What does the GameStop story mean for the future of the stock market?
Ross Middleton CA, Senior Investment Manager at Murray Asset Management, gives an insight into the turbulence caused by GameStop’s stock market story.
GameStop Corp. is an American video game, consumer electronics, and gaming merchandise retailer. The general view is that it is an outdated retail business in decline and financial institutions who took this view saw an opportunity to benefit from the falling share price. This was particularly attractive for ‘short’ sellers, where shares are borrowed in order to sell at a higher price, with the aim of purchasing these shares back in the future at a lower price. In addition, other institutions issued ‘call options’, allowing the purchaser to buy stock in the future at a price agreed today, with the objective of also benefitting from share price declines.
Users on a Reddit forum called ‘WallStreetBets’ decided to buy into GameStop shares (or options to buy them), initially because they thought it was undervalued, then it became a ‘movement’ by the ordinary investor to send a message to short sellers. This surge in demand pushed prices higher and resulted in short sellers facing significant losses.
In order to hedge their exposure against the prices increasing further, the short sellers had to buy more shares in GameStop. The more shares they bought, the higher the share price rose, creating an inflationary spiral. This upward pressure on the price from short positions and options is referred to as a short squeeze and a gamma squeeze.
This drastic increase in price only attracted more investors looking to make a profit in the hope that the squeeze would continue, leading to a significant rise in the share price of GameStop.
For hedge funds invested in GameStop, most notably Melvin Capital, this squeeze meant that significant losses were incurred on the short positions and these funds have lost billions as a result. Many commentators believe the current share price is not sustainable over the long term, the squeeze will eventually come to an end and demand will fall resulting in the share price dropping. If this happens investors still holding the stock will suffer significant losses, a large proportion of whom will likely be retail investors.
A sign of things to come?
Looking at the bigger picture, what does this mean for the wider market? Fortunately for most institutions these events are occurring on the market fringes, on heavily shorted stocks with uncertain future prospects. For most companies that are valued on future cash, cashflows, and growth prospects, they are likely to be unaffected by this. Therefore, the impact of this is likely to be mostly contained. However, we have seen significant inflows to other heavily shorted companies like AMC and Bed Bath and Beyond leading to similar jumps in share price.
The overall impact of this trend will only be fully understood as time passes and it is too early to say whether this will be a permanent feature of markets going forward. Many believe that following the media attention the GameStop story and the vast sums of money involved, the US and possibly worldwide regulators will get involved. We have already seen multiple members of US Congress pressuring the Securities and Exchange Commission (SEC) to look into brokerage sites restricting the purchasing of certain shares and how this influenced share prices.
There is also increasing pressure for the SEC to review whether a collective group of investors are allowed to communicate and coordinate investments like this given the implications for market manipulation. Elizabeth Warren, known for her aggressive oversight of Wall Street and financial institutions and who has a seat on both the US Finance Committee and Banking Committee has written to the acting chair of the SEC asking how it intends to review and address the recent volatility in the markets. Both institutions and retail investors will be closely monitoring the outcome and how this will impact them.
Since the onset of the financial crisis in 2008, many EU countries have taken action to suspend or ban short selling. However, because these were uncoordinated, it was possible to circumvent restrictions in one jurisdiction by carrying out transactions in another. They also created additional costs and difficulties for investors operating in several markets. This led to the EU adopting a regulation in 2012 which increases transparency by requiring the flagging of short sales, so that regulators know which transactions are short and gives national regulators powers – in exceptional circumstances, and subject to coordination by European Securities and Markets Authority (ESMA) – to temporarily restrict or ban short selling of any financial instrument.
Will the US follow with similar regulations? The answer is anyone’s guess and hotly anticipated, as are the ramifications for institutions, such as hedge funds, where short selling forms a significant element of the overall investment approach.