The GameStop-Reddit stock market rigamarole has become another case study of stock market manias and bubbles.
We may be just a few months removed from the oddity that has been given such affectionate names as “GameStonks,” but there are plenty of books on the phenomenon it represents. Take the 1949 classic The Intelligent Investor, which retells how Sir Isaac Newton lost the equivalent of more than $3 million (adjusted for inflation) when the physicist succumbed to the enthusiasm surrounding one of the hottest stocks in England.
The GameStop kerfuffle wasn’t much different. In January, users on the internet forum Reddit triggered a short squeeze of the American video game retailer’s stock, causing large losses for some hedge funds and short sellers.
In general, investors borrow shares from a broker to sell them quickly on the market.
Those investors have to close the shorts, or give the shares back to the broker, by buying back the shares, and they make a profit if they buy back at a price lower than the one for which they sold.
Investors assumed GameStop would be an easy stock to short. But that didn’t happen, as people using investing platforms such as Robinhood began buying up GameStop stock. Affected short sellers rushed to buy back those stocks to avoid taking a huge financial loss, causing GameStop’s value to increase further.
“I think the lessons are that the market can be irrational,” says Alex Durbin, a chartered financial analyst at Columbus-based The Joseph Group Capital Management. “’Things like this occur, and that’s why the markets can remain irrational longer than you can remain solvent.”
Durbin says two things drive individual stocks in the market: the fundamentals, a company’s actual situation, and the sentiment investors have about that particular company or its stock. The two don’t always align, and several short sellers of GameStop stock had more negative sentiment than perhaps the fundamentals of the company might have suggested, Durbin says.
The Reddit user who triggered the incident, however, had been following the stock for years beforehand, Durbin adds.
“(His) thesis was that the fundamentals for GameStop really weren’t as bad as people thought. … He was thinking about this in 2018, and for a long time, the market didn’t agree with him,” he says. “And then COVID came and the situation facing brick and mortar retailers looked pretty grim. So for a while, it didn’t look like a great trade.”
The uniqueness of the pandemic caused changes in the product cycle, as did the release of the PlayStation 5 and Xbox Series X consoles.
“There was this surge in retail activity that benefited a company like GameStop. And sentiment really began to shift, I would say, late in the year of 2020. And then a few other things happened. … Activist investors got involved and people really started paying attention,” says Durbin. “… More and more people started to kind of catch on to this.”
Investors can appreciate how one Reddit user did the research to determine that a stock’s worth was more than the market was recognizing, Durbin says.
“Hey, you do your homework and you see a good opportunity and have the conviction to hold through. That’s a good thing,” he says.
However, Durbin cautions investors about getting caught up in these kinds of manias and bubbles.
“In the short term, it’s really difficult to have a good read on the direction of an individual stock or markets in general and make a lot of money, even if you’re well informed,” he says. “It’s very, very hard to have any kind of predictive power over what the market or what a stock is going to do today, tomorrow, next week or next month.”
He notes a number of stories of people taking out graduate school loans or using savings for a house to buy GameStop stock at several hundred dollars per share.
“I think that’s where it becomes somewhat foolish,” he says.
In addition, investors should always have conversations with their financial advisers and brokers on what types of funds, particularly hedge funds, their money is being invested in, Durbin says.
“Thinking about the other side of this trade, the hedge funds that suffered tremendous losses, it highlights some of the challenges that investing in a hedge fund presents – less transparency, less liquidity. Hedge funds aren’t required to report with the same level of detail that a mutual fund might need to report,” Durbin says. “And the liquidity feature is such that if you want your money from the hedge fund tomorrow, you probably can’t get it. … You might have a one-year lock-up, and then after that, you might have access on a quarterly basis and you may only be able to access a certain percentage of your investment.”
Not all hedge funds are the same. Some perform well and limit risk. What’s important is understanding the process as an investor and having a good financial adviser.
“It’s often very difficult for an individual investor in a hedge fund or any pooled investment vehicle to have access to the portfolio manager,” Durbin says. “Having a financial adviser who is able to get a sense of what’s going on and what the risks are who can then relay that information to clients is key.”
Brandon Klein is an associate editor. Feedback welcome at bklein@cityscenemediagroup.com.
