“The house always wins. Play long enough, you never change the stakes, the house takes you. Unless, when that perfect hand comes along, you bet big, and then you take the house”
- Danny Ocean, Ocean’s 11
This week, the Main Street traders of Reddit wreaked havoc on the financial performance of several hedge funds that overexposed themselves on a short position they had taken on GameStop. A lot of people have posted about it and given their two cents, and while the field may be crowded, I have a few thoughts of my own to add. First off, while the psychology behind why these investors decided to rise up in solidarity to inflate the price of this stock is no doubt fascinating and worthy of study, it is far outside my area of expertise, so I will limit my thoughts to the financial aspects, and leave analysis of the psychological components of the incident to people far more qualified than I.
Now, far be it from me to defend hedge fund brokers, but in this instance their analysis was correct - GameStop has posted losses of $471,000,000 and $673,000,000 for 2020 and 2019, and given industry conditions and market trends, it is very unlikely that they will continue to operate over a 5- to 10-year time horizon. Taking a short position was, based on financial performance and industry considerations, the smart play. This makes it a virtually certainty that GameStop’s stock price will come crashing back down from the $350-400 high to a more realistic price of somewhere between $5-20 a share. Why do I suspect this? Well, first of all, that’s the range that GameStop’s price has traded at consistently over the past 4 years, and I am not aware of any fundamental changes that would alter the price and place it outside of that range. Second, because over a long enough time horizon, stock price will generally follow financial performance, and GameStop has had abysmal financial performance over the past 3 years. “Irrational exuberance”, to use the term coined by Alan Greenspan, may temporarily alter a stock’s price, but it will generally drift back to a level befitting it’s underlying fundamentals.
So why does this matter? Well, first and foremost it matters because the traders on Robinhood who are celebrating this week now own stock in which they have a cost basis of $250-350 per share, but is, in all likelihood, worth less than 10% of that amount. In fact, even as I write this the stock has come crashing down to only $190 a share, and I expect that anyone who still owns the stock at the middle of next week will be looking down the barrel of some very serious losses. Second, it’s important to realize that people who work for hedge funds and investment banks have dedicated their entire lives, often working tremendous hours, towards exploiting market inefficiencies- part of the reason that “too-big-to-fail” banks exist is because they have gotten very good at it. I don’t say any of this as a way of defending our current financial system, rather, I say it as a caution- this type of viral investing worked this week, but when billions of dollars are at stake the investment banks will not, in any meaningful sense of the phrase, play fair. It is very likely that they are, at this very moment, figuring out the best way to turn this type of “viral trading” to their advantage, and it is very likely that they will succeed. In the future, people who hop on the bandwagon of this kind of trading will become more and more likely to wind up on the losing end as the major players in the market adapt to the changing landscape.
In closing, I’ll give three points that I think are prudent to follow when making investment decisions:
- Buy a stock because a company has strong underlying fundamentals that make it more attractive than the current price would indicate. Remember, you aren’t making a bet, you are buying a piece of a company.
- If you read about something in the news or on a message board that makes you think you should buy the stock, do your homework and make sure that the news you’ve discovered hasn’t already been built into the stock price.
- Never, ever, ever, buy stock on margin.