The takeaway: GameStop is a declining company, whose stock enabled one investor to turn $53,000 into $48 million in barely 18 months. The stock’s unlikely investors have driven its share price to new heights, savaged Wall Street hedge funds, and caught the eye of Congress, due to fears their actions are roiling financial markets. It’s billed as real life David and Goliath game. But your real life game is to achieve and sustain retirement freedom.
How do you turn $53,000 into $48 million in barely 18 months? You buy shares of GameStop (GME), get tons of others to do the same, all the while promoting the message that you and your fellow buyers are sticking to Wall Street, which, in fact, you are. But first things first.
What is GameStop?
GameStop, located primarily in malls, is a chain of stores that sells video games, consumer electronics, and other gaming merchandise. The company’s sales and profits have steadily declined because consumers aren’t driving as much to stores, since comparable goods can be purchased online or downloaded to their computers. Consequently, before this recent enthusiasm, GameStop’s stock had heretofore lost favor with Wall Street.
So why has the stock now gone up?
A GameStop pied piper
Although not the only one, a featured player in this caper is 34 year-old Keith Gill, a chartered financial analyst, licensed securities seller, and former insurance company financial educator. In mid-2019, he bought $53,000 in GameStop stock shares and began promoting the stock all across social media. Over time, the band wagon effect took hold and he and his followers pumped the stock price up to stratospheric heights.
Even Congress is talking about it…”
Many of his followers invested in the stock through what’s called “options,” which allow you to essentially bet on whether a stock will go up or down, at a fraction of what simply buying the stock’s shares would cost you. In short order he, and his friends, (are temporarily) getting rich quickly. They’ve used a commission-free trading app called Robinhood, which let’s them execute their trades for free.
The GameStop merry band meets hedge funds.
The largess of Mr. Gill and his merry band became a David and Goliath drama between GameStop buyers and hedge funds. Hedge funds are like mutual funds, except they require an investment anywhere from $100,000 to $2 million to join. They are not typically subject to regulatory requirements designed to protect the investing public.
While Mr. Gill and the merry band were making money when the stock went up, Wall Street hedge funds were making money when the stock went down. The merry band saw a stock ready to rebound, while hedge funds saw it headed for the dumpster. For the merry band, it became a cause of not just making money, but for sticking it to the fat cats on Wall Street–namely hedge funds.
How did the merry band force hedge funds to hemorrhage money and why do you care?
Here’s why you care. One day you may find yourself in the company of a financial advisor who wants to “short” your position in a stock or a stock index. You’ll want to know what a short is so you don’t end up like those savaged hedge funds.
(At the very least, knowing what a short is gives you cache at the next cocktail party where you might throw the term around as in, “Can you believe how awful it was for Susie’s nest-egg when the hedge fund she was in ‘shorted’ GameStop?”)
But I digress. As I was saying…
Hedge funds began losing money with GameStop because they were “shorting” GameStop and the “short” went bad.
Alright, already. What’s a “short?”
When you believe the price of a stock is going to fall “short” of its current price, i.e., you believe the stock’s price is going to go down, you can execute a short sale of the stock, which is called “shorting.” When you short a declining stock, you:
- borrow shares from a brokerage firm;
- sell those shares on the open market;
- wait for the shares to fall in price;
- buy them back at the lower price;
- return these borrowed shares back to the brokerage firm; and
- pocket whatever gain you made.
If that textbook definition of a “short” was clear to you, we’re moving you into the gifted class and authorizing you to skip ahead a couple of sections.”
Let’s try this again: what’s a short sale?
For the rest of you lovable mortals, it’s important to understand how shorts work, because therein is the essence of how David has spanked Goliath, so that you don’t get spanked in a short sale gone bad, and to understand why respected financial sources began to wonder if the whole caper had roiled the stock market.
Here’s an everyday example that’s analogous to a short sale.
- You decide to make a road trip to a neighboring state.
- Just in case you run out of gas, you borrow your dad’s gas can that’s already filled with $4.00-a-gallon gas.
- You hop on the road and come upon a stranded motorist who’s out of gas. Since gas is selling for $4.00 a gallon, you tell the motorist that, for $4.00, you’ll pour a gallon of gas in his tank. He happily accepts your offer and hands you $4.00. Off you go richer than you started.
- Shortly thereafter, you cross the state line where gas has fallen to a mere $2.50 a gallon.
- You buy the gas at the lower price and fill your dad’s gas can back up.
- Upon your arrival home, you return the borrowed gas can, full of gas, back to your dad–pocketing your $1.50 profit.
If you were a hedge fund...
If you were a hedge fund, we’d say you just “shorted” gas. In essence, you:
- borrowed a can of gas from your dad,
- sold the gas for a high price ($4.00),
- bought the gas back at a low price ($2.50),
- returned the borrowed gas back to your dad, and
- pocketed your profit ($1.50).
So, just like a hedge fund, you borrowed something that wasn’t yours. You sold it at a high price. Bought it back at a low price, and pocketed the difference just before you returned it to the lender.
Like a hedge fund, savvy Boomer, you are now an expert in the short sell.
Cue the merry band.
Short sales can go bad. Very bad.
Again, an example you may have encountered in your own life.
Once again, you:
- borrow a can filled with $4.00 gas from your dad;
- hit the road and encounter a stranded motorist;
- offer your $4.00 gas, the motorist accepts, and off you go that much richer.
But here’s where darkness descends…
- Upon your return home, which is Christmas Eve, every gas station in the area is closed but one.
- You, savvy Boomer, realize that the gas station owner only has so much gas. The owner’s going to sell it to the highest bidder, just like he’d do if he were trying to sell his house or his car. Nonetheless, you’re willing to wait in line and pay what you must because you must return a full gas can to your dad–tonight.
By the time you get to the front of the line, gas is no longer selling at $4.00, but has ticked up to $6.00 a gallon.
- You pay with the $4.00 the stranded motorist gave you. Then you kick in an additional $2.00 of your own money.
You’re $2.00 in the hole.
GameStop’s share price heads heavenward, hedge funds descend into hell, and Congress takes notice.
Like with the gas, there’s only a limited supply of GameStop stock. As the merry band began buying more and more shares of GameStop, they were driving up the price–just like what happened with the Christmas Eve gas. With every gallon of gas sold, the price ticked higher and you, my little hedge funder, were that much more in the hole.
As GameStop’s share price ticks upward, hedge funds are indeed that much more in the hole. Moreover, like all those cars in the gas line, competing to get the gas before the price ticks up even higher, hedge funds are competing with each other to get their hands on those shares before they go up further and hedge funds descend deeper in the hole.
This, ladies and gentlemen is called the ‘short squeeze.’ “
In a two week period in January 2021, GameStop shares increased 771%, going from $39.91 a share to $374.51.
With every stock purchase, the merry band is awash in money while hedge funds hemorrhage it. All the while, both are driving up the price. As a result of this squeeze, hedge funds have had to borrow millions to keep from going bankrupt. There’s discussion of them selling off their blue chip holdings like Amazon, Apple, and Microsoft, just to cover their losses. And lately, each time the S&P 500 has fallen, there’s speculation it’s a result of hedge fund selling.
When will it end?
It’ll probably end in a matter of days…maybe a couple of months… The price of GameStop has already begun the fall. Historically, like with multi-level marketing, those who get in early are the only ones who make the serious money. Moreover, buying assets — like stocks — completely untethered from their underlying valuations is the perfect set up for losing money.
A lot of money..
Anybody remember the dotcom bust? How about those shacks selling for millions in 2008? Beanie Babies anyone?
You got game, but GameStop isn’t it.
Morgan Housel, in his book The Psychology of Money, cautions us to beware of taking financial cues from those playing a different game us. The GameStop caper is not our game.
Our game is to:
- judiciously invest in low cost index funds, which historically outperform both managed funds and hedge funds;
- diversify our funds across small, medium, and large cap stocks, while staying true to our investing personality;
- understand that a proper asset allocation accounts for 90% of our investment gains and as such maintain an asset allocation of stocks and bonds—and as explained in the asset allocation series (right side bar) — understand why;
- keep a stash of cash for life’s unexpected emergencies–we don’t want to sell our stocks to cover those emergencies during a market downturn; and
- accept the admission price for being in financial markets, while respecting your risk tolerance.
Don’t be distracted by gladiators playing a different game than you. Historically, these things don’t end well for the players.
You’ve seen it before.
You’ll see it again.