Gamestop, AMC, and, to a lesser extent, silver rocketed spectacularly last week, driven by a group of speculators on an online forum hosted by Reddit called Wall Street Bets. The run up shocked the financial world not for its violence (this particular flavor is something called a short squeeze and it is nothing new), but for the fact that the squeeze was triggered by retail investors. The snowballing effect of thousands of ‘little guys’ taking the opposite side of an oversized bet on the part of a couple of hedge funds was also exacerbated by the way the bet was made. At the highs, Gamestop, in particular, reached a price nearly 200 times its 52-week lows and more than 20 times its price immediately preceding the rally. The case is nearly certain to have serious repercussions, regulatory or otherwise.
Before we get into all that, though, let’s dive into Gamestop. The stock was the most heavily shorted in the market by a pretty wide margin and had some minor good news in the form of a board shake-up. ‘Shorting’ a stock is done by borrowing the shares and selling them. You can make money by buying the stock back lower and pocketing the excess cash. Shorts perform a valuable service to the market by helping prevent bubbles or calling attention to fraudulent activity. In Gamestop’s case, the short interest, or percentage of publicly traded shares sold short, was 150%. Short interest is publicly available information, so both Reddit netizens and hedge fund shorts would have known about it. Since there is no limit to how high a stock can go, a short seller can lose an unlimited amount of money. When losses start piling up, shorts are forced to close their positions, leading to an upward explosion of prices when the weakest players start to puke and a domino effect up the food chain takes out more of them. Normally, retail lacks the buying power to force a short squeeze (in the past, it has almost always been a pissing contest of financial powerhouses). However, because of the monolithic action of a forum of thousands and the leverage provided by options, retail buyers briefly pushed around large asset managers.
The entire ordeal would have been nothing more than an oddity if it were not for the events that followed. Several brokerages suspended the trading of shares of those stocks. Robinhood, a popular brokerage firm among the retail buyers of Gamestop, was widely panned for the move. Robinhood does not charge any fees to its ‘customers’ for trading; instead, it sells order flow and data to the very same hedge funds that were taking heavy losses from the short squeeze. They are not the only brokerage to do this, but they were the first. This is clearly a conflict of interest and raises questions about the reasons for the suspension. A benign explanation would be that they ran out of liquidity when executing those orders (exchanges require money for margin). However, it is also entirely possible that they did so out of deference to their real customers: the hedge funds and market makers paying them money for the privilege of trading with their customers.
Companies selling the data of people using their (free or discounted) service is not limited to Robinhood. Social media giants do it. Google does it. Many news outlets do it. The question we are left with is: how comfortable should we be with this business model? In financial markets, the potential for abuse is particularly pernicious. In theory, Facebook selling data to advertisers could lead to better targeting and a better product for consumers. A market maker or hedge fund paying Robinhood for order flow is paying because they know they can give Robinhood’s customers a worse price on their trades. Financial regulators should consider limiting the practice or at least requiring more disclosures.
Zooming out, there are some broader takeaways. Fundamental business value and stock prices have become increasingly separated from each other, something that has historically preceded market crashes. The combination of the Federal Reserve’s monetary stimulus and fiscal stimulus putting money in pockets that have no way of spending it is one explanation. This could be just a flash in the pan while the market continues to rise. However, money managers have less cash ready for deployment than they have in decades and bullish sentiment is sky-high. If stocks start selling off, there won’t be many buyers left to break the fall.