Wall Street: When David challenged Goliath

If the chatter about GME, AMC or r\WSb* look like an Alphabet soup to you, I wouldn’t blame you.  Discord isn’t the word of the year for 2020 but rather a free messaging service with chatrooms. Reddit is a news platform, which allows for communities to congregate around common topics of interest. The feature of the global lockdown is that social media has become an alternative social structure where people with common interests have been interacting. As we all have been starved of personal interactions, social media has, like it or not, become a substitute.

In finance, online brokers have taken the market by storm. The free trading app Robinhood in the United States (US) accumulated huge numbers of subscribers as the lockdown and the Coronavirus (COVID-19) induced market sell-off attracted newbie investors. For most new participants, timing couldn’t be more opportune. The rising tide lifted all ships with the S&P 500 rising 66% from March lows. The work from home trend meant that there was more time for investors to engage in trading. Cheap money propped up a number of Zombie companies which staged eye popping rallies in the face of bankruptcies such as Hertz and Eastman Kodak. In the US, a number of so-called blank cheque companies were listed, whose whole purpose was to raise funding to acquire an existing business – reflecting the frenzied demand by investors for new opportunities.

Meanwhile, as big pharmaceuticals rushed to find a cure for the COVID-19, social media was awash with conspiracies. A New World Order was to be ushered and vaccination was meant to be the first step towards some global mind control experiment. Sceptics doubted Microsoft Founder Bill Gates. Alternative cures with no scientific trials were celebrated. As the US election campaign intensified, Donald Trump supporters embraced even more outlandish theories fueled by fringe grouping QAnon. Trump was to be re-anointed to drain Washington’s swamp and the MSM (mainstream media) wasn’t to be trusted. Alternative truths ruled. Battlegrounds were drawn - resist was the battle cry of those opposing the mainstream.

On Wall Street, another titanic battle was brewing. Information cascades from financial blogs were fueling a feeding frenzy by retail investors. Retail investors were lured by retail trading apps like Robinhood, which offered commission free trades, and this promptly drove the average number of trades online up some 60% over the past year. It has become easier and cheaper to speculate in stocks in the US, and with online apps even offering ‘free’ derivative instruments to juice up returns for their newly acquired customers just as the US equity markets were hitting new highs.  Messaging blogs found a new audience - the gospel truth was found on r\Wsb a blog with a number of obscure hot tips, which many retail investors found exciting. Traditional financial services players launched into acquisitions with Morgan Stanley buying up Etrade and Charles Swab merging with TD Ameritrade.

Last year, message boards developed a cult like obsession for called Gamestop, which had been losing money since 2018. This little know international gaming retailer listed in the US was one of the most heavily shorted stocks by hedge funds. And yet, gamers were abuzz about the pre-Christmas launch of Sony’s latest Playstation 5. Waiting lists were growing as the Japanese company responded slowly to the growing demand. Retail investors felt that sales of the console would provide a boost to Gamestop and started going long the stock. The resistance was organised on various blogs and as the news spread most retail investors swamped the market with buy orders. Hedge funds which had heavily shorted the stock by more than its free float – despite so called ‘naked shorting’ being illegal – and this triggered margin calls as they took huge losses when their bets went sour. Goliath was teetering. Some experienced operators joined the fray, with Scion Asset Management (founded by Michael Bury of The Big Short fame) joined the buying frenzy further fueling another wave of buying.

Gamestop shareprice_
Source: Bloomberg, Ashburton Investments

Anonymous digital markets suddenly had a human face. The retail buyers launched psychological warfare against short sellers with Citron research being hounded on social media. Any increase in short selling was met with a countervailing force of the ragtag army of retail buyers. The Gamestop share price kept climbing.  Meanwhile after a Trump rally in front of the White House, Trump supporters stormed the Capitol to a deadly effect. Many were convinced that this attack on the establishment would serve to “stop the steal”, after having been fed several false claims about election interference. None of these claims stood over 60 court cases but none of this mattered.

On the financial markets, the dam was breaking. Hedge funds like Melvin Capital Management were forced to cover their shorts as they could not stomach losses any further. As JM Keynes famously said, the market can remain irrational longer than you can remain solvent. David had toppled Goliath. A revolution was brewing on wall street. Many online brokers prevented retail investor from cornering some of the heavily shorted stocks providing some relief to the hedge funds, further enraging retail investors who saw the system as rigged by the establishment. And yet the SEC takes a dim view when there is collusion to corner a stock.

For many, this was retribution for hedge funds who had were adept at holding companies to ransom by exerting downward pressure on their share prices. Many research journals** have, however, rebuffed the notion that hedge funds cause excess market volatility.  Recently, Elon Musk who had previously called the SEC, the “Short seller Enrichment Commission”, berated hedge funds who had shorted his own company, weighed in with the following tweet:

“U can’t sell houses u don’t own

U can’t sell cars u don’t own


U can sell stock you don’t own.”

As trading volumes become increasingly influenced by social media chatter, there is a risk that those looking for quick fortunes will be lured by the siren call of speculative trading. Our era of cheap money is the driver behind such exuberance but as we saw during the dot.com bubble. If it is too good to be true, it often is. In the business of investing, always invest in fundamentally sound companies and stay the course for the long term. For those, wanting a quick buck, I would say "Caveat emptor!".

*r/Wsb = Wallstreetbets (an investment blog), GME = Game Stop, AMC = another heavily shorted theatre chain group

** Measuring the market impact of Hedge funds. Journal of Empirical Finance (2000)