What Wall Street’s ‘Short Squeeze’ Means for Investors and Regulators

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Wharton’s Sasha Indarte speaks with Wharton Business Daily on SiriusXM about the GameStop stock ‘short squeeze.’

Equity stock investors of all sizes woke up this past week to a powerful new market force – individual investors congregating on social media and acting on their own, but with a common motive. They grouped together on Reddit, Discord, Facebook, Twitter and other platforms to drive sharp surges in the stock prices of chiefly online video game retailer GameStop and movie theater operator AMC Entertainment. The market capitalization of GameStop briefly soared to $26.5 billion on Wednesday, January 27, surpassing that of Delta Air Lines; by the next day, it had plunged 44%.

All that drew scrutiny from the Securities and Exchange Commission, Treasury Secretary Janet Yellen and others in the Biden administration, as well as House Speaker Nancy Pelosi. As the frenzy calms, retail investors could end up hurting, warranting scrutiny by securities regulators, said experts at Wharton.

In the latest rally, the collective purchasing power of retail investors singed big hedge funds and other short sellers who were forced to buy those stocks to meet margin requirements or delivery commitments. Gleeful individual investors, such as those on Reddit’s wallstreetbets page, saw that “short squeeze” (Wall Street parlance for pressure on short sellers) as comeuppance for hedge funds and professional money managers, whose market heft and perceived predatorial behavior they have long resented.

“The hedge funds that were engaging in short-selling activity are certainly the ones feeling the most acute pain right now,” Wharton finance professor Sasha Indarte said in an interview on the Wharton Business Daily radio show that airs on SiriusXM (Listen to the podcast above).

“Bearish investors who took short positions have lost $23.6 billion this year on GameStop alone,” The Wall Street Journal reported, citing financial analytics company S3 Partners. Melvin Capital Management, a prominent hedge fund that lost 30% of its $12.5 billion asset base in its bets on GameStop, secured a $2.75 billion in emergency financing to stabilize its finances.

“I think we’re going to see more pain felt potentially by the retail investors that are in effect bidding up the price of GameStop.” –Sasha Indarte

Clearly, the newest actor in stock price discovery is social media, bringing along concerns over the authenticity of the information that is shared. “The recent price fluctuations of these companies (GameStop and AMC) seem at least partially driven by social-media coordinated demand effects,” said Wharton finance professor Jules H. van Binsbergen. “The influence of attention and diffusion of information – or misinformation – through social media is growing in importance in financial markets, as it has in the rest of society.”

Stocks like GameStop and AMC that hedge funds had shorted have seen rallying cries on social media forums for several months now, culminating in the trading session on Wednesday. A flurry of developments sent the stocks recoiling on Thursday, even as the broader Dow Jones index inched up 1%. Popular online investment brokerages Robinhood, E*Trade and WeBull suspended or restricted trading in the stocks in question; Robinhood has since raised $1 billion to meet “surging cash demands” and also lifted some of the trading curbs on 13 stocks, including retailer Bed Bath & Beyond, Blackberry and headphones maker Koss.

A Question of Price

The consternation over the stock price surges at GameStop and AMC is rooted in their disconnect with their financial performance – both companies are losing money, made worse by the pandemic lockdowns.

The other shoe is yet to drop for those who bid up the share price of GameStop, according to Indarte. “I think we’re going to see more pain felt potentially by the retail investors that are in effect bidding up the price of GameStop,” she predicted. “It’s hard to justify the prices that we’ve been seeing for the company, based on the company’s fundamentals.” In the latest quarter, GameStop reported a 30% fall in revenues to $1 billion and a loss of $18.8 million. Similarly, AMC has also shuttered most of its theaters, and recently secured $917 million in financing to stave off bankruptcy.

In addition to the soundness of its fundamentals, a company’s stock price can also be driven by investor sentiment, “but there is large heterogeneity between different companies for the importance of both,” according to Binsbergen. Much of the price discovery depends on the liquidity and the total market capitalization of the stock, he noted. Small and illiquid stocks are more susceptible to non-fundamental price movements than larger stocks, he explained.

Short sellers sell shares before they buy them, hoping to sell high and buy low, Indarte explained. “It’s a trade that allows you to bet on a price decrease.” Short-selling is more common among financial institutions or investment professionals and less so with retail investors, she noted. In addition to short-selling being “a potentially opaque type of transaction” with which retail investors are less familiar, they are also wary of the downsides, she said. “Retail investors are more hesitant to participate in shorting because the risks are potentially much higher when you short sell a stock, compared to when you’re just outright buying and then later selling a stock.”

Short-sellers and the companies they target have often clashed. Tesla CEO Elon Musk has for long battled short sellers. “We’ve typically seen [short-seller interest] with companies where there’s uncertainty about growth,” said Indarte. In the case of GameStop, its “business model might face some challenges during a pandemic, where more people are buying online rather than going to stores in person,” she noted. However, some investors drew optimism from management changes at the company, she added.

“The influence of attention and diffusion of information – or misinformation – through social media is growing in importance in financial markets, as it has in the rest of society.” –Jules H. van Binsbergen

Social Media and Regulation

Regulators don’t have easy or ready solutions to prevent the speculation in stock prices that can occur on social media, and the harm it can cause unsuspecting or relatively less-savvy investors. At the same time, social media can also be a good and desirable actor in price discovery with information dissemination.

“The complication for regulators is that actual information that is supposed to be incorporated in prices can also be diffused through social media,” said Binsbergen. “This can still lead to sizeable price changes, but those price changes make financial markets more informative, which is beneficial to the real economy.”

The GameStop and AMC cases can be tricky for regulators. “What makes this case even more interesting is the claim that the other side of the trade was made up of professional investors that were betting in the other direction,” said Binsbergen. “I do not think that regulators should pick a side in that debate. That said, cases like this could potentially qualify as pump-and-dump schemes based on misinformation, warranting further investigation by regulators on a case-by-case basis.”

Many traders have been questioning whether users who have been posting about the company and urging others to buy shares and calls could be considered a “group” by the SEC’s definition, according to the Wall Street Journal report.

Differing investor viewpoints on the fortunes of companies will refine price discovery, but “in the current environment, stocks are especially sensitive to changes in their long-term growth prospects,” Binsbergen said. “On the rational (fundamental) side of the debate, market-wide discount rates are at very low levels today, which makes the duration of stocks, and thus their sensitivity to long-term growth expectations large. (Equity duration is a measure of the time it will take for investors to recover their investments through dividends.) Many investors are struggling to separate the short- and potentially permanent long-term effects of the COVID-19 pandemic.”

Learn more: Jules H. van Binsbergen teaches in Wharton Executive Education’s Investment Strategies and Portfolio Management, designed to help investment professionals and financial advisors interpret and understand market data and capitalize on investment opportunities that are emerging today.

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