads to margin calls, which would trigger partial liquidation (short covering by weak hands) leading to more buying pressure and faster rise in the stock price. Which again triggers more margin calls and more liquidation and stronger buying pressure. This is what is referred to as a short squeeze. The cycle continues until:
- In normal conditions: it stabilizes where supply and demand are in equilibrium.
- In oversold conditions: it gets out of hand quickly and violently. Leading to more instability — violently veering one way then the other. In extreme situations, the repercussions go beyond the stock in question to the overall market (margin calls leading to liquidation of other positions by trapped short sellers, leading to panicked sale of other stocks and other assets (to finance these margin calls) causing downward price pressures on these assets, contagion, bigger losses, liquidity crunch, failure, or bankruptcy.
As of early January, GME stock was the most shorted stock on the market (to such an extent that there were more shorted shares than there are shares available for trading.) Many other names were also heavily shorted. Which made them ripe for a violent short squeeze given the right trigger.
Many small amateur day traders on social media realized that they can target these most-shorted names with sustained buying until they trigger a short squeeze realizing outsized gains and causing hedge funds on the other side of the trade substantial losses.
PART III: Popular Delusions and Madness
It’s the 1980’s! The Soviet Union is collapsing leaving the USA as the singular superpower with no expensive wars to fight. This ushered a new era of solid economic expansion most apparent during Bill Clinton’s presidency through the turn of the century: strong economic growth and solid job creation; low inflation and interest rates; a fiscal surplus (1998–2001) for the first time since 1969 and falling national debt. Free and growing international trade was in full swing (NAFTA, elimination of tariffs and free trade agreements notably with China.) Multinational companies made record profits with better, faster, cheaper products. Technological advances and deregulation made both Silicon Value and Wall Street the innovation hubs and hottest job markets attracting theoretical physicists, engineering PhD’s, whizz kids, divas, and con artists from around the world.
Alan Greenspan, the chairman of the Federal Reserve (1987–2006) was hailed as one of the architects of this prosperous and stable period. Nicknamed the Maestro, he masterfully used his toolbox (Fed rates and cryptic messages) to stimulate the economy, keep inflation in check and contain bubbles and external shocks. He moved markets and commanded influence and respect from Washington, Wall Street and around the world even after the end of his mandate in 2006.
It was the best of times. It was the worst of times.
Less than two years later, and the Maestro of yesteryear has been blamed for the worst economic shock since the Great Depression of 1930’s. The Great Financial Recession that started in 2007 shook the American economy to its core and brought the world to a standstill. To be sure, the seeds of the recession were sown long before.
In combination with other longer-term trends like automation, the push for globalization enabled the outsourcing of manufacturing which gutted good paying middle-class jobs to transform America into a predominantly service- and consumption-based, debt-driven economy. Globalization and automation also helped mask the inevitable inflation (subsidized by low wages and poor working conditions oversees) that would have resulted from accommodative monetary and fiscal policies. The US ran large deficits to finance the post-9/11 twin wars and stimulate a slowing economy. Bush administration’s push to sell the increasingly out-of-reach homeownership dream and debt-fueled consumption binge to more people, led to the rise of risky subprime and lax lending. Alan Greenspan’s Fed reduced its lending rates from 6.1% to 1% and kept them at historic lows for longer than experts think was warranted, fueling even more risk-taking and risky borrowing. Greenspan even personally advised homebuyers to take on even riskier forms mortgages just before the he started raising its lending rate. Deregulation, low interest rates and lax lending conditions, and over-reliance on Fed backstop made Wall Street more risk-blind and led to the rise of unregulated shadow banking system, toxic and poorly-understood financial instruments, more speculative bubble formation and misallocation of capital, and inevitably fraud. Vulnerabilities and dependencies built up and multiplied through the fabric of the global financial and economic network turning it into a house of card, built at the end of a domino chain, on a minefield.
It was the best of times. It was the worst of times. It was also the end of times.
Superlatives were made for this! Monday, September 15, 2008, in the middle of the night, Lehman Brothers — the 5th largest and a 150-year-old investment bank — became the largest bankruptcy in history. During the most memorable weekend in financial history and following days the government had to rescue the insurance giant AIG, force gunpoint marriages between banks that were deemed too-big-to-fail.
Interbank lending, the lubricant to financial system and commerce, froze due to a complete collapse in trust. International trade and shipping froze. The Federal Reserve, along with other central banks, then-unprecedented programs of forced lending, buying of toxic papers and bailouts. And after driving their lending rates towards 0, central banks embarked on an unprecedented balance sheet expansion buying up the toxic securities off the financial system. Apart from the moral hazard that these bailouts were sure to cause, not only are these programs still not reversed, 12 years later, but had to be expanded (the Fed is on its fourth round of quantitative easing and some countries are effectively in negative rate territory.)
Meanwhile, the same entities who made profits shuffling risky instruments on the way up went unpunished (no prosecutions or bonus clawbacks) on the way down, are the same beneficiaries of the policies implemented by governments and central banks. On the other hand, millions of families lost their homes and jobs in the process and were set years behind. And while the stock market recovered and is setting all time high, many families never did to this day.
This is often what happens when a large debt-fueled bubble pops.
Part IV. A Tale of Two Economies
The financial crisis of 2007 and ensuing global recession didn’t just cause economic havoc, it exposed a big disconnect that was papered over by decades of easy money, debt, and wealth transfer.
The extraordinary remedies implemented by central banks and governments since then — to stabilize the economic system — largely penalized middle- and lower-income families and benefitted the wealthiest. The trickle-down ideology, while repeatedly debunked, is still used as a mechanism to pump money at the top of the economic pyramid in the hopes it flows favorably downwards. Instead, this just contributed to the destruction of the middle class and exacerbate wealth inequality between rich and poor.
As an example, there are mechanisms through which central bank policies influence the overall economy. By artificially driving interest rates to historically low levels and expanding its balance sheet (effectively printing money), a central bank causes the economy to overheat by encouraging lax lending standards and over-indebtedness, risking the rise of inflation, and stoking speculative asset bubbles as happened in the runup to 2007 and what, while still in debate, is currently happening.
These policies contributed to deteriorating prospects for average households who straggled with stagnant or even falling incomes, increasing cost of living and debts.
However, as economists know, wealth follows the Pareto principle, which renders average statistics (e.g. income and debt) meaningless. To get a better picture we should compare the impact on different income levels.
Yes, there has been a recovery, but it is best described as K-shaped recovery. The middle and lower classes haven’t recovered, facing falling or stagnant wages, increasing cost of living and worse employment environment. Many of the already vulnerable has been punished hardest by the lockdowns and lost their jobs while others smoothly transitioned to WFH or saw their investments explode in value. Inflation and asset bubbles are a two-edged sword: punishing those who earn income through wages and spend it on necessities while making the wealthy capital-owners (e.g. high-net-worth investors, business owners, large landlords…) richer.
The wealthiest have been realizing the bulk of the increase in income. But income concentration only shows part of the story as the richest households accumulate their wealth not through income but mainly through capital and asset returns (rent, corporate profits, stock profits and dividends…)
For example, the stock market fully recovered from the 2008 recession, and more recently from the covid-induced shock, and is making record-after-record. Notwithstanding the obsession of the Fed, policymakers and the media with the S&P500 index as a proxy to the health and wealth of the nation, the majority are not benefiting because most are not invested (because they can’t.)
The wealthiest are not just making more, they are also owning more and more of the pie.
The pandemic and ensuing lockdowns just seemed to make the rich richer faster by the day.
PART V: OccupyWallstreetBets: David vs Goliath?
The Global recession triggered, directly or indirectly, many other events around the world: the European debt crisis (2009), the Icelandic financial crisis (2008), and the spark to Arab Spring (Dec 2010 partly due to rising energy and food prices) to name a few.
Back then, these events made it clear that the system is not working for most. In September 2011, the Occupy Wall Street (OWS) movement protested economic inequality, corruption and greed and was a window to the rising frustration and resentment felt by many. “We are the 99%” the slogan said. Even then-president Barack Obama admitted that the movement expressed “the frustrations the American people feel, that we had the biggest financial crisis since the Great Depression… and yet you’re still seeing some of the same folks who acted irresponsibly trying to fight efforts to crack down on the abusive practices that got us into this in the first place.”
Yet still, nothing changed, most forgot but few never got over it.
During January 2021, GameStop saw its stock price whiplash from around $17 to $500. Although short squeezes are a regular occurrence even in a healthy market, what makes this one different and significant, is that, as Ray Dalio suggests, it is a reminder that the “system” is still not working for most people, a symptom of division and inequality.
This is for you dad! is how one of the posters on r/wallstreetbets discussion board justified his decision, with little regards to the economics of his trade, to inflict pain on the amorphous Wall Street bad guys. Resentment and a will to vengeance. But that alone would not have been enough without 2 new ingredients: democratization of trading through low-barrier platforms and a social media where amateur young traders, caught in the midst of a rising tide bubble, talked, self-organized and coordinated.
But like in every story, it is complicated. This was not a Robinhood story either (pun intended.) Beside the vigilantes, there were also those who realized the power of crowds on social media to execute such trading strategies. Pump-and-dump schemes were not the exclusive preserve of the big boys anymore. And then, indicative of a bubble in its advanced stages, there were those who bought “meme stocks” just because they were trending, many of whom were left holding the bag.
In those first days, there were many failures to deliver GameStop stock — which is sometimes indicative of the illegal practice of naked short selling. As often happens in a distorted market, even savvy investors get complacent and lazy and pile up on “profitable” trades: making it ripe for outsized shocks. So some hedge funds did suffer substantial losses and few were close to blowing up as a result, to the delight of some. On the other hand, many, including the same maligned hedge funds participated in and profited from the short squeeze.
Robinhood, the commission-free trading app most popular with these reddit traders, enraged its customers as it moved to halt buying in these shares at the height of the buying spree to cause the short-squeeze. Accusations of collusion and manipulation came from both users and Congress. The market regulator SEC suspended trading in even more “meme” securities in February, kindling the conviction for many that the table is tilted against small retail investors. Following the events, congressional hearing also investigated allegations of selling customer orders by Robinhood to market-makers and the practice of front-running these customer orders by HFT. To paraphrase the old investment dictum states: there are no commission-free lunch and Robinhood users re-learned the lesson that if you are not paying for it, you are the product.
The unusual high price and volatility of many of these meme stocks continues to this day but will certainly taper off.
The underlying story however will remain. It is a story about unresolved economic dislocations and remedies put in place to mask the consequences causing more vulnerabilities in the system and the destruction of the market as a mechanism for price discovery and efficient allocation of capital and resources where even short-selling serves a healthy role in the ecosystem. A story of an all-encompassing bubble that is bound to implode in a spectacular fashion. A story of worsening wealth divide and unwillingness to resolve the wealth redistribution part of the equation. And while it is not the beginning of a civil war as Ray Dalio warned if nothing is fixed, the GameStop episode proved to be a small tectonic plate tremor… or a warning for those who want to heed it.
