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The Short Game Stops

Posted on February 9, 2021

“Just wait...the game will stop. It’s a matter of when not if.” - Peter Cecchini, AlphaOmega Advisors

2021.02.09_stop_sign.jpgThe GameStop saga that unfolded last month was one of the most interesting market events we’ve seen. It is also one of the most written about. While we feel compelled to add something to the conversation, rather than recycling the same information we will address a few misnomers that we think have worked their way into the popular narrative as well as touching on how this event fits into some broader themes.

Although this post will assume that its reader has at least a general knowledge of what happened with GameStop, I do want to start with a few high-level comments on short selling. When you buy a stock in the hopes that it will increase in value, you are what’s referred to as being “long” the stock. By definition, then, being “short” a stock is taking the opposite position and hoping that it decreases in value. The mechanics of short selling, while a bit more nuanced than this, can be boiled down to the following:

  1. A would-be short seller borrows the shares from an existing shareholder
  2. They then sell those shares into the market, receiving the cash proceeds from the sale
  3. At some point they then buy those shares back, hopefully at a lower price 
  4. They then deliver those shares back to the original owner

A short seller, then is hoping that the stock declines in price so that they can keep the spread between the cash they received in step 2 and the cash they had to spend in step 3. A key point to remember is that when you’re long a stock your max loss is 100% (stock goes to $0) and max gain is uncapped (stock goes up forever), while if you’re short a stock your risk/return structure is the exact opposite: your max gain is 100% and max loss is uncapped. A “short squeeze” is when a stock begins climbing in value so rapidly that short sellers are forced to buy back the shares (step 3 above) to limit losses. This dynamic only serves to push the stock higher, triggering more short covers, etc, until the feedback loop runs its course.

This, in essence, is what happened to GameStop stock in late January. There was a massive amount of short interest in the stock, and a group of traders collaborated to push the price up and trigger a short squeeze.

With that as context let’s look at a handful of misnomers that we think have worked their way into the popular narrative surrounding this epic event. Not that all of these misnomers are rooted in some form of truth, but we think some clarifications should be made to more accurately understand what happened. 

Misnomer #1: “The event was completely disconnected from fundamentals.”

Okay, okay...it’s easy to look at what happened last month and recognize that it wasn’t driven by fundamentals. As Goldman Sachs observed in a recent research note:

The entire episode was all about price, and nothing about valuation. Social media commentary typically referenced price action with lofty targets sometimes illustrated with rocket ship emojis. We almost never read a comment about valuation because the rally implied an astronomical P/E multiple.

Yes, we agree - mostly. But it’s technically not accurate to characterize the entire thing as being all about price and nothing about valuation. Bloomberg put out a great piece that traced the seeds of what happened in January back to nearly two years ago, when a user on Reddit’s WallStreetBets forum first began making the bull case for GameStop - and it had nothing to do with a short squeeze.

After laying out the basic elements of his fundamental analysis, Reddit user @delaneydi wrote the following (emphasis ours):

... this is solely a deep value play. Even if we assume double-digit top line sales declines and gross margin contraction, the companies valuation does not reflect the current earnings power, especially when considering the companies large cash horde.

Around that same time, Michael Burry (legendary investor played by Christian Bale in The Big Short) disclosed a long position in the shares in his investment fund, and Reddit contributor @DeepF-----gValue (also known on YouTube as “Roaring Kitty”) began aggressively proliferating his analysis showing the fundamental value that he believed GameStop shares represented. Again, at this point the whole concept of a short squeeze was nothing more than a whisper...the majority of the buzz tied back to fundamental analysis.

Then, in August of 2020, the big announcement came. Bloomberg reports,

Then another break, maybe the biggest of them all. Ryan Cohen, co-founder of Chewy Inc., disclosed a 5.8 million-share stake in GameStop through his RC Ventures ... Cohen’s announcement was the tipping point. A visionary and a classic disruptor, Cohen’s Chewy was everything GameStop wasn’t: an internet juggernaut, nimble, and, perhaps most importantly, it had already served up plates full of tendies* with a triple-digit year-to-date return at the time of Cohen’s holding going public.

Cohen would later be added to GameStop’s board of directors, further amplifying his potential impact on the future of the company.

It wasn’t until around September of last year that the concept of a short squeeze really came into focus on WallStreetBets, and even then the short squeeze argument was still being embedded in a much broader fundamental bull case. So, while the bulk of the madness that occurred in January had to do with a short squeeze, the army of traders communing on Reddit originally saw the opportunity through the lens of good old fashioned value investing. 

Misnomer #2: “This was retail vs professional, and retail won.”

Again, this is somewhat true but only in a very generic sense. It was mostly retail investors participating openly on the WallStreetBets forum, but we’ve already mentioned Michael Burry and Ryan Cohen – just two of the many professional investors who were long the stock. As each day goes by, more news is coming out about the role of institutional money in this event, to include hedge funds that use artificial intelligence and algorithms to track sentiment on social media platforms in an attempt front-run retail investment trends. So while it’s true that an isolated handful of concentrated short sellers were taken to the woodshed (Melvin Capital, Citron Research), there are many other institutional investors who exploited the event to the tune of tens or even hundreds of millions in profits.

What’s more, many retail investors took losses. Order flow data from late January reveals that retail investors were relatively balanced between buyers and sellers. Volume data also shows that the number of shares traded during the two most volatile days was roughly 2.5X the number of shares outstanding. It was like a massive round of hot potato, and a lot of retail investors were late to the game.

Matt Levine explained the dynamic this way,

If you are buying GameStop right now, at 1,700% or whatever above its price a month ago, you would ideally have some theory of who you are going to sell it to. “Somebody else on Reddit” is one answer. ... Everyone on Reddit buying the stock right now is hoping to get out before it collapses, so if your plan is to sell it to them, and their plan is to sell it to you, somebody is in trouble.

The bottom line is that while many investors who rode the shares up were taking gains, in many cases it was another retail investor that they were selling the shares to at those elevated prices. Many of those investors are now sitting on massive losses with the stock down roughly 90% from its intraday high. As the Washington Post recently observed, “The rise and fall of GameStop’s stock may end up reinforcing what professional investors have known for a long time: Wall Street is very good at making money, and more often than not, smaller investors lose out to wealthy traders and giant institutions.” 

Misnomer #3: “RobinHood screwed its investors over.”

The popular retail brokerage RobinHood made headlines when it announced it was curbing trading in GameStop stock right in the middle of all the chaos. This move triggered outrage from investors that accused the brokerage of trying to limit the damage that was being inflicted on Wall Street hedge funds who were short the stock. The assumption was that RobinHood was voluntarily implementing the restrictions simply because it didn’t like what was going on. It was seen as yet another example of how the financial system, including the banks, brokerage firms, and even regulatory authorities, were all working together to keep the little guy down, and the outcry was joined by celebrity and political voices from both sides of the aisle.

In reality, the decision by RobinHood (and other brokerage houses, by the way) was necessary as a result of how trades settle and clear through the back-end plumbing of the financial system. When stocks are bought and sold, those trades don’t settle (stock and cash don’t trade hands) until two trading days later. As such, the SEC mandates certain capital requirements that are tied to how many unsettled trades are in process on any brokerage’s books. And the more volatile a stock is in a single direction, the more potential exposure there is for a brokerage who is facilitating a high volume of trades in that stock, and the more capital reserves are required. In short, RobinHood wasn’t set up and capitalized properly for what happened with GameStop stock on its platform. This is why it temporarily curbed trading, and this is why it has raised more capital (over $3 billion) in the last week and half than in its previous 8 years of existence. 

Misnomer #4: “Short sellers are evil.”

This is a sentiment that has broad populist appeal since many of the most well-known and outspoken short sellers are Wall Street suits. And yes, many practices associated with being a dedicated short seller are sort of gross (pumping negative research into the market to drive the price of a security down, etc). That said, we disagree that short selling is in and of itself wrong, nor do we think that anyone who is engaging in short selling is evil.

The reality is that short selling plays a vital role in markets. Throughout history many of the most damaging financial shams and internal frauds have been discovered and brought to light by short sellers. Additionally, much of the short selling that occurs is done for the purposes of hedging existing positions and managing portfolio risk. Ultimately, the ability for investors to express a bearish view on a security only adds to the efficiency and robustness of price discovery in markets. And by the way, does anyone really believe that the Reddit crowd never pumps up short ideas or buys put options? We shouldn’t be so naïve.

All that said, the business of short selling will be permanently altered by this event. The cat is out of the bag, and the prospect of a mob-induced short squeeze will forever factor into the analysis for these market participants. Citron Research, one of Wall Street’s most infamous short sellers, has even declared that it is completely pivoting its business model and will never again publish negative research in support of its short positions. Ironically, the quote we chose for the opening of this post was in reference to the GameStop volatility, but as our title suggests the “game” of short selling – at least as it previously existed – has also stopped. 

In some ways the GameStop saga is a standalone event, but in so many other ways it’s a microcosm of larger themes that have been developing for years. The market landscape is changing before our eyes, and as of roughly two weeks ago it has permanently changed for short sellers. On a larger scale, we think this story folds into themes of Fed-induced optimism, irrational speculation, and the formation of micro bubbles. There is a lot to consider here, and we plan to continue unpacking some of these themes in our upcoming posts.

 

* Note: “tendies” is slang for “profits” in Reddit-speak.


david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.


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