GameStop, a struggling, mall-based video games retailer, has topped the business news this week. In part, this is because its common stock (ticker: GME) has seen an incredible run-up in price. But the story has also garnered a lot of attention because the media is portraying the company as the latest battleground between populism and the establishment.
On one side are the hedge funds that have bet against GameStop by short selling GME. That’s to say, hedge funds have borrowed the company’s stock, sold it and are betting that they can buy it back at a lower price. On the other side are the investors, including retail investors on Reddit’s r/wallstreetbets, who are betting on GameStop stock to go up. Moreover, they’re buying GME and encouraging other investors to do the same to push up the price of the stock and bankrupt the hedge funds that have shorted it.
Bulls and bears have fought for as long as we’ve had financial markets. The difference now? The increasing availability of derivatives to retail traders, who can use these sophisticated investment products to lever returns. For example, consider a vanilla call option. Owning a call on GME gives me the right (but not the obligation) to purchase a share of GME at a fixed price (called the strike) and on a fixed date (called the expiry).
Let’s use some illustrative numbers. Suppose I bought a call on GME back on Jan. 4 with a strike of $250 and an expiry of Jan. 27. The fair price of this option would have been very cheap, say a few dollars or less. Why? For the call to have a positive payoff, termed being “in the money,” GME would have had to rise from $20 (the price on the 4th) to above $250 (the strike) by the expiry. Essentially, buying the GME call would have been a bet on incredible levels of stock price volatility.
As it turns out, that’s what happened. Since GME closed at about $350 on Jan. 27, the payoff of that single call (purchased for pocket change) would have been $100. That’s because exercising the call gets the owner a share of GME (worth $350) at the strike price ($250). That’s a return of two orders of magnitude greater than the initial investment. In this way, close-to-expiry, far out-of-the-money call options allow for extremely leveraged bets. Like a lottery ticket or roulette wheel spin, these calls may only cost a few dollars but have a possibility of unlimited profit. The allure of stock speculation? Like poker, you’re playing against real humans. If you can outsmart them, then you can eat their lunch. And now we can do it during lunch on our phones.
With GameStop, we have a classic short squeeze. When the price of GME rises, the investment banks and brokerage firms that lent out the stock require that the short sellers provide more collateral. To do this, the shorts might have to sell their existing positions in other stocks at bad prices to quickly raise cash. Worse, the lenders can immediately call the loaned stock back. The short seller is then forced to buy back the stock at a higher price than they originally sold it at, often taking a bath. In the short sellers’ scramble to cover their shorts, the GME price rises further. Because stock prices have unlimited potential to rise, the short seller is exposed to potentially unlimited losses. Therefore, in a short squeeze, the short sellers risk bankruptcy even if they are ultimately right about the fair value of the stock. But, as John Maynard Keynes is reputed to have said, “The market can stay irrational longer than you can stay solvent.”
But is the run-up in GME price irrational? Does it illustrate the inefficiency of financial markets, like a modern version of tulip mania?
First, we should be skeptical of bite-sized economic history. Case in point: Keynes never made that quip, according to expert historians Robert Skidelsky and Donald Moggridge. And the tulip mania story might also be bust, as historian Peter Garber explains in Famous First Bubbles: The Fundamentals of Early Manias. History has useful economics, but beware history badly done. Still the question remains: Is GME a bubble, born of irrational exuberance?
Bubbles are a favorite topic of my Mercatus colleague Scott Sumner. In the simplest model of an efficient market, stock prices follow a random walk. Since prices instantly and perfectly reflect all available information, price changes are only caused by unexpected news. And since you can’t predict unexpected news, prices evolve randomly. So as Scott has pointed out, even efficient market prices can exhibit bubble-like patterns by chance. Some stock prices will rapidly rise on good news and subsequently collapse on bad news. But you can’t know which stocks ahead of time.
But there’s a problem applying this reasoning in the GameStop case. What news about the company’s business could have plausibly driven the large swings in GME? The stock price steadily tripled from about $20 at the beginning of January to about $60 roughly three weeks later on the 22nd. Then this week, the stock price and volatility exploded. The share price ran up to nearly $475, amid much bouncing around. For instance, on Thursday, Jan. 28, the stock reached $468 soon after the opening bell, only to fall to $126 about an hour later. To my knowledge, no news about GameStop’s business explains these swings. I suspect the truth mixes rationality and human psychology. Here’s my theory:
For starters, the hedge funds shorting GME got greedy. More shares of GME have been shorted than there are shares of GME outstanding. This fact means that if all the shorts are called in at the same time, they couldn’t all be covered. Moreover, GameStop isn’t obviously destined for failure. I don’t give financial advice and haven’t taken either side of the GME trade. But in the same way that some investors are pessimistic about GME, other investors are optimistic about GME. Both sets of investors try to convince the public of their view. This is perfectly normal. The key difference here? The optimistic GME investors have realized the vulnerable position of the short sellers, and they’ve coordinated to expose it. Why GME and not another stock? Because gamers like GameStop.
In this way, bidding up the price of GME is akin to a bank run or a foreign-exchange speculative attack. Investors realize, often suddenly and simultaneously, “If something cannot go on forever, it will stop.” The realization leads to coordinated action by self-interested individuals—Smithian spontaneous order—causing the unsustainable arrangement to collapse. Some call it creative destruction; others call it financial instability. Your language might depend on whether you’ve gained or lost.
Wednesday, the Securities and Exchange Commission (SEC) announced that it was “actively monitoring” the situation. And so are Treasury Secretary Janet Yellen and other Biden administration officials, according to White House Press Secretary Jen Psaki. The SEC and other securities regulators may be concerned that the GameStop short squeeze is an illegal form of market manipulation, a notoriously vague crime under U.S. securities law. I’m not a lawyer and can’t offer a legal opinion.
Nevertheless, retail investors must not be prosecuted simply because they were on the winning side of a trade and used colorful language on the internet. Hedge funds are sophisticated financial market actors that are responsible for managing their own risk. SEC regulations prohibit the general public from investing in them under their “accredited investor” rules. And as SEC officials regularly point out in their indictments, professional traders also use colorful language in their chats. So, let’s be fair. Absent an underlying crime, when hedge funds leave a free lunch on the table, don’t punish retail traders for eating it.
Like GameStop, I say: Power to the players.