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No shortage of villains as the games stop

28 January 2021

By Adam Lloyd

We keep seeing startling evidence of the power of social media to influence behaviour, be it advertising the latest fashions or promoting political ideology and now it has reared its head on Wall Street.

GameStop as a loss-making bricks-and-mortar video game retailer listed on the New York Stock Exchange (NYSE) is an obvious target for short sellers. The inexorable direction of travel for GameStop’s customers is away from the mall and onto the online world. We have seen it time and again with traditional retailers as household names across the world finally call it a day. There seems little chance that GameStop’s fortunes as a traditional retailer will ever improve.

Hedge funds and short sellers are popular hate figures for critics of the establishment and capitalism in general.  There is no shortage of negative commentary on their activities and they are frequently cited as the worst examples of the rich getting richer at the expense of the rest of us. The unspoken assumption seems to be that hedge funds sit like vultures, picking away at the wealth of the nation, and that short selling is how they steal money from good honest citizens.

The problem is that they are lazy and profoundly wrong assumptions. It’s true that hedge funds exist to make money. They do not operate on the basis of making the world a better place and they do employ short selling to make money.  The thing is, they don’t just make money for themselves, like pension funds and unit trusts they make money for their investors - mostly ordinary people saving for the future. They are not inherently evil, they are just very effective at making money in the financial markets.

Short selling is not some evil scheme dreamt up by greedy money men. It is and always has been a fundamental mechanism for ensuring healthy levels of liquidity in the financial markets. Without that liquidity the value of stock markets would be significantly lower and their ability to fund all sorts of vital activities, like building factories and funding the next start-up, would be severely curtailed.

So, back to GameStop. What happened was an unprecedented social media campaign waged on Reddit’s WallStreetBets message board. Having spotted a ‘big short’ position in GameStop, they egged each other on to buy shares and force the price against the shorting hedge fund.  The remarkable thing is just how much money they were able to bring to bear to push up the price. The power of social media to mobilise large numbers of highly motivated people should surprise no one anymore.

Most of the reporting on this event has been favourable to the ‘Reddit bros’, as they have been called, complimenting their heroic efforts to sock it to the money men. Some of them will have made a lot of money in the ensuing chaos, not least because it forced the shorting hedge fund to buy back the shares they had sold at much higher prices, pushing the shares higher still - in stock market circles this is known as a bear squeeze, the bear being the hedge fund and the squeeze being them closing their short in a rising market.

The high profile of this event has emboldened private investors around the world to take aim at other heavily shorted shares in the hope of making killing like the Reddit bros. There are two big problems with this. The first is that coordinated share trading like this is quite possibly market abuse which can be punishable with unlimited fines. The private investors who think these rules don’t apply to them or that the regulators are only interested in the big institutions could be in for a very big shock. The second is that the underlying reason for shorting GameStop has not changed and the shares will inevitably fall back when the dust settles. The late buyers stand to lose a lot of money when gravity takes hold again and some of the poor souls drawn late in the day to this fiasco may lose everything. There is already evidence that other hedge funds have stepped in to take advantage of the big jump in the GameStop share price by opening new short positions.

Ultimately the hedge funds will be the winners because they base their investment decisions on the back of extensive research and a deep understanding of how businesses and markets work. Gossip and hearsay may be powerful in the short term but in the end a company’s share price is driven by its own fundamental underlying circumstances. Good fund managers know this, buying selling shares is what they do and whether you like it or not they are better at it that the Reddit bros and their ilk.