The Anatomy of a Short Squeeze: GameStop

What is going on in shares of GameStop?

That's a popular question I've been fielding over the past week, and the entire story reads like a Hollywood movie script: the average Joe taking on (and beating) Wall Street.

The Setup: GameStop had been left for dead by investors over the past few years. The company hasn't been profitable since 2017 as a continued rise in e-commerce shopping came at the expense of physical retailers like GameStop.

On top of that, next generation video game consoles now allow users to quickly download games via the internet rather than having to buy a physical disc from the store.

The impending revenue cliff from digital downloads painted a grim outlook for GameStop's future, leading more and more professional investors to bet against the company.

By the end of 2020, GameStop was the most shorted stock in the entire market.

Shorting a stock allows you to profit when it goes down in price, but it carries a big risk: unlimited losses, as a stock price has no limit as to how high it can go (see Berkshire Hathaway Class A shares BRK.A)

The Catalyst: As GameStop was slowly unraveling, a global pandemic led to millions of new investors discovering the stock market. A bulk of these investors embrace an ultra-risky investment style best summed up as "YOLO" (you only live once).

Millions of these retail investors talk stocks on Reddit's WallStreetBets forum, and one user posted a screenshot of his $50,000 bullish bet on GameStop.

‍The user's GameStop bet began to pick up steam on Reddit and inspired other "YOLO" traders to pile into the stock via upside call options, creating unprecedented demand for the stock.

The Result: As the stock price of GameStop kept rallying thanks to the group of retail traders on Reddit, the Wall Street hedge funds that were short GameStop began to see mounting losses.

As those losses began to pile up, the short sellers had to close out their losing positions by buying the stock back at a higher price, further adding fuel to the fire. This is what's called a short squeeze.

Since the squeeze began, shares of GameStop have surged more than 700% on no fundamental news. And now, the original Reddit user that sparked this entire saga has seen his $50,000 bet turn into $48 million.

Herd mentality has taken over Wall Street this week, driven by a group of retail day-traders congregating on internet forums.

The Precedent: Elements of the GameStop fiasco do have some precedent.

In 2008, hedge funds lost more than $30 billion after Porsche cornered short-sellers in shares of Volkswagen.

Professional investors had been betting that shares of Volkswagen would continue to drift lower as a global recession sent auto sales plummeting.

But Porsche, which already owned a sizable stake in Volkswagen, announced that it bought more shares of the German automaker, ultimately sparking a short-squeeze. Volkswagen briefly rallied 376%.

And during the dot-com bubble, internet forums like YahooFinance were largely blamed for fueling a speculative mania in technology stocks, just like Reddit is being blamed today.

The Takeaway: Ultimately, what's the lesson learned from the volatility in GameStop?

It's that markets are made up of people, and people are irrational. Is GameStop really worth upwards of $26 billion?

No, but that's not stopping herd mentality from taking over your brain and urging you to buy shares at inflated prices as you see your friend or co-worker printing money out of thin air.

When it comes to money, fear and greed are the two emotions that are hardest to control. Greed has been in the air this week.

If you're emotions are in check and you're enjoying the show from the sidelines, a question you may be asking is: should I take today's GameStop mania as a cue that the stock market is in a bubble and it's time to head for the exits?

I don't think so. Not when Apple is posting quarterly revenue of more than $100 billion and Microsoft is growing its $150+ billion revenue base at 20% a year.

And especially not when interest rates are near 0% and the Fed shows no signs of lifting them.

There are undoubtedly pockets of froth in the market right now, but they're mostly in unprofitable companies that retail investors are treating like a casino.

We're not invested in them.

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‍Thanks for reading, and please reach out with any feedback or questions.