Hey guys, Mike Frontera here with another Retirement Theory Video
It’s somewhat cliché to say at this point but it’s never been more true. The most predictable part about the stock market is just how unpredictable it is. This past week saw so-called Internet “meme” stocks traded up to unfathomable levels, while at the same time broader indexes, like the S&P 500 had their worst week in months. The whole phenomenon has many people scratching their heads trying to figure out what’s actually going on. And while it may be interesting or even amusing to have people making big money on has-been companies, like GameStop, this kind of trading impacts all of us. So let’s take a few minutes to break down what’s actually happening, and what it means to your retirement portfolio.
Well let’s start with the source of the stock buying frenzy. The social media platform, Reddit, hosts large online discussions that are broken down into various categories called communities or sub-reddits. Users can post, and can read other people’s posts, on the specific topic of that community. Now one of those communities, WallStreetBets, shares investing ideas, particularly those of a more speculative variety.
Most recently, the idea evolved within the community to start buying the stock of GameStop. Now, if you’ve ever been to a mall recently, which you probably haven’t, you’re likely to come across a GameStop store. They’re brick-and-mortar shops selling physical disc video games in an era where both of those things are aging out of existence. They’ve lost money in five out of the last six quarters with steadily declining sales numbers. So then why buy the stock?
Well the plan for these Reddit users was to beat hedge fund managers at their own game through something called a “short squeeze”. But to understand what a short squeeze is, let’s first go over what a short is.
When an investor shorts a stock, they are betting that that stock will lose money in the future. To make this bet, the investor borrows this stock, generally from a brokerage firm, and then immediately sells it. So let’s say it’s 1,000 shares of a stock worth $48 per share, which equals $48,000. When the stock goes down, let’s say to $30 per share, the investor can then buy those 1,000 shares back for a total of $30,000, deliver them back to the lender and keep the $18,000 difference, less interest and any commissions. The risk for the investor of course is that the stock price goes up rather than down. And the important distinction here is that since there is no limit on how high a stock can go, a short seller has unlimited risk. So in this scenario above, if that $48 dollar stock, instead of going down to $30 per share, went up $500 per share, the investor would still need to deliver those 100 shares back to the broker. He’d have to come up with $500,000 in order to pay back his debt. And having the stock price bid up in an effort to strain a short seller like this, is what’s known as a “short squeeze” and is exactly what the users of the WallStreetBets Reddit community were looking to do.
And so far they’ve been successful at it. Gamestop, which over the 5 prior years before last had a cumulative return of -85.24%, has now gained an astonishing 7769.25% over the last year, including a nearly 400% return just last week. And as news of this buying hysteria has reached mainstream, the Wallstreetbets community has exploded in users, giving them even more buying power to influence stocks. Discussions have moved onto other beaten down stocks like the AMC movie theater group, Bed Bath & Beyond, Blackberry and Nokia just to name a few. And while some may take pleasure in seeing Hedge Fund managers or so-called Wall Street Insiders getting beat at their own game, the consequences are being felt by the larger investing public as a whole.
How? Well, when short sellers get squeezed, especially this quickly and this severely, they must quickly come up with a lot of money to pay back those short positions. This forces them to sell out of their other positions to raise money. This selling is often out of larger, more liquid positions like index funds, or more actively traded stocks, which are the very ones that the average investor is also in. And all of that selling puts pressure on prices and is one of the reasons we saw the stock market sell off the way it did last week.
Now, one of the other issues at hand here is that the stocks being pushed up by this online community are gaining the attention of more and more people. So people see prices going up and want to get in on the action. I mean, heck a 400% return in one week is pretty sweet! Now you start to have this major disconnect between the fundamental value of a stock and what people are willing to pay for it.
It’s the epitome of a investment bubble and it’s nothing new. One of the most famous investing bubbles was the dutch tulip bubble of 1637. Tulip bulbs in of themselves aren’t terribly valuable, but, as certain rare bulbs became more sought after their price started to rise. And as prices continued to go up, people became willing to pay more for them. People would invest in the bulbs, not because of their intrinsic value, but simply because they believed that someone else would pay them more for the bulb than they paid for it themselves.
Now, historically speaking, all bubbles eventually burst. All of a sudden there are more people selling their tulip bulbs than there are people willing to buy them. And at that point of this collective realization, there becomes a race for the exits with prices falling through the floor. And for those jumping onto the Wallstreetbets train in the wrong time, or staying on the train too late, the ultimate derailment will be particularly painful.
For those of us diversified, long-term investors, we’d be well served to avoid getting caught up in this particularly perilous game of paying astronomical prices for companies that dying a slow death. Over the short-term it would not be surprising to see pricing pressure on broader markets. Short sellers will need to come up with money to cover their bets that may blow up still. It would be some what more unexpected for this frenzy to have deeper consequences, though it is something we continue that we are watching closely. At the end of the day though, as disciplined investors that are saving for long-term goals, we remember that sound fundamentals ultimately rule the day.
So, do you have questions for me? Let me know. Come visit me at www.retirementtheory.com or send me an email at firstname.lastname@example.org. Did you click subscribe on this video or follow me on Facebook? I think that you should. You’ll continue to see videos like these on everything retirement planning. Once again, thank you for joining me. Take care of yourselves. We’ll see you next time.