With a bit of detached amusement, I watched the outrageous price gyrations of some stocks that many had written off as almost total losers.
Whether it was GameStop’s collection of dated retail stores playing in an industry that is totally online, or AMC Theatres standing empty for nearly a year, or Tootsie Roll candies not selling with no Halloween parties, the “smart money” in hedge funds decided to bet big on these companies’ demise.
What’s a Short Sale?
To understand how this is done, you need to comprehend the simple process of a “short sale.” That’s what it is called when you — legally — sell shares you don’t own, hoping to buy them back at a much lower price.
It turns the old concept of “buy low, sell high” on its head. With a short sale you sell high and then buy low.
Of course, there are rules to be followed. You can’t simply dump unlimited shares of stock. In most cases, you can only execute a short sale on an “uptick” — after the stock trades slightly higher — not when it is cascading lower. And you must put up margin money in case the stock goes up instead of down. You might need to buy the stock at a higher price if that happens, so the brokerage firm wants to make sure you have cash to do so. There are other requirements for the brokerage firm as well.
So What Happened with GameStop?
For months the so-called smart money hedge funds had been short selling shares of GameStop and other similar companies, betting they would file for bankruptcy and the shares would become worthless. Then the short-sellers could “cover their shorts” — buy the stock for just pennies to complete their transaction. They planned to book huge profits.
Hedge funds have a lot of power. They can be offered only to accredited investors — those with a lot of money and sophistication. And hedge funds can use a lot of leverage — borrowed money to make bigger bets than ordinary investors are allowed to do. Plus, unlike the mutual funds and ETFs offered to individual investors, they are not obligated to publish their investment positions.
Hedge funds swagger with their power. Yes, they may make buying and selling mistakes, but they have quite an edge — and few dare to stand in their way. Until now.
Revenge of the Nerds
Imagine a schoolyard bully who is always taking the little kids’ cookies and lunch money. Individually the kids can’t do much. But suppose they are suddenly equipped with cell phones and come up with a plan to attack all at once. Suddenly the bully isn’t so brave any more. In fact, he turns tail and runs when faced with a concerted effort to turn the tables.
And that’s what happened on Wall Street with GameStop. Small investors, gathering together on online message boards like Reddit, decided to start buying the stock — and pushing the price up sharply.
They knew the hedge fund short-sellers would have to put up more margin money — or buy back their short-sale stock at higher prices. It’s a classic squeeze. Shares of the companies involved soared as the amateur investors — the playground nerds — jumped in to buy, and profit as the stock went up.
The hedge fund bullies lost a fortune, running into the billions. Some were indeed forced to buy back stock at higher prices, booking huge losses. Some hedge funds might simply fold and close their operations.
So Who is Right, and What Went Wrong?
Critics say there is no real reason for those stocks to trade at such high prices. But “the market is always right.” The price is set at the level where buyers and sellers agree to transact. Likely the stock prices of the companies involved won’t stay so high, because the business fundamentals don’t justify those valuations on a traditional basis of earnings prospects.
There’s been a lot of complaint about Robinhood, a relatively new trading app for smaller investors. But whether these individual traders bought stock through their own brokerage accounts at Schwab, Fidelity or Robinhood, the old fable came to life.
Like the Robin Hood of legend, they robbed the rich hedge funds, and many booked profits to pay down student loans or make a down payment on a home. Yes, if they sold, the profits were real. Real money. But a word of caution.
Remember the old saying: The bigger they come, the harder they fall. And that’s The Savage Truth.
Terry Savage is a registered investment adviser and the author of four best-selling books, including “The Savage Truth on Money.” Terry responds to questions on her blog at TerrySavage.com.
(c)2021 Terry Savage.
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