New Phenomena in Behavioral and Social Investing

Itay Goldstein: Hello, everyone. We are doing a miniseries of podcasts here at the Wharton School on the future of finance. Today, we are going to explore a new phenomenon — behavioral and social investing. Of course, behavioral investing is not a new phenomenon. We have known about it and talked about it for a long time. The new element that has come into it more recently is social investing — how behavioral investing is assisted by social media and the desire of people to participate in a social phenomenon, like a cultural phenomenon. And we saw different episodes of this with meme stocks, starting from GameStop and AMC and others.

We have the best guest to dive into all this — Matt Levine, who is a columnist at Bloomberg and the author of the very famous Money Stuff newsletter. I’m Itay Goldstein, a professor of finance at the Wharton School, and currently the chair of the finance department. I will conduct this conversation with you, Matt.

In your May 13 issue of Money Stuff — in which, by the way, you generously link to the Wharton MBA curriculum — you ask the audience, “Is this just how life is now?” Is this the case? Are we going to expect more of these GameStop sagas, or is this just a unique phenomenon?

Matt Levine: My gut is that it is more the former, that this is the way life is now. I think that GameStop was sort of a proof-of-concept. But really, ultimately, Bitcoin and crypto were a bigger proof of it — that something like social investing can work. Sometimes the way I think of it is that for most of the history of financial markets, people thought of the stock market as this sort of social gambling game, where you were trying to out-guess the other person. And then there was almost a brief blip of scientific finance, where people thought, “Oh, stocks are worth the present value of their future cash flows.”

We’ve now gone back to the old system, where stocks are worth what you can get someone else to pay for them. People realize that you could harness social media technologies to collectively influence the prices of stocks. I think that that just remains true.

I don’t think you’ll see GameStop again. The real insanity of that was because it was the first time and because it was such a novelty. But the basic idea [that] memes can drive the prices of financial instruments seems pretty well-established in crypto by this point, to the point that it’s not even newsworthy. And it continues to reverberate through the stock market.

Revisiting stock valuation models

Goldstein: This is very interesting. Basically, what you’re saying is that our models of finance where the value of a stock is going to be determined by the present value of future cash flows [are] a blip on the timeline of financial markets. And [that] people used to think about it in less scientific terms, and this is what we’re going to see going forward?

Levine: I’m probably exaggerating when I say that. One thing that the GameStop episode taught you is that there’s good reason to think that the present value of future cash flows of an asset set some sort of floor under the price of the asset, because if it goes to zero, then someone can go buy it and extract the cash flow to themselves.

But I think people developed this rational system, where they assumed that the present value of the cash flows was also a cap on the value of the asset. There’s no real reason for that. If a lot of retail investors want to bid up a thing for years at a time, then what you learned in GameStop was that there’s not really a clear corrective mechanism, right? It’s not like short sellers can come in and force the price down to a rational level. That, to me, is the lesson. That there’s not a corrective mechanism in the short or medium term for just a meme-driven price.

Goldstein: Right. It’s very interesting that you draw the parallel to Bitcoin and crypto assets. When we talk about Bitcoin in the classroom, we say that there is really no clear way to price them. There is really no way to tell what the right price is for Bitcoin. So, you think that Bitcoin and other cryptocurrencies are maybe the central phenomenon, and GameStop was maybe one other example of that?

Levine: I think that, yes. GameStop being a stock that moved like a coordinated social movement for a few months was really interesting — [that] brought it to closer to the financial mainstream. That’s also true in a less silly but more important way of Bitcoin, right? When you talk about how you value Bitcoin, any legitimate and real effort to value it is going to be based on its social adoption. If people buy it, then it’s worth a lot of money. And if no one believes in it, then it’s not worth a lot of money.

That is the core of what happened in GameStop, where GameStop was also a company. But the real meme-driven stuff was about its popularity in a social investing universe. I think that Bitcoin is the clearer illustration of how strange this is, and how enduring it is. Bitcoin has had a five-figure valuation for years now. Its social adoption is enough to drive the value in a way that it wasn’t really for the long term for GameStop.

The “Coordination Problem” in Valuation

Goldstein: Yes. When we talk about it as economists, we would think about it as a coordination problem, where if everyone thinks it’s valuable, it will be valuable. If no one thinks it’s valuable, it will not be valuable. And then it can end up anywhere in terms of price.

Levine: Bitcoin [is] meant to be a currency. Everyone understands that it’s a coordination problem. Whereas there’s no reason for GameStop to work that way. It just did for a while.

Goldstein: Right. Yes, exactly. This is where the deviation is. That with GameStop, there is a way to price it that is not based on coordination with Bitcoin. There isn’t. But the fact that this migrated into GameStop and AMC was really the new thing, and maybe the very interesting element here. Diving a bit deeper into that, what do you think are the psychological and social triggers that were behind the AMC and GameStop saga? How would you characterize them?

How Meme-stock Trading Was an Entertainment Option

Levine: I do think that there is a cultural moment that is somewhat pandemic-driven. I mean, a lot of people were stuck at home. They had a lot fewer entertainment options. They were turning to the internet for entertainment because sporting events and television shows were canceled, and live events were canceled. There was a lower bar for entertainment. Going to a message board and talking about trading GameStop options was relatively more entertaining than it would have been at any other time.

And it was just like a real [option] — it fed on itself, in the sense that people were having fun trading GameStop. GameStop [prices] went up. This got attention. GameStop went up more, and then it became like a truly insane event where people were making 10,000% returns in a couple of days.

So, that attracted a lot of people. It was a combination of people making a lot of money very quickly, and also very evidently having a lot of fun doing it.

One thing that happened in GameStop is that the stock went up a lot. But another thing that happened is that the number of users of the “Wall Street Bets” message board went from under a million to 8 million people in a couple of days. That was in a time where people were starved for entertainment and starved for social interaction, [and the message board] was a very fun place to be socializing. The coin of socializing there was you buying and holding GameStop.

Goldstein: This is all sort of pandemic-era driven, as you say. But then when you saw this coming back in May of this year, what were you thinking?

Levine: One thing I was thinking is, this can’t work as well, again, just for entertainment reasons. It’s just not as [much] fun the second time. And it wasn’t, right? People were interested in it. Keith Gill, the influencer who was the main driving force behind the first GameStop rally — I’m not sure that’s true — came back to Twitter to tweet inscrutable things and to try to get the band back together.

People who were interested in the stock shot up, and GameStop was able to do an at-the-market stock offering. But it didn’t have either the financial or the cultural impact that it had the previous time — the stock did not go up that much. It got attention in the financial press. The original GameStop rally was on Good Morning America. It was the biggest news story in the world. Keith Gill coming back was like a financial niche news story.

The Coordination Power of Retail Investors

Goldstein: When we analyze financial markets, we tend to think about retail investors and institutional investors. The usual thinking is that institutional investors are going to be more sophisticated. They are the experts. They have time, they have money to do the research, and at the end of the day, they will know how to pick the stocks.

Retail investors are maybe more naïve, and they don’t have the financial resources to make the right investment. At the end of the day, they might be taken advantage of. This was not exactly how things played out in these episodes. Did these episodes lead you to reconsider the way you’re thinking about institutional versus retail investors?

Levine: It suggests that retail investors have more power than you would have expected, right? I have read for years people talking — on Reddit or whatever — about gamma squeezes. [It was] like saying, “If we all buy call options, then that will force the price of the stock up, and dealers will have to hedge their call options by buying more stock, and then the stock will keep going up, and the dealers will have to buy more to keep hedging, and the stock will spiral up infinitely.”

I would read that and say, okay, there’s no perpetual motion machine. But also, how big of an impact on a big liquid stock can retail call option buying have? The answer is, [retail investors have] much more [of an impact] than I expected. It’s just that you think of retail investors as being dispersed and random. They traditionally don’t have access to a lot of information. But they’re also just like individuals with small accounts.

One thing that you learned in the GameStop saga is that retail investors can coordinate around one thing, where they’re all buying the same call options at the same company at the same time, and then the stock really does go up. And the stuff about gamma squeezes — that looks like an urban legend — turns out to be true, some of the time.

So, that has been an interesting shift where retail investors just have the power to move markets in a way that nobody really expected. You see that in institutional investors being much more cautious about short selling — particularly vocal activist short selling, because they worry that if they go after a company, they short a company, some retail investors on a message board will say, “Let’s go after that hedge fund.” It turns out that if they all do that, then it can have a material effect on the hedge fund.

You talk about retail investors being less sophisticated and having less access to information. I don’t know that the retail investors, in the long run, look particularly smart from the GameStop episode, right? It’s not like GameStop is killing it in its business. I think there are interesting effects where GameStop and AMC were able to raise so much money and get some runway from their retail involvement. That has interestingly shifted the dynamics of their underlying businesses.

But ultimately, I don’t know. The hedge funds were shorting GameStop. The hedge funds shorted GameStop at [about] $14. Maybe they were wrong. But the hedge funds who shorted GameStop at $80 seem right. But they also got blown up.

I don’t think that this is a story of retail investors being better analysts of companies than professional investors. But I do think it’s a story of retail investors coordinating in a way that is much more impactful on the market than anyone really thought.

Goldstein: Yes, I completely agree. It’s not that [retail investors] did the underlying analysis. But it is that when they come together, they managed to move markets in a way that puts institutional investors in a bind, in a way that they didn’t really expect. In that sense, it’s a little more subtle than the traditional story we had about retail versus institutions.

Levine: Yes. I read a lot about market structure, and about high-frequency trading firms market-making to retail traders. The popular perception is that retail traders are random noise traders, where they’ll buy a stock or they’ll sell a stock, but there’s no overarching coordination among retail traders. So, you can make a lot of money market-making to retail traders, because they are buying at the offer and selling at the bid, and not predictive of prices.

I don’t really know how market makers did in this [meme-stock episode]. I think they did very well, for the most part. But you see in this that retail trades are much more predictive than people would have thought. There is a directionality to retail trades, where — sometimes — if one retail trader buys a stock, that is a sign the stock is going to keep going up. [That is] because a lot of other retail traders are going to buy it. That’s an interesting shift where a retail trader is not an atomized individual buying stock, independent of all the retail traders. There is this ability for retail traders to coordinate.

Bridge Finance from Meme-stock Rallies

Goldstein: Right. You mentioned the fact that AMC and GameStop were able to raise capital out of this increase in stock price. For example, in the case of AMC, this led them to avoid bankruptcy, which I think was a real concern at that point. This raises a very interesting question. At the end of the day, if this just stays in the financial market, [where] some people make money, and some people lose money, you can say it’s okay. People go to the financial market at their own risk, and they should be prepared to lose money.

But when this spills over to the real economy in the way that it did here, because you have a firm that is able to raise more capital and stay in business even though maybe it shouldn’t have, then this raises deeper questions. Are you worried about that — that firms are using this phenomenon?

Levine: I put myself in the shoes of the CFOs and think, “Well, how could you not try to raise money here?” I mentioned earlier the idea that there’s no mechanism to cap the price of a company at its cash flows. [Similarly], if retail investors all want to buy a stock, there’s no mechanism to prevent the price from going as high as they want.

But of course, the company can sell the stock. You see a little bit of that in some of the meme-stock episodes, where if the price gets too high, the company is going to hit the bid. And then the price will come down to a more reasonable level, in part because there’ll be more supply, but also in part because it deflates the social phenomenon. If everyone’s [saying], “Oh, we’re buying and holding,” and then the company is [saying], “We’re a seller at this price,” it’s bad for the meme.

But it’s probably bad if financial markets are allocating capital on retail wins. It’s not that bad. There are other forms of gambling that are probably equally expensive.

There’s something interesting about AMC. On the one hand, their business was struggling, and they got a lifeline from meme-stock investors. On the other hand, those meme-stock investors were not driven by pure irrationality. They were driven by nostalgia for movie theaters, right? Their business was struggling — there were other problems — in part because they were in a pandemic where they couldn’t show movies. So the idea that these retail investors driven by nostalgia were bridging them through a difficult business period doesn’t seem that bad. It seems like, in some ways, the retail investors made a rational allocation of capital there.

I do think that you can look at some of these [issues]. There’s a real cynicism to some of the capital raising off of meme stocks. One very cynical-looking trade was when Hertz raised money from meme-stock investors while it was in bankruptcy, which is just a crazy thing to do. But also, it emerged from bankruptcy with equity value, and those meme-stock investors made money. [That] again is a pandemic-driven thing, where the business crashed and then recovered, and the meme-stock investors bridged them through the pandemic.

There are other cases. Bed Bath & Beyond is a case where it raised money from meme-stock investors all the way to zero in a way that looks really cynical and looked really like a transfer of money from retail investors to, essentially, bond holders. But I don’t know how big of a misallocation of capital [that] was, because it did go bankrupt in pretty short order.

Goldstein: You’re making good points here. It is clear that this meme-stock phenomenon can help firms go through a bad time. Whether this is good or bad, it’s not clear. It depends on whether the underlying stress was efficient or not. And yes, certainly there was some business proposition behind AMC staying alive. So, in that sense, maybe the investors did them a favor.

Levine: If your model is that the retail investors doing this are just always systematically less rational than institutional investors who’d normally fund companies, then, yes, this is bad. I think that model is largely correct, but it’s not so obviously correct. I mean, institutional investors make mistakes too.

Takeaways for Regulators

Goldstein: Yes, absolutely. I would be the first one to agree with that. If you are a regulator sitting and watching all this, what are your main takeaways? What do you think should be done to make financial markets more orderly?

Levine: I’m sympathetic to the actual response of regulators, which was that this is all fine. Embarrassing, but fine. When the GameStop [rally] originally happened, there was a lot of interest in whether there was some sort of secret coordination [of] pump-and-dump, where the people on Reddit touting GameStop were secretly doing something nefarious. It doesn’t ever look like that was true, right? It just looked like they liked the stock. There was maybe an awkward amount of coordination, and an awkward amount of cheerleading, but no one was lying, really.

That’s the main thing that the SEC (Securities and Exchange Commission) is concerned about.

People misrepresent things, or lie. This strikes me as an emergent phenomenon of retail traders, and one that can’t be regulated away. If people want to put their money on this thing, then they’re allowed to. Now, there’s tinkering at the edges. I mean, one thing that came out of this was the move to T+1 settlement, which is a really arcane response to the GameStop saga. But the GameStop phenomenon led to increased credit risk of clearing, because everyone was buying the stock — this incredibly volatile stock — at increasing prices. That led to hiccups in the system of stock settlement, where Robinhood [Markets]was getting giant margin calls from the clearing house. And so the the SEC subsequently moved to T+1 settlement to tamp that down.

Another response you saw is that the SEC expressed very clear skepticism about companies raising capital off meme-stock [rallies], and they demanded that companies put a lot of dire warnings in their prospectuses when they did these offerings. But of course, when you do a retail at-the-market offering, zero of your investors read the prospectus. So, it doesn’t really matter.

I don’t know that there’s much that they can do. I do think that this was a thing that happened during the pandemic as a sort of entertainment substitute. You look at what entertainment options are available to people these days. It’s a lot of gambling. And so, I’m not sure that like investing in GameStop options is that much different or that much worse than betting on sports. So, the regulators are in a bit of a bind. I think it’s very embarrassing for the SEC to have this occur, because they would love for financial markets to just look more orderly and rational and less like an insane entertainment product. But people are coming to the stock market for a lot of reasons, and one of them is clearly entertainment.

Goldstein: Right. [The SEC] will have a problem thinking about the stock market as a casino. They would like it to be a place where allocation of capital is being done. I think this is why they look at it and are a little worried by that.

Levine: I think that’s right. But I also think the SEC has such a bias and mission in favor of retail investors that includes letting retail investors do what they want. I mean, if your goal is efficient allocation of capital, you might be skeptical of a lot of retail investor decision-making, right? You might say, “Everyone’s got to put everything into an index fund, and only professionals can trade stocks.” But that’s not the American way. I think that there is a bias towards letting retail investors do what they want, even if the SEC is sure it’s bad for them.

I talked about Hertz. The SEC stopped the Hertz equity offering. That offering turned out to be a good idea for the people who [were] buying it — in the sense that the stock went up, right? So, the SEC doesn’t always know what is irrational for retail investors.

Parallels with Bank Runs

Goldstein: Yes. To close our conversation, I want to ask you more broadly: where else do you think we are going to see episodes like this? I want to bring up something that is related, but also different in many ways. This is the Silicon Valley Bank that had the biggest bank run in history. It was also driven by social media. Of course, this is not the stock market. It’s a bank, [with] people pulling out deposits. But at the end of the day, there were some similarities because of the contagion that happens through social media. Do you see some connection? Where do you think we are going to see more action along these lines?

Levine: SVB collapsed because of a bank run. The people doing that bank run were largely very sophisticated, well connected VCs and tech startups who [were] largely the depositors there. People talk about it being a social-media-driven bank run. But my gut sense is that a lot of what happened there was not happening on Twitter, but on private text messages or just phone calls between VCs. So, it’s not exactly social-media-driven. It’s a fast tech-intermediated traditional rumor mill.

The interesting bank run, from a social media perspective, was Credit Suisse, before it collapsed. In in the months leading up to its collapse, there were a lot of Redditors trying to take down Credit Suisse. The possibility of coordinating a bank run on social media is interesting. It is, as you say, the inverse of the meme-stock phenomenon, where if people on social media can get together to drive a stock up, they can get together to drive it down.

In general, as I said at the beginning, the cash flows are a floor on a stock price. You can’t really come together to drive the stock price of Tesla to zero. But you can [do that] with a bank, because banks are so perception-dependent. If you have a bank run, then the bank really can go to zero. So, I do think that the possibility of using social media to coordinate a run on a bank is something that occurred to people after GameStop, and something that tentatively played out a little bit in Credit Suisse — although ultimately, it was not the causal problem with Credit Suisse.

More generally, where does this go in the long term? Two things I’d point to. People have developed a better understanding of the social dynamics of investing. That’s going to get just keep being reused in crypto. The other thing I’d point to is Donald Trump’s SPAC. GameStop is a real company. You could have a range of opinions on how much money GameStop will make selling video games in 10 years, right?

Donald Trump’s Trump Media and Technology Group is a real teeny nub of a company, right? It’s got a social media site that doesn’t seem to bring in very much revenue. It talks a big game about getting into streaming video and other things, but it’s not clear what they’re doing. And on its very, very small revenue and minor, small, negative net income, it has a multi-billion-dollar valuation. It’s just very clear that the people buying it are not buying it because they’re doing financial analysis, but because they are trying to get behind Donald Trump in some way. I don’t think he’ll be the last person to make use of this phenomenon. I do think that GameStop proved out the possibility here. And then Trump Media Group capitalized on it.

Goldstein: Okay. Lots to think about. Thank you very much, Matt. It was a pleasure talking to you about all these issues, and we should all stay tuned to see what’s next.