Three “Wise” Guys On: GameStop
This is a collaboration project that I discussed with Simon Tryzna and Michael Kelly, CFA, CFP® in late 2020. We constantly text / call / Zoom to chat about the markets, sports, client issues, and anything else on our minds. We all thought it would be fun to collaborate on a couple of topics in an old-school Bill Simmons style column. With the crazy-ness in the stock market this past week, we all hopped online and had a great conversation. I hope you enjoy this as much as we all enjoyed putting this together.
Simon Tryzna (ST): This has certainly been a historic week in the capital markets. When did you guys first learn of this story and what were your first thoughts?
Matthew Ricks (MR): I saw it making the rounds on Twitter yesterday (Jan 26th). At first, I thought the whole story was simply Melvin made some bad trades and needed a capital infusion. Not all that uncommon for hedge funds but certainly odd in a market that is seemingly on a never ending bull run. When I saw the stories kept mentioning Reddit users I assumed it was just referencing chatter on the boards about Melvin and its GME trade. Never did I imagine that some of the users of r/WallStreetBets had caused damage to a hedge fund.
ST: So I think I was actually late to the game because I was trying hard to stay off from social media as it was the one year anniversary of Kobe Bryant’s passing. I logged on to Twitter in the morning and just saw the flood of tributes and was basically like - “Nope. Don’t have the emotional bandwidth for this today.” Only later did I see a twitter thread breaking down what the users of a sub-Reddit did and how it all unfolded. I then started to get a few text messages from friends asking if I had seen what the stock did and what my thoughts were on it. To me - what was most remarkable is how a large group of individuals came together to successfully implement and execute a short squeeze on a hedge fund. This is the stuff that we see in Billions, or The Big Short, so it was absolutely crazy to see it play out in real time.
Mike Kelly (MK): I saw GME on Bloomberg the other afternoon pop but didn’t think anything too much of it. Figured it was another Kodak. Only until this morning after I had a call with a buddy of mine who has jumped into the Robinhood version of trading did I realize what was really happening.
Simon, it's funny you mention Billions because that is who I picture that the Reddit users are trying to target with this whole thing. I think they see hedge fund and think they are going after a Bobby Axelrod type of guy. I don’t think they understand that in taking down the ‘high and mighty’ they are also taking down pensions - teachers, unions, etc.
ST: I wholeheartedly agree with you Mike, and, I can’t say I blame them for it. I think there is definitely an “anti-establishment,” and an anti-Wall Street feel to it. And, you just nailed it there Mike. One of the bigger sources of capital for hedge funds are the pension funds and endowment funds. Those type of portfolios have a different mandate and different goals than an average individuals and look to hedge funds in order to provide a differentiated source of returns to help them meet their funding objectives. So when we see rumours of Melvin losing, what, $13.1B in assets, I can only imagine how much of that is going to trickle down to pension fund participants.
MR: That’s a great point. Hedge funds are not strictly a bunch of rich people’s money. With Melvin losing billions of dollars, that will most certainly trickle down to “regular people” via the pensions. We already have a major pension crisis on our hands where a lot are underfunded and struggle to meet their obligations. That impacts individuals like teachers, construction workers, police officers, and others that are members of these unions because it means they may not receive the benefits they were promised. That can be devastating for these individuals’ retirement and financial goals. How do these individuals that were relying on the pensions make up that shortfall?
MK: Can they?!? And can the pensions funds keep to the strict investment policies they are forced to now?
MR: With the Fed coming out and stating their preference to keep interest rates lower for the next few years, I believe you’ll see some pensions make adjustments. It’s not realistic for them to have assumed rates of returns around 7.5% like they’ve historically used. Something has to give.
Let’s take a quick step back though. You guys are the investment guys. Break down what the Reddit users did here for me.
ST: The users identified companies that had a significant short position as a percentage of their overall shares outstanding. When someone “shorts” shares, they effectively borrow shares from another holder and sell them on the open market. They profit when the value of the shares decrease and they can repurchase them at a lower price and return them to the original holder. When borrowing shares, there is a finite amount of leeway (i.e. margin) that the borrower has. Should the value of the shares appreciate, the bank that provided the shares will look to recover some of the shares (or equal value) so that they aren’t on the hook for the loss. This is what’s known as a margin call. If the short sells are appreciating, the short seller often will look to exit their position by buying the shares back and returning at a loss.
In GameStop’s case, the investors went hard to purchase shares of the company in order to drive the price higher. The short sellers had to go to the open market to purchase shares back, but there was a lot more buyers than sellers. The re-purchase price was significantly higher, Melvin was forced to liquidate their other holdings, and, as rumours have it, are now bankrupt.
The other important thing to note is the role that options contract play in this. Many redditors bought options contracts that would have them profit should the price go up. Banks, as the option contract underwriters, look to purchase shares in order to hedge their liabilities. This puts even more buy-side pressure.
Mike - did I get that right?
MK: Ya the biggest thing in the short squeeze is that it forces those holding the short position to recognize those losses. Shorting is always risky because it is the only (at least basic position) you can take in which you have unlimited downside risk. However, historically, since it is a more complex position to take due to the margin the institutional players can at least see an exit. That is what makes this case so unique.
It really is just fascinating to me all around. Especially to see that people came together to do this in a very ‘grassroots’ movement.
MR: So do you think this is the start of a trend or simply a one-off? Will we see more manipulation at a ‘grassroots’ level?
MK: The one thing this pandemic has done that is both a plus and minus is that it has made the retail investor more educated. I use that term loosely though because it’s who they are getting educated by. Put it this way - that buddy of mine who got me to look deeper at this also said he has been following a guy on YouTube who is a real ‘expert’. He then tried to legitimize him by saying “Ya he has worked with El Pres at Barstool on stuff”. That is the scary part.
ST: You make a really good point about the importance of education and where new investors are sourcing their information from. The best thing I can say is that a lot of learn by doing. I want to learn more about crypto so I opened up a Coinbase account. Investors will make mistakes during this period and it will empower them in the future. Also - a lot of people simply have a lot of time and money on their hands. For those fortunate enough to keep their jobs - many were able to increase their overall asset base and now have the willingness (and perhaps ability) to take more risk.
MK: Agree Simon. That is the positives of this time period. People have gotten the investment itch. There is a desire to know and learn more about this world which is all good. I am all for making finance more understandable for everyone. It shouldn’t take studying your 300 hours to be able to be actively involved in your portfolio decisions - although I will always say its best to at least work with a professional in partnership.
ST: The other thing I can see happening is, if there is indeed a bubble, and a lot of people get hurt, they will simply look to give up and outsource investment management to a professional.
MR: We absolutely need more financial education available. I had friends similarly come to me for my opinion after seeing someone on TikTok, Reddit, YoutTube, etc. give “advice.” I have no idea who most of these people are and what qualifications they may or may not have. Is that really where we want the next generations to get their foundational knowledge from? I feel like we’re setting them up for failure because a lot of these “hot takes” on social media leave out the basics and the relevant historical context. I will give them credit in that they do a great job of distilling some of the complex ideas down to a manageable sound bite. Yet if any of the three of us were to go on social media and freely spout off like this, we’d have FINRA, the SEC, or our state regulators coming after us HARD.
If this becomes more of a common occurrence, I could see regulations being put in place. What do you guys think?
ST: I think it’s hard to see regulations being put in place because technically those “content creators” aren’t promoting themselves as “advisors” or “professionals” - merely as “here is what I’m doing, you guys can follow or not.” The other thing we have to remember is the behavioral nature of this. The Fear of Missing Out (FOMO) is real and people are just quickly, and often time, blindly following one another.
MK: I hear you on that one Simon. That is also my biggest issue at times with the industry - but we can save that rant for another.
MR: I don’t want to make sweeping generalizations about who is taking part in this trading. The running joke is that it’s young males living in their parents’ basement who have too much time on their hands. However, I highly doubt that’s a true representation. It’s more than likely some of these people have families or other obligations. Should they be risking this money? Yeah, it worked. This time. Most of us know someone who tried to get rich quick and it failed. How many are going to think this is easy and eventually get seriously hurt financially?
MK: That is the worst part of this. I joked with you guys originally via text that clearly these guys haven’t read the beginning of “A Random Walk Down Wall Street” where he talks about all the historical bubbles and the greater fool theory. What I am afraid of is the guy who sees it working for people this time around and he jumps in on the tail end of this only to get stuck with a 30x valuation on a company. At the end of the day someone is stuck holding this stock and it isn’t going to be just the hedge funds.
ST: You know there will be Wall Street Journal article featuring those who got burned by this. But, Matt, to your point, there are definitely investors are there partaking in this that really shouldn’t be. What I tell my clients and my friends is that it’s important to know your limit. What I mean by that, is that when I go to a casino with my friends, we usually have a predetermined amount of money we are willing to lose. We rely on a buddy system to limit how many ATM runs we are allowed. The same thing needs to happen in client’s portfolios. I encourage people to go out and, for the lack of better words, have fun in the markets. But have a limit. Have, maybe 80-90% of your portfolio invested with a long term time frame in mind, and then the rest be “fun-money.”
MR: I’m right there with you Simon. If a client wants to do some more active trading, we set aside an account dedicated strictly for that, but within the context of their overall financial plan. Let’s say you’re a married couple in your mid 30’s, have a 3-year old child, own a home, moderate student loans and other debt, collectively earn around $200,000 a year, and have a total of $250,000 in retirement accounts (i.e. 401k & IRAs). Does it make sense to risk $25,000 trading like this if you’re not getting the match in your 401(k) from your employer or if you’re paying the minimum on your debt? I’d say no and probably suggest something more along the lines of $5,000-7,500 to start. We’d also agree that if it grows to a certain threshold, let’s use $15,000 in this example, we take some of the gains and put them towards our other goals.
ST: I’d say place those investments in your IRA and not your taxable account.
MR: Absolutely. Make sure that these funds are in an account that works for you and your plan.
ST: Side-note - I’m reminded of the Bitcoin craze of late 2017 and the subsequent tax season where Bitcoin traders forgot to account for short term capital gains and didn’t save enough to pay Uncle Sam…
In all seriousness though, Matt you nailed it with the “plan” bit. I believe that every investment needs to have a purpose behind it and choosing the appropriate account is a big part of it.
MR: And Uncle Sam will get his money. You can be sure of it.
ST: Where do we go from here - do you think we see regulators crack down on market manipulation (pumping up stocks for gains is a no-no) and do we see the rules get tweaked that favor the large players and, once again, shortchange the smaller guys?
MR: Conspiracy theorists certainly think the latter is true. They were ablaze today when a lot of the online brokerage sites were down. Personally, I think it’s going to take more than one occurrence for regulators to enact something. Mostly because I don’t believe they understand what happened well enough to draft legislation to crack down on it. Also, with commissions on trades being at or near zero, the proverbial floodgates have opened. I could see some course correction where brokerages change how they charge, especially on option contracts, but right now I am not sure what that will look like.
MK: I am just going to take the lame duck response -- we will see. There is just too much in the air right now. It really is uncharted territory. And Matt the last question off your response, is what do you see the brokerages view on this? Won’t that be the impact on how this proceeds?
MR: They showed their hand a bit today when they restricted trading on some of the targeted securities. This probably scares the ever-loving-<bleep> out of them. The threat of lawsuits and that regulators could find them responsible when it doesn’t work out for some of these ‘grassroots’ traders has to at least give them pause.
ST: I did see that you couldn’t short GTE as the brokerage firms couldn’t source shares to borrow. It will be very interesting to see what happens next (and the inevitable backlash from one of the parties). We may have to have another one of these in a few weeks to have our reaction to the broader reaction.
This was the first installment of Three “Wise” Guys On. We look forward to bringing you more of these in the future so stay tuned and give us a follow on Twitter: @SimonTryzna, @the_MikeKelly, & @MatthewRicks_
Disclaimer: This post is for educational, informational, and entertainment purposes only. Consult your fiduciary, tax, legal, and other advisors before making any decisions regarding your financial plan.