The Market Seems Jumpy, Ctd

Today the market indices dropped by more than 2% across the board. Here’s the DJIA for the last year:

I’m not alarmed by this. Market goes up, market goes down. Long term investors shrug and go about their business.

But that fact that Gamestop and AMC, the cinema company, have climbed precipitously recently did catch my attention. How much?

Gamestop (GME) is up nearly 10 fold in the last week.

Same for AMC (AMC).

So what’s going on?

GameStop, hedge funds’ most-hated stock, was targeted by an army of retail investors who marshaled forces against short sellers in online chat rooms. In the Reddit forum “wallstreetbets” with more than 2 million subscribers, rookie investors encouraged each other to pile into GameStop’s shares and call options, creating massive short squeezes in the stock. [CNBC]

And so we see the power of the Internet as a group of individual investors, a coordinated army, have successfully moved to boost the price of a stock in the face of short selling, resulting in a short squeeze^[1]. The shorts, in this case, are hedge funds, immensely large amounts of money that attempt to make lucrative, yet safe, investments through novel strategies not available to smaller investors. And sometimes fail.

This is the first time that I’ve seen retail investors take aim at the hedge fund industry, which, in my limited experience, are generally regarded with some suspicion by the individual investor as being entities which manipulate the market for their own profit, and other investors bedamned. Whether it’s true or not, I don’t know, and as a long-term investor I generally feel I can ignore the question, unlike day traders or short-term (not short position!) or even short position traders, all of whom are far too sensitive – in my opinion – to the eddies in the river of capital.

But the emergence of a coordinated army of individual investors declaring war – and quite successfully, as their target, Melvin Capital, was apparently badly hurt when GME shares took off – on a hedge fund is something new, and thus needs to be considered carefully. Why?

There’s an underlying assumption to the market, and that everyone’s in it for the same reason: to make money. That’s not entirely true, of course, because there’s investors who are investing to promote the social good, and there are some very few who hope to accumulate enough shares to take over a company. But, by and large, the statement is accurate enough.

But what about now? What if this coordinated army is mobilized towards some other end, not having to do with finance? That’s what’s stirring in my mind. How are such maneuvers to be recognized? If the general assumption is suddenly falsified, am I in trouble? is this army regulatable, and should they be?

Or is it really a significant phenomenon?

I can’t help but notice the similarity between this army and a traditional old pump ‘n dumper, a disreputable denizen of the penny stocks who selects one, goes about pumping out good, but false, news about it after investing in it at a low price, and when the pump results in an inflated value, dumps their shares for an ill-gained profit.

For the investors that invested at the top, they lose nearly everything, but so does almost everyone else, especially if they made the mistake of being patient. And how is this different for those who pumped up GME?

There are three classes of investor here: the coordinated army, the investors who don’t know any better and jumped on the rocket – and the targeted hedge fund who owes a hellacious amount of the targeted company’s stock. While the second class of investor will be contributing some of their wealth to the coordinated army, and so will members of the army itself in a case of cannibalism, consisting of those who got in late, the intended, and real victim, will be a hedge fund which eventually ends up buying the shares it owes at vastly inflated prices.

In a sense, this is a Robin Hood scenario in that a vast treasury was just raided by means that are not exactly ethical, but probably not quite illegal. Yet. If you don’t like hedge funds, this sounds like a good thing.

But I do worry that it could be turned against me, or people in some category to which I belong, and could thus negatively impact me some day.

Look, the market is ideally a way for people to lay bets on the future value of public companies. If this coordinated army screws with that purpose, then it’ll make it harder for honest investors to honestly make those bets.

But if the hedge funds do have an unfair advantage, then is this the way to even the board? I doubt it, and I say that as someone who was furious when Long Term Capital Management, an early, huge hedge fund, received a government bailout after making a series of bad investments. That should have never have happened, they should have just failed, and those who felt the pain would have been object lessons for everyone else.

But one must be partially divorced from emotions when evaluating situations like this. Sure, it might be nice to see a manipulative – if they are – hedge fund go down in flames. But is this coordinated army a general menace?

So when I look at that 2% loss in the market indices, I don’t believe that’s a sign of what’s to come in the shadow of the coordinated army of investors. In my experience, the market goes up, the market goes down – but rarely more than it’s gone up.

But I am going to keep this coordinated army incident in the back of my mind. Just in case.

¹ A short position occurs when an investor borrows some set number of shares of a stock from one or more investors, sells them on the market, and then buys them back for return to those who own them. The investor profits when the price drops from his sell point, and loses money when the price is higher and they are forced to buy back. A short squeeze occurs when the price of a stock is forced higher because a large number of shorts are in the market and on the wrong side of trades. They have to scramble to buy and return the shares at a loss – and if demand is high, the price skyrockets. A short’s profit potential is always limited, and loss potential is unlimited.