The remarkable rise and fall of GameStop (GME), a distressed video game retailer, has been nothing short of extraordinary. Echoing the speculative flurry of past bubbles, GameStop rallied from under $20 a share on January 12th to an intraday high of $483 on January 27th – a gain of over 2,300% in just ten trading days. The fall has been equally impressive. As of this writing, GameStop is trading for $90 a share, down more than 80% from its high less than a week ago. These price swings raise several important questions: What happened? What, if anything, does it mean for the broader market? And will this impact your Osborne Partners portfolio?
GameStop is a mall-based retailer of video games with a business that has been in structural decline for the past several years. GameStop has been hurt as shopping has moved away from malls, and video game distribution has moved away from physical disks to online downloads. Before the events of the last couple of weeks, GameStop was a small-capitalization stock with a market value well below $1 billion. Many investors, including hedge funds, believed that GameStop was in terminal decline and expressed this belief by shorting the stock. Shorting a stock is the process of borrowing stock and selling it with the hope of repurchasing it for a lower price at a later date – pocketing the price difference in the process. However, other investors, including Dr. Michael Burry of The Big Short fame and Ryan Cohen, the founder of Chewy, believed the launch of the latest video game consoles (Xbox X and PS5) in late 2020 would offer GameStop a reprieve, allowing the company to make fundamental changes to its business necessary to survive.
Up until this point, the GameStop story was rather conventional. Some investors thought the company was heading towards bankruptcy and betted against it by shorting the stock, while others believed this view was too pessimistic and purchased stock in the company. Eventually, the company’s fundamental performance (revenue and earnings growth) would determine which side was right. However, things began to change late last year when GameStop and other distressed companies such as AMC Theaters, Blackberry, and Bed Bath and Beyond began to gain prominence on r/WallStreetBets, a message board on the online social network Reddit. Speculative bets (alternatively known as YOLO trades – You Only Live Once) on small, distressed companies and subsequently bragging about the ensuing losses, and less frequently gains, is the raison d’etre of r/WallStreetBets.
A short squeeze, technical aspects of options trading, the emergence of the retail trader, and wall-to-wall media coverage have been the key drivers of the market swings for GameStop and other heavily shorted companies over the past couple of weeks. A short squeeze occurs when investors who have shorted a stock are forced to repurchase the stock as its price rises to stem their losses, pushing the stock even higher and creating a feedback loop where other short-sellers are forced to do the same. Before its massive rally, GameStop was the most shorted company in the market, with the number of shares short equaling more than 140% of its market capitalization. Comparatively, the median stock in the S&P 500 Index has a short interest of 1.7% of its market cap, and only 13 of the S&P 500 companies have short interest above 10%. The heavy short interest in GameStop and other companies, set the stage for the insanity that was about to unfold.
The use of call options to add leverage to speculative bets, the relative ease with which apps like Robinhood have made trading options, and retail traders organizing on Reddit drove the next act in the GameStop drama. Purchasing call options used to be difficult and expensive. The advent of Robinhood and commission-free trading has made options trading both quick and simple, belying the risks involved and complicated nature of the derivatives. This dynamic echoes similarities to the dotcom boom in the late 1990s when day traders, Yahoo message boards, and E-Trade spurred rampant speculation in internet stocks.
For a relatively small premium, purchasing one call option gives an investor the right to buy 100 shares of a stock at a set price before an expiration date. If the stock price doesn’t reach the call price before the expiration date, the option expires worthless, and the investor loses their premium. If the stock reaches the call price or higher, the investor can buy the shares for the agreed-upon price and sell them on the market. The gains from options can be massive. On January 8th, when GameStop was trading around $18, you could have purchased an option to buy 100 shares of GameStop for $30 per share before February 21st for $57. By the time GameStock reach $483 on January 27th, this same call option was worth nearly $35,000, returning nearly 60,426% in less than three weeks – YOLO indeed. It’s not the gains accrued to the purchaser of the call option that is important to this story; it’s the market maker’s actions who sold the call to the investors that matter.
Option market makers are in the business of providing liquidity, ensuring that you can trade whatever options you want. They do not take bets on the fortunes of individual stocks. They make a small spread on each trade while hedging their exposure to the underlying share price changes. When selling a call option, the market maker will simultaneously purchase the underlying shares to hedge their stock price risk. When the call price is well above the stock’s current price, they will only need to buy a few shares; however, as the stock price increases, they need to purchase more and more shares to remain hedged. With coordination on Reddit and easy access to option trading on Robinhood, retail investors bought massive quantities of call options with prices well above GameStop’s market price. In the first half of 2020, about 12,000 GameStop call options traded per day, by the fourth quarter, it was about 75,000 call options, and in the two weeks preceding GameStop’s peak price of over $480 a share, daily call option volume averaged 424,000 contracts and as much as 1,000,000 a day. All these call options and the subsequent hedging by market makers as the share price of GameStop rocketed higher drove huge volumes of buying by market makers to maintain their hedges – a dynamic know as delta hedging or a gamma squeeze.
The confluence of the large short interest in the stock, the massive scale of option buying, the buying of GME stock by market makers to hedge their option exposure, the forced short-covering by hedge funds, and the ensuing media frenzy that attracted more speculators, created the perfect environment for the explosive move in GME. But, by late last week, the frenzy had begun to die down. Brokers like Robinhood were forced to limit trading in GME due to the need to post large amounts of collateral that they did not have at clearinghouses, most of the hedge funds that were short GME had begun to cover their positions at massive losses, and with GME not doubling every day, new investors stopped rushing into the stock.
While the final chapter of the story is still being written, we believe it will very likely end with GameStop, AMC Theaters, Blackberry, Bed Bath and Beyond, and other similarly situated stocks ending up right back where they began this remarkable journey. Along the way, a select few will have made money, though most retail traders will undoubtedly lose, a few hedge funds will have almost failed in the short squeeze, and many more speculators and hedge funds will make a fortune on the price collapse.
We do not believe that this episode represents a paradigm shift in the markets. GameStop is a unique situation where exceptionally high short interest and a small market capitalization allowed retail investors organizing on Reddit to jumpstart a short squeeze. As noted earlier, the short interest on companies in the S&P 500 is in the low single-digits. Additionally, the average market capitalization of S&P 500 companies is almost $70 billion – nearly three times the market capitalization of GME at its peak price. These two facts make it unlikely that we will see such stock moves become commonplace. While we won’t be surprised if the members of r/WallStreetBets raid another company, it will likely be nothing more than a diversion. What concerns us more is the emergence of excessive speculation in other parts of the market.
Stock squeezes like GameStop are just one of a few parts of the financial markets that are exhibiting spectacular exuberance. Other areas of recent excess include the lofty valuations of companies that recently went public, the numerous launches of special purpose acquisition companies (SPAC) – a speculative investment since it’s not clear yet what company, if any, the SPAC will acquire, and the recent rally in cryptocurrencies. All these investments represent the prospect of large, immediate, and easily accessible gains. The allure of easy money propels these investments higher right until the day it doesn’t, and just like GameStop today and previous bubbles, we expect these investments will turn out very poorly for most investors.
While the explosive gains in GameStop made it clear that the stock was disconnected from reality and thus made it easy to sit on the sidelines and just marvel at the craziness of it all, that is not always the case. Often, stocks will post impressive gains month after month as their valuation slowly disconnects from the business’s underlying fundamentals. It can become exceptionally difficult to remain disciplined in times of market excess; however, history shows us that it is exactly what we must do. Eventually, markets always correct, and it is the investors who couldn’t wait on the sidelines any longer and jumped in last that pay the price. While we see areas of exuberance and excess in pockets of the market today, we do not believe we are in nor entering a market bubble. We believe that our disciplined, dynamic multi-asset class investment strategy, focused on fundamentals and valuation, will enable our clients to meet their financial goals across various market conditions while avoiding getting caught up in the speculative excess that is beginning to emerge in parts of the market.