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CMI Explains: Why Is Everyone Talking About GameStop?

Source: Clay Banks

For many businesses in the west, 2021 is not off to a great start. Poor earnings reports combined with a slow vaccine rollout in the US and EU sent equity prices tumbling over the last couple of weeks, and there seems to be a long way to go until normal service is resumed in the economy. If asked to predict those that would buck the trend, you would certainly be forgiven for naming big tech companies like Amazon and Zoom over traditional brick-and-mortar. However, GameStop, America’s largest video game retailer with over 5,000 physical stores, is undoubtedly the biggest winner of the year so far. On the 28th January, the GameStop share price reached $469 - a 2619% increase from $17 at the beginning of the month.

So why have the shares of GameStop, a company that reported a 30% reduction in sales in the first three quarters of 2020, seen this stratospheric rise?

The story is a little strange. As it emerged at the beginning of the year that several famed short-sellers had bet against the stock, a group of retail investors got together on the Reddit forum r/wallstreetbets and began doing the opposite. They planned to drive the stock up - in what is called a short-squeeze - in an attempt to get under the skin of institutional investors and make some money in the process. Needless to say, they were rather successful. The biggest loser was Melvin Capital, a New York hedge fund, who finished the month down 36% - and this was following a cash injection of almost $3 billion.

What exactly is a short-squeeze?

To answer this, we must first explain a ‘short’. When an investor shorts a company, they effectively borrow shares of the company and sell them, with the intention of re-buying them when the price has fallen and pocketing the difference. In a short-squeeze, a rising share price forces investors to re-buy early in order to limit losses, driving demand upwards in a vicious self-reinforcing cycle.

Has this happened before?

Sort of. Short-squeezes are not a new phenomenon, but historically, they have been limited to large companies and ultra-high net worth individuals with lots of market power, with retail investors watching from the sidelines. However, the rise of commission-free trading platforms like Robinhood combined with a pandemic that has left millions of people stuck at home with nothing to do has given the little guy an opportunity to get involved. There have been public calls for a strong response from the SEC - the US financial market regulator - to prevent this kind of thing from happening again, but it is unlikely that they will respond with the severity that many hope. The SEC was famously quiet during Carl Icahn’s short-squeeze on Bill Ackman and Herbalife, and even if they wanted to, it is unclear who they would prosecute this time.

What’s next?

Robinhood caused a stir when they suspended trading on GameStop, with many suspecting underhand dealings with the hedge funds at risk. In reality, it seems that their business model simply couldn’t handle soaring trade volume and volatility, which forced the company to raise $1 billion on Thursday and an additional $2.4 billion yesterday. They have slowly reintroduced the option to buy GameStop shares with a purchase limit on each account, but the asset appears to be on the decline. Experts estimate that the shares of GameStop are worth little more than $10 when valued using fundamentals and that it will be a long ride back down. However, investors have seemingly moved on. Members of r/wallstreetbets have shifted their attention to the likes of Blackberry, Cineworld, and even silver - the commodity.

Although the market influence of retail investors pales in comparison to those of institutions, they have shown that they are not to be ignored. Hedge funds will need to proceed with caution when announcing risky trades on popular companies, and trading algorithms monitoring Reddit forums are likely in development.