The day that self-proclaimed degenerates held investors hostage is one that will live in infamy. But the virality and chaos of GameStop’s now-infamous short squeeze call the efficacy of short bets into question.
The meme-ability of the stock market has been steadily ramping up as Internet culture finds more ways to defy wealthy brokers and hedge funds. Tesla stock is highly overvalued, with investors treating it as if it were a Silicon Valley startup. But the cumulative loss of shorters by December of 2020 was over $35 billion.
Much of the attention surrounding January’s short squeeze came from the clash between traditional Wall-Streeters and their intrepid, unruly and upvote-driven counterparts. But it is important that the character of Reddit fanatics does not distract from the gravity of their grandiose achievement. The surreality was palpable for anyone following the story as hedge funds were left shaking in their boots, the shares they had shorted rocketing “to the moon.”
How shorts and short squeezes work
The Clarion has previously covered the specifics of the revolution, but a short synopsis is that on Wall Street, hedge funds often short stocks as a way to make quick money (as opposed to longer investments which can be more reliable, but slow-moving). To short a stock, a hedge fund borrows shares of a stock they believe will soon plummet. They immediately sell the stock onto the market and pocket the cash.
If the stock drops as planned, the hedge fund buys the borrowed shares back at the decreased price. Now, when they return the borrowed shares, they receive the monetary difference between what the stocks were and what they are when returned, minus any interest or fees that may have accumulated.
However, hedge funds like Melvin-Capital only profit if the stock goes down. The problem arises when the stock runs.
Since profits are capped at whatever amount the shares were when borrowed, there is only so much that a hedge fund can make when the stock falls. But, theoretically, a stock could skyrocket to infinite values, making the possible losses for shorts limitless. Of course, should the stock reach high enough, hedge funds will cover their shorts, shelling out the cash to buy back their shares and avoid further losses. In the case of a heavily shorted stock like GameStop, this process creates a chain reaction where covered bets push the stocks higher and force other investors to cover as well.
This process—the exponential covering of short bets when the stock defies expectations and shoots up—is called a short squeeze.
The GME short squeeze
The users of r/wallstreetbets, a Reddit forum aptly described “like 4chan found a Bloomberg terminal,” realized that hedge funds were shorting Gamestop. The short interest exceeded 130%, which is excessive. Gamestop’s business has struggled in the past, reporting losses of $740 million in 2020. But for the most part, it remains viable.
Brandon Kochodin of Bloomberg News explained that “GameStop [was] being treated in the market as if the company already went bankrupt.” Hedge funds were undervaluing the stock and counting on the company to go under. They were aiming to capitalize off apparent trends in the market that led to the fall of Blockbuster Video as consumers began to prefer digital purchases.
It seems uniquely un-American and against stock market ideals to bet against a company’s success. Especially if the company in question is stable.
At its best, the stock market is meant to coincide with the economic performance of companies. If investors wager that a business’ impermanent turmoil will diminish the worth of its shares, despite evidence to the contrary, then the market becomes no different than a casino.
The consequence of heedless shorting is when other investors take notice, as r/wallstreetbets did, and prompt a short squeeze. However, like any casino, the house often comes out on top regardless.
Piggly Wiggly and bail-outs
Around a century ago, a bear cartel was attempting to manipulate the market and capitalize off the recent struggles of a few Piggly Wiggly franchises, despite the company’s overall stability. In response, Clarence Saunders—the founder of the Piggly Wiggly grocery store chain—brought a briefcase of $10 million and a Muskian abhorrence for short sellers to New York. With an overwhelming majority of Piggly Wiggly shares in his possession, he would have the power to set the price when investors began scrambling to cover their bets.
Saunders had the ethos of “the little guy” behind him, just as r/wallstreetbets had against the shorters one hundred years later. But in both cases, the big-money shorters held the system. Saunders’ efforts were foiled by the New York Stock Exchange when the exchange of Piggly Wiggly stock was outright banned, bailing out Wall Street much like the RobinHood app during the GameStop short squeeze.
Additionally, the risk involved makes shorts dicey to pursue in the first place. Often, heavily-shorted stocks have the tendency to rally or defy expectations as in Tesla’s case. If the stock market’s purpose is to replicate the successes and failures of publicly traded companies, shorts seem prone to do the opposite.
The future of short bets
Hedge funds are already widely unpopular by design, as they make the rich even richer. Unfortunately, it is rare that they suffer too greatly. Even under the circumstances of a short squeeze, market actors like the trading app Robinhood soften the blow.
If shorts distort the stock market for the short-term financial gain of the uber-wealthy, it is hard to discern a valid use for them in the general economy. As a system that only benefits a select few, it must be reassessed.
Shorts are not altogether useless. If used correctly, they could be a healthy way to gauge the market. But investors often overstep and bet against companies with short-term problems rather than long-term issues. A means for checks and balances is necessary. It is already in place, albeit imperfectly. Watchdog investors analyzing the market for hedge funds shorting superfluously is a form of regulation in a sense.
What needs to change are the bail-outs. Short squeezes are already risky enough for the average investor. Hedge funds like Melvin Capital do not need or deserve extra protections for their own shortsighted practices.
If anyone does, it is the stonk-selling, meme-ers of the internet who are often literally squeezing the man with everything they have.
