Who Wins the GameStop Stock Game?

Investors who survived the dot-com stock market bubble in the 1990s may be experiencing post-traumatic stress these days thanks to the GameStop craze. 

In the 1990s, the stock market bubble was driven by technophiles believing each new Internet startup was a unicorn, and many of these investors were wiped out. This time, the bubble is inflated by a new breed of retail investor driven more by opinions on Reddit, Discord and other social media platforms than stock fundamentals. Will the result be the same?

Today’s investors co-ordinate in online groups such as Reddit’s WallStreetBets to drive up the price of “meme stocks” such as GameStop, AMC and others. Their motivation seems to be a mix of get-rich-quick and stick-it-to-the-man, the “man” being the short sellers who bet billions that these stocks would fall. As the small investors drove up the share price of GameStop to almost US$500 per share from $18, hedge funds were caught in a “short squeeze”—forced to spend billions to cover their losses.

Is this the start of a trend or will meme stocks fizzle out? Are new online investment platforms such as Robinhood that make stock trading easy and fun a good thing? Smith Business Insight asked Paul Calluzzo, Toller Family Fellow of Finance at Smith School of Business, to weigh in.

As far as you’re concerned, what is the most significant storyline in the GameStop episode?

There were probably journalists looking at this and saying, what can we write about cautionary tales? When the GameStop stock price was at $350, the cautionary tale was that you could create domino effects within the market that could lead to financial players crashing. But now, the cautionary tale is different. 

The attention drawn to investing as a result of GameStop hasn’t been seen since the dot-com bubble in the 1990s, and there are cautionary tales from that experience. If there are copycat instances where people focus on just the upward swing and not the fact that the stock dropped 70 per cent in two days, then more retail investors will be sucked in who will ultimately lose money. They’re not going to be the next Warren Buffett. They’re going to be like millions of people in the dot-com bubble who lost assets like their retirement savings.

At least with the dot-com bubble, there was a compelling narrative behind it, that these Internet companies were the way of the future. With GameStop, there’s no narrative. There are investors who are proud of how much money they lost. These people, they’re going to look back and say it was fun but that they lost thousands of dollars that could gone towards a down payment on a house. 

Will this social media frenzy of stock purchasing affect the wider market?

I think it’s unlikely but anything is possible. You never know what the next domino effect in the financial markets will be. In 2008, it was the housing bubble that spilled over. 

I’m more concerned that people will watch this GameStop event and think to themselves: I see these people on Reddit making money. If these naïve investors can do it, so can I. Forget about investing in diversified index funds. This type of thinking could lead people to pursue risky and suboptimal investment strategies. 

If you believe media reports, the motivation for some of these traders was not necessarily to make a killing but to make a point about short selling, and that they were okay with losing money.

The market is ruled by Darwinian forces. If you pursue strategies that lose money, you won’t survive. You’ll be giving money to the more sophisticated players in the market, likely the hedge fund traders these WallStreetBets people set out against. Now that’s within the market. The one caveat is that outside the market, if it inspires other people who are willing, like Don Quixote, to act on principle even if the outcome for them would be bad, then that sort of behaviour could persist.

But did they (the WallStreetBets day traders) really do it for a point? It is hard to say, and maybe some of them did. In economics, we assume that individuals act in their best self-interest, and there were no doubt those who thought they could do a short squeeze on the hedge funds and make money. And it worked to an extent. The people who bought (GameStop shares) at $15, I’m sure some of them sold at $350 and made a killing. I don’t want to speculate to what extent that was market manipulation [in fact, regulators are looking at this right now], and assuming it doesn’t fall into that manipulation category, they earned their profits. But the people who bought at $350 to make a point, I hope they didn’t buy so much that they’re now broke. There are more efficient ways to make a point than losing your hard-earned savings. 

Can we expect short sellers to change their behaviour at all?

I don’t think this will deter short sellers. Investing, especially in complex strategies like short selling, is risky. At the beginning of the coronavirus, when the markets crashed, plenty of hedge funds lost even more. That’s just the nature of the beast. Even last week, as the price of GameStop skyrocketed and shorter sellers lost a boatload, short sellers as a whole made money. 

What may change a bit is that short sellers may perceive an increase in the likelihood they get squeezed. They can mitigate against this risk by taking more diversified short positions or using other complex instruments, like put options, to limit the amount they could lose on a specific stock. 

Let me add that a world in which no one is short selling would be a world in which prices are further removed from their efficient level. The idea that short selling of GameStop is an inherently bad thing, I just don’t buy it. Short selling can be a positive force towards efficient markets. If you don’t have short sellers exerting downward price pressure on stocks or any asset, there will likely be more trading bubbles, which can be really dangerous. 

Online trading platforms such as Robinhood have reduced the friction of retail trading by waiving commissions. Is this a positive development? 

Well, from whose perspective? I think Robinhood is bad for society because it encourages day trading, which is not an optimal way for retail investors to access financial markets. It can also obscure the risks associated with this sort of trading. GameStop draws attention to the need to tone it down. 

At the end of the day, you don’t meet many people who say, I day-traded during the dot-com bubble and never had to work again. These things don’t end well for day traders. The net good for society is having people who are uninformed about individual stocks buying index funds, myself included. 

Are you suggesting regulators should step in and make it harder for day traders to operate?

There are two sides to the issue. Is it fair to say that some people are not allowed to make bets that other people are allowed to? It might be. There are already restrictions on who is allowed to invest in hedge funds, and my own brokerage requires a questionnaire about investment experience to access margins. Maybe putting more teeth into those questions for retail investors would be a good thing. 

The other side is the political argument, made by both the left and right, of putting restrictions in the way of any individual. The left views it through the prism of inequity, that the rich are allowed to access something others are restricted from. For the right, it is more a story that individuals are able to act in their own self-interest, and that we don’t need the government telling us what is good or bad.

The counter to both of these arguments is that there’s a huge financial illiteracy problem in both the U.S. and Canada. And until we address this underlying problem, there is value in policy that at least directs people away from destructive financial behaviour and towards responsible investing. 

My concern is that the narrative around GameStop is that it’s another time where the little guy got the short end of the stick. That would be sad because the financial markets can be a world where everyone benefits, even the little guy.