• M74 Editorial Team

The Madness of Crowds: Why The GameStop Saga is Dangerous

By Lulwa Taqi

Before January 26, like most people, I never thought much of GameStop. We always used it in business school as a prime example of a struggling traditional retail store approaching doom. Everyone assumed that the move toward e-commerce would eventually drive GameStop to the ground. The COVID-19 pandemic seemed like the perfect catalyst to accelerate that process. Lockdowns, losses of consumer confidence, rising unemployment rates, and increased demand for online retail all served as exacerbating conditions. Wall Street was sure GameStop would fail, so they made it one of the most heavily bet-against stocks. However, in January, a group of Reddit users bought up shares, which pumped up GameStop’s value. The value of GameStop went so high that it cost Wall Street investors billions of dollars.

On February 18, the saga entered a new chapter. Key players, such as Robinhood CEO Vlad Tenev, Reddit Co-Founder Steve Hoffman, retail trader Keith Gill, and Citadel CEO Ken Griffin found themselves in a hearing before the Financial Services Committee of the United States House of Representatives. They had to defend each of their respective positions and agendas. Each player had to gainsay any notions of bias or foul play. Perhaps the most interesting and telling fact to come out of the hearing is that Robinhood didn’t have the collateral on hand to settle the trades with their clearinghouse.

Yesterday, the House Financial Services Committee revisited the saga, but focused the scope of the hearing on the rise of commission-free trading apps, which had enabled the stock market circus surrounding GameStop. The Committee heard arguments from both sides: one which called for a ban of the payment-for-order-flow system that it claims is “a flawed and conflict-ridden practice,” and the other which suggested that banning the practice would curtail the recent democratization of finance. Your personal opinions on commission-free trading apps aside, it’s hard not to take the GameStop saga and market behavior in January as a warning sign.

Depending on who you ask, there are two key elements at play here. 1. The retail traders (namely, the Reddit users who bought GameStop) are seen as underdogs (vigilantes of sorts) going against the Wall Street giants. 2. The GameStop short-squeeze is not an isolated event. Retail and institutional traders alike have been bidding up the shares of companies like Tesla and Shopify to prices that have nothing to do with these companies’ actual earning prospects. This type of investing is dangerous, because it leads to copycat behavior and speculative bubbles. As Charles Mackay notes, the exuberance displayed by the so-called “madness of crowds” can have catastrophic effects on the global economy.

The Reddit crowd understood that if they created enough demand for Gamestop shares with their own money, then they could undermine Wall Street and force them to change their bets, thereby pushing prices even higher. It’s important to understand the basic mechanisms of trading in order to fully comprehend how this story unfolded. When traders buy a stock, they are usually betting if it’ll rise to the point that they can profit by selling it at a higher price. Short sellers, however, do the opposite. They trade with borrowed shares and sell them, with the hope that they can make a profit if the stock price falls in the future.

For example, XYZ is a public company, and its shares are worth $10. A short would borrow shares of XYZ, and sell them for $10. The trader has $10, but they owe their broker for the shares that they borrowed. The trader is betting that XYZ stock will drop below that, to say $4. If it does, then they can buy the shares at $4, return them to the broker, and keep the other $6 as their profit. However, if XYZ stock jumps to $20, then the lender may push the short up to cover their bet, which means that they have to buy the shares at the new higher price. If short sellers are right in their bets against companies, they can make a lot of money. But, if they’re wrong, they can lose even more money.

On January 27, GameStop’s share price peaked at $350. GameStop was the single-most traded stock in the US on January 26, so much so that volumes matched those of the five most prominent tech companies combined. The retail investors wanted the shorts to lose money. They were happy when Wall Street had to hedge against rising prices by buying shares. They wanted to level the playing field, and give Wall Street a taste of their own medicine. After all, during the COVID-19 pandemic, they have seen how government intervention has allowed stocks to rise, while many individuals (and the US as a whole) are still facing the effects of business closures and record-breaking unemployment rates. Melvin Capital, a hedge fund with significant short positions, had to accept a $2.7 billion capital injection from another hedge fund to cover their losses. This stand-off between the establishment and retail traders has occurred for a few reasons. One is the rise in retail trading. Tens of thousands of traders join trading forums on Reddit daily. Trading apps like Robinhood have also claimed to democratize trading by opening Wall Street up to outsiders. Some retail traders actually understand the sophisticated mechanisms of how the stock market works. However, many don’t. Like institutional traders, these retail traders fall victim to herding and copycat behavior.

There has been speculation of a potential stock market bubble for some time now. The enthusiasm and exhilaration displayed by retail investors during the GameStop saga mimic many institutional investors riding the extraordinary rise of tech stocks, like Amazon and Tesla, despite the apparent risks. The GameStop mania is just a symptom of a larger problem that fosters, in the words of Bloomberg, “large scale financial volatility and market dysfunction.”

The US Federal Reserve’s response to the pandemic has involved slashing short-term interests to near zero and employing a quantitative easing policy. With prices soaring, and logic, skepticism, and conservatism giving way to greed, more and more people have been entering an overly-inflated market. This is when you see copycat behavior kick in. You see people taking risks that they don’t fully understand to make “easy money.” Many Reddit traders who bought GameStop were first-time traders who didn’t really know what they were doing. All of the publicity pulled them in. Fund managers and institutional investors are also no strangers to herding. They can’t afford to hold certain positions for too long or avoid high flyers, regardless of how sound these decisions might be. They are judged on a short-term basis, so they will lose their jobs if they do not ride certain short-term waves. To keep their jobs, they follow what they think other investors are doing, rather than their own conventional analyses. This type of behavior is hazardous, because it gives way to speculative bubbles, which, as we saw in 2008, has significant spillover effects.

In March 2020, when the first wave of COVID was at its peak, the Nasdaq rose by almost 100%, although the world was plunging into a deep recession. The US GDP also declined by 3.5% in 2020, the biggest fall since 1946. However, during the past year, there have been more IPOs than in any period since 1999. So, it’s safe to say that the stock market tells us very little about the actual state of the US economy. At times, the stock market and the economy can display very different perspectives of recovery.

Major indexes (including the S&P, the DJIA, and the Nasdaq) have increased since the national downturn began. It is important to remember that the make-ups of such indexes are not representative of the US economy. They are mostly made up of larger companies with access to vast capital markets that smaller companies cannot access.

The GameStop saga isn’t simply an epic “David vs. Goliath” story. What transpired has real-world and far-reaching implications. It raises many questions about market efficiency, the valuation of markets, and the democratization of trade and finance. It’ll be interesting to follow the regulatory and political ramifications that are yet to be determined, and see how and if they will spill over to international markets.

Lulwa Taqi is an intern at M74 from Kuwait. She is a recent graduate of Pace University in New York City, where she earned a bachelor’s degree in International Management and Economics. Her interests include the European Union’s integration policies, the Middle East’s geopolitical climate, and international trade.

The views expressed above are those of the author and do not reflect the official position of the M74 Group, which remains neutral on all matters. Publishers assume no liability for content.