TThe recent fireworks in GameStop (GME) have dominated headlines over the past couple weeks.  Folks are naturally curious about what happened and how does it end.  So, I thought you might find it interesting for me to “unpack” the GameStop situation, without getting too far into the weeds!

Briefly, some multi-billion-dollar hedge funds (lightly-regulated investment pools) built massive short positions in GameStop (GME), betting the stock price would fall.  Their fundamental belief was GameStop is a struggling bricks-and-mortar retailer of video games (it closed about 1500 stores or 20% of its locations over the past five years) at a time when retailers are abandoning physical stores and game consoles are migrating to “disc-less” formats.

In other words, GameStop would eventually be the next Blockbuster Video.

A virtual army of individual investors formed on Reddit’s WallStreetBets (WSB) online forum and seized upon a couple positives for GameStop.  First, Michael Burry of The Big Short fame (he correctly bet on the bursting of the housing bubble that led to the global financial crisis in 2007-2008), announced he had accumulated a large long position, based on the fact more than 100% of GameStop’s tradeable stock had been sold short (a massive sum that would eventually have to be repurchased).  Second, Ryan Cohen, co-founder of pet e-commerce company Chewy, also disclosed a large long position and the company added him to its board of directors.

This populist army of individual investors coalesced around the idea that coordinated buying of GameStop would cause the stock price to leap, a “short squeeze” would ensue and major pain would be inflicted on the hedge funds.  The group declared war on the easy-to-despise billionaire “Masters of the Universe” (picture Gordon “Greed is Good” Gekko, portrayed by Michael Douglas in Wall Street-1987), with individuals placing tens of thousands of zero-commission buy orders on platforms like Robinhood, TD Ameritrade and E*Trade.  Importantly, there were also instructions posted to WSB on how to prohibit your broker from lending your GameStop shares, further squeezing the shorts.

Mission accomplished!  GameStop closed at $18.84 at year-end 2020 and traded as high as $483 on January 28, giving it a market capitalization of $33.7 billion (slightly less than Cummins Inc.).  The hedge funds were forced to cover their short positions by repurchasing shares, losing tens of billions of dollars.

When you buy 1000 shares of XYZ @ $10/share, you have a “long” position.  You profit if the stock price increases and your upside is theoretically unlimited.  The worst you can do is lose 100% of your investment ($10K—if the stock goes to $0).

Conversely, you can “short sell” 1000 shares of XYZ @ $10/share.  You arrange with a broker to borrow 1000 shares, sell the shares, pay “rent” on the borrowed shares and lastly return the shares (“cover the short” by repurchasing the shares) by a future date.  You also deposit 150% of the proceeds with the broker as collateral.

You profit if you can repurchase the shares at a lower price.  Your upside is limited to $10K (if the stock goes to $0), but your downside is theoretically unlimited.

A “short squeeze” occurs when the stock price rises rapidly.  The broker that loaned the stock will demand more collateral as the stock price rises (the dreaded “margin call”).  You can either deliver the additional collateral or cover your short.  Buying to cover short positions adds even more upward pressure on the stock price, leading to a melt-UP in price and even more pain.

On January 28, Robinhood (along with Charles Schwab’s TD Ameritrade, Morgan Stanley’s E*Trade, Interactive Brokers and Webull) incited investor fury and invited hearings from Congress (first one scheduled for February 18) and inquiries from the Securities and Exchange Commission when they restricted buying in GameStop and a handful of other highly volatile stocks the WSB army had been buying en masse.  The Davids smelled a rat and saw the brokers colluding with the Goliaths, which were being pummeled.

I suspect the real reason is more mundane and has to do with the market’s internal “plumbing.”  The Depository Trust & Clearing Corporation, or DTCC, is owned by its member brokers and is responsible for “settling” trades, guaranteeing the buying broker delivers cash and the selling broker delivers the stock.

The sell side of the trade is straightforward, but the buy side can be problematic, since it involves coming up with the cash.  Similar to how a broker limits its exposure to a customer not paying by requiring collateral or “margin,” DTCC limits its exposure by requiring every member broker to post collateral.

DTCC operates quietly and in the background 99% of the time, but it became concerned when GameStop and a handful of other stocks became insanely volatile (daily moves of 100% or more) at the same time the online brokers’ customers’ trades were essentially 100% on the buy side.

DTCC was worried that if XYZ were to drop 50% in the two days between “trade date” and “settlement date,” the buyers might balk at paying.

To protect itself, on January 28 DTCC required Robinhood (and the others) to immediately post additional cash as collateral in order to keep buying these stocks.  Robinhood was unable to meet this margin call (reportedly a whopping $3 billion), so was forced to cease taking buy orders from its customers.  It was able to partially lift its buy restrictions after drawing $500 million from its bank credit lines and raising $3.4 billion from its current owners, but Robinhood’s own liquidity remains uncomfortably tight.

Buying stock is purchasing a piece of a business, not a ticker symbol.  While stock prices can fluctuate wildly, the value of the underlying business does not.  As Ben Graham (Warren Buffett’s professor) famously said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”  This means stock prices can be impacted by the madness of crowds, short-squeezes and a thousand other things.  However, in the harsh light of day, stock prices reflect the cash flow generation prospects of the underlying business (its “intrinsic value”).

Baseball philosopher Yogi Berra once said, “It’s tough to make predictions, especially about the future.”  Rampant fee-less online day trading conducted by individual investors who, thanks to the pandemic, have more time than ever at home to trade with the ease of a thumb swipe may make this time feel different, but bubbles and manias have been around for as long as financial markets have.

When the memes stop, the excitement fades and the GameStop mania has run its course, what will be left is the underlying business. The “flash mob” successfully drove GME to $483, but it cannot make GameStop’s business worth $33.7 billion.  Once all of the shorts have been covered, who will they sell to?

As J.P. Morgan said, “Nothing so undermines your financial judgement as the sight of your neighbor getting rich.”

The opinions expressed in these articles are those of the author as of the date the article was published. These opinions have not been updated or supplemented and may not reflect the author’s views today. The information provided in these articles does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular stock or other investment.