There has been much in the news about the Reddit crowd beating the hedge funds at their own game. GameStop Corp (GME), the retailer of video games and consumer electronics received the most attention. For the most recent twelve months that were reported ending in October 2020, the company had revenue of $5.16 billion and a net loss of $274.8 million. Revenue for the October quarter had declined by 30.2% from the prior year’s comparable quarter and the company had $446 million of cash and short-term investments. The declining fundamentals attracted short sellers. GME has a 52-week low price of $2.57 per share and a 52-week high of $483.00, achieved during its spectacular run-up last week. As recently as January 12, GME closed at $19.95 per share.
GME has 69.7 million shares outstanding. The float, which excludes restricted stock that cannot be sold to the public, is 49.3 million shares. In mid-January, there were 71.2 million shares of GME that had been sold short, or 144.3% of the float. Technically, shares which are sold short must be borrowed from a brokerage firm that holds the shares in the margin account of customers. Short sales generate additional business for brokerage firms. The cost of borrowing shares of GME stock exceeded 20%. When a brokerage firm lends shares that it does not hold in a customer margin account, it is called a “naked short” and the brokerage firm is taking a financial risk.
Call options contributed to the price action in GME stock. Some speculators buy options instead of the stock to get more leverage. Options dealers who sell the call options usually purchase the stock to hedge their exposure on the call options. So, the options dealers become another source of demand for the stock.
The large GME short position attracted some attention and the Reddit/WallStreetBets crowd, with over 8 million members, pushed the idea of buying GME stock and its call options en masse to force additional buying by the shorts to cover their losses. It worked! According to some traders, as older shorts incurred large mark-to-market losses and were forced to buy shares to meet margin calls during the last week of January, new shorts who were able to find shares to borrow established new short positions. The shorts were then aided by several brokerage firms who forbid the purchase of GME shares by retail investors late last week. The hedge funds and other short sellers were able to cover their short positions (buy shares) without competition from the Reddit crowd, many of whom were unable to buy shares but were allowed to sell shares. By Monday, February 1, the GME short interest had declined to 39% of the float.
Other heavily shorted stocks benefitted from the market action. AMC Entertainment (AMC), BlackBerry (BB), and Nokia (NOK) all had similar but less exaggerated price action. AMC and American Airlines (AAL) used the price spike to sell additional shares to the public to raise some cash for their businesses.
Some media commentators, professional investors, and politicians have called for a Congressional investigation and additional regulatory intervention. Jack Inglis, CEO of the Alternative Investment Management Association (AIMA), said, “What is dangerous, amid this trading frenzy, is that retail investors have been chasing prices so far above any sane valuation and that many well end up nursing losses.” True, but many are skeptical that an organization that includes many hedge fund managers is concerned about small investors.
Hedge funds that shorted Gamestop and other companies with poor fundamentals have large losses for the month of January. ZeroHedge.com estimates that one hedge fund, Melvin Capital, lost over $7 billion or 53% of its capital in the month of January. The Wall Street Journal reported that another smaller hedge fund, Maplelane Capital, started the year with $3.5 billion and had a loss of 45% by the end of January.
Regarding potential changes in the regulatory environment to rein in the Reddit crowd, Ryan McMaken, senior editor at the Mises Institute wrote this:
This “exemption from free market discipline” is what Wall Street is all about these days. The financial sector has become accustomed to enjoying bailouts, easy money, and the resulting financialization which puts ever greater amounts of the US economy into the hands of Wall Street money managers. The sector is now built on corporate welfare, not “free markets.” No matter what happens, Wall Street expects the deck to be stacked in its favor.
One question that has not been addressed in all the media coverage of the GME saga is the function of short sales in the financial markets. It generates more commissions and fees for brokerage firms, and the hedge funds claim that it is a strategy that justifies their generous fees. But short sales shift capital from a productive economy that produces goods and services to a speculative economy that does not provide capital to produce anything but has a lot of activity to support a zero-sum game where market participants place bets against each other. Is it any wonder that the US now has large trade deficits every month? For the last reported month of November 2020, the US trade deficit was $68.1 billion. Maybe our financial markets should put a greater emphasis on providing capital to companies that can provide goods and services at a profit.
If you have any questions or comments, please contact me.
Robert G. Kahl
CFA, CPA, MBA