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The Long & Short on The Short Squeeze Trend

The drama witnessed over the past two weeks in a couple of previously ho-hum stocks is the stuff Hollywood screenwriters dream of: retail investors vs. hedge funds, spectacular stock price movements, and fortunes won and lost overnight.  

Interestingly, we’re still not sure what type of screenplay we’re talking about here.  Is this a dark story of stock price manipulation?  Or a triumph of Main Street over Wall Street?   Were securities laws broken, or did David simply best Goliath?  We offer our thoughts on the Reddit / Robinhood / GameStop / Short squeeze frenzy.

Recapping The Scene 

Video game retailer GameStop (ticker: GME) has been left for dead until a 34-year-old trader decided there was value in the company not recognized by the market.  (He wasn’t alone.)  He made his case online via YouTube and Reddit.  The investment thesis included more than just an undervalued stock.  It was an opportunity to take down a hedge fund or two that had bet against the stock.  Other individual investors bought in, hitting a tipping point that sent GME shares soaring 400% for the week ending January 29th.   This crowd didn’t limit themselves to GME, as other heavily shorted stocks saw similarly miraculous gains.

This week, the bubble burst.   The Reddit crowd cashed in, sending these stocks crashing.  The winners and losers still need to be sorted out, but the early victims include hedge fund Melvin Capital (lost 53%, needed a $2.75 billion infusion from other funds) and online trading firm Robinhood (needed to raise $3.4 billion to meet liquidity and regulatory requirements.)

The GME short squeeze is not an isolated event, albeit it is one of the most dramatic.  The performance of heavily shorted stocks has been quite strong in recent months.  Goldman Sachs called it “the biggest short squeeze in 25 years.”

The Initial Response 

The SEC and the brokerage industry’s regulatory body, FINRA, are both investigating the situation, but the logical first question is this: were any securities laws actually broken?

If institutions collude to drive prices up or down, then yes, securities laws forbid price manipulation.   Historical examples are plenty (and we all remember the movie Wall Street, right?)

But individuals sharing investment ideas on message boards are seemingly protected by their First Amendment rights.   Anyone can go tell the world why they think stock XYZ is the next Tesla.  The fact that a critical mass of traders followed along doesn’t qualify as stock price manipulation … or does it?  Was there a coordinated effort to move the stock price?  History is littered with “pump and dump” schemes, and it seems that the answer in this case may be a matter of interpretation.  

A Ban on Short-Selling? 

The fact that so many retail traders bonded together to create such upward demand (granted, with some leverage) is remarkable.  But it should be noted how GME already had tremendous downward pressure on it from the hedge fund community.  How?   There were more shares shorted than there were available shares to buy.  

Quick tutorial: To bet against a stock, one must borrow the shares, then sell them.  To make money, they buy them back at a lower price.  They lose money if the stock goes up, and the potential loss is unlimited. So, a group of buyers can force a short seller to buy back his/her shares, hence, “a short squeeze.”

But is short selling the problem?  Should it be limited or banned, as some have suggested?  To us, the answer is no.  Anyone invested in the markets takes on risk for the possibility of reward.  Short sellers simply express their risk in the opposite direction of buyers, and no one said stock prices should only go up.   Without a check on rising stock prices, we’d argue the risk becomes more systemic.  

Now, it should be noted that extreme positions can produce extreme results.  Other hedge funds have described Melvin Capital’s massive short position in GME as reckless.  After all, advisors have preached diversification for a reason.  If you have a concentrated position, long or short, you live and die by that sword.  No regulation required here, but perhaps some risk management lessons to be learned.

An Investor’s Response

Importantly, we’re talking about trading here, not investing.  Anyone who deploys a sound investment process that, perhaps most importantly, has a time horizon beyond two weeks (or even two years) is relatively unaffected by the GME short squeeze.  And anyone trying to play the short-term trading game should abide by “The Vegas Rule” (OK, I just made that name up): gamble only with what you’re willing to lose.  

Or don’t gamble at all.  Instead, invest over time and put the odds of success in your favor:

What do you think?