A Short Squeeze
Most of us are experiencing COVID fatigue. Locked in your house, restricted from enjoying previously taken-for-granted freedoms, although, perhaps with some excess money resulting from your incarceration. But the markets did provide us with some entertainment to break up a gloomy, monotonous winter, in the form of the GameStop short squeeze.
People sometimes ask me, what’s the craziest thing you’ve ever seen in the markets? From my career, there is a lot to choose from: the portfolio insurance meltdown in 1987; the long-term capital management crisis in 1998; the “melt-up” of the tech bubble in 1999 and 2000; and the mortgage crisis of 2008, to name a few. In some respects, speculation is always the root cause of these crises. In one of the first explorations of these catastrophic, all-too-familiar phenomena, Manias, Panics, and Crashes, author Charles Kindleberger points out that people always think this time is different. Whether it’s private family homes, tulips, junk bonds, or GameStop stock, speculative investors feel uniquely qualified to beat the system. In our view, it always pays to remember that a bubble is a bubble is a bubble, and that they will eventually end the same way - in a price collapse. But the euphoria on the way up certainly is amazing and amusing. Which brings me to a request we’ve received from many of our clients this quarter, to explain what happened with the short sale of GameStop in January and February. Let’s start with the basics.
What is a Short, Short Sale, Short Squeeze, Short Selling, etc.?
A short occurs when an individual or institutional investor borrows shares of a high-priced security with a brokerage loan (or options contract) with the intention of repaying the loan when the price of the security declines.
For example, an institutional investor believes that she’s found a company, (generally via authentic research), whose stock price is way too high compared to the underlying value of the company. She believes she’s found an overvalued stock, and that the broader market will discover this at some point in the future. Having this advanced insight puts her ahead of the market, and provides her with a profit opportunity using a short sale. Here’s how it generally works:
1. She goes to her brokerage and asks to borrow a number of shares of the overvalued stock.
2. The investor and brokerage work out a stock loan agreement, (e.g., term, % fee rate, collateral, call provisions), and the brokerage makes the stock loan.
3. The short seller acquires the stock and immediately sells it for what she believes is the overvalued price. She then holds the cash proceeds, waiting for the price to drop so she can buy back the shares to return to the brokerage.
4. In our scenario, at some time in the near future, the broader market determines that the stock is overvalued, and other investors begin to sell their shares in an attempt to get out of their positions before the price plummets. As shares flood the market, supply of the stock goes up, and the price goes down. Theoretically, the price will go down to the point at which it aligns with the actual underlying value of the company.
5. As the stock price declines, the short seller waits for the price to fall into her target range before she buys the shares back. Oftentimes, she will have a “strike price” at which she will automatically execute the transaction, locking in predetermined gains.
6. To close out the loan, she transfers the same number of shares she borrowed back to the brokerage. She keeps the difference between what she sold the stock for right after the loan (#3 above) and what she bought it back for (#5 above). The profit is the difference between the two stock prices less the fees charged by the broker. The entire transaction is recorded via electronic entries at the brokerage.
7. And that’s a simple short sale that works out as planned by the short seller.
Now, these transactions can get much more complicated, but that illustrates the general idea. While our example worked out nicely, make no mistake, playing the short game is highly speculative and super risky. Suppose the price goes up, not down, for any number of unanticipated reasons. The overvalued company develops a new product with patents, changing the company’s future outlook; a primary competitor goes out of business and the remaining company’s market share goes up, along with sales and profits; a different company offers to acquire them at a premium; the Federal Reserve floods the market with cash and 0% interest rates, making the stock market the best available place to invest, and the stock market booms. Perhaps the short seller discovers that their original analysis was just plain wrong. Generally speaking, the price of a decent company will rise over time; if a short seller has made a bad bet, their losses will grow (infinitely!) as the stock price goes up. In such a scenario, the short seller will have to determine whether to sell now, and take the current loss before it gets worse, or hold on, maintaining their belief that the stock really is overvalued. Of course, if the price starts rocketing up, the brokerage can demand repayment on the loan if the account balance requirements are not met, taking away the short seller’s choices and locking in their losses.
The Big Short
In the movie The Big Short, Wall Street guru, Michael Burry, realizes in early 2004 that a massive amount of subprime home loans were in danger of defaulting. As he researches all the unsound mortgage lending that was going on across the US, he becomes convinced that he’s discovered a financial disaster in the making. With a preponderance of highly questionable mortgages being issued, and then bundled into securities collateralized by those same mortgages (Mortgage-Backed Securities “MBS”), a meltdown seemed inevitable. To Burry, it was only a matter of time before the high-risk mortgages went delinquent and became bad loans, causing the MBS and the investment banks issuing them to crash and burn. So, in 2005, Burry bets against the housing market (which heretofore had never gone down) by throwing more than $1 billion of his investors’ money into credit default swaps, purchasing insurance for subprime mortgage bonds. He locates and insures the riskiest subprime mortgage bonds he can find, with their high premiums and the massive risk he’s taking on being the rub. It’s a classic short strategy. And this, of course, is also a true story, and Burry’s research was spot on. The banks, as we now know, were extremely negligent in their lending practices, and the brokerages were equally complicit, accelerating the ensuing crisis with their aggressive selling of MBS.
The key variable in this story is timing; Burry miscalculated when the collapse would occur. The housing market trucked along through 2006, and the mortgage market frothed, rather than nose diving, as he had expected. The premiums kept coming and his investors grew anxious. Burry’s timing of the collapse was so far off that he almost went bankrupt trying to keep up with his outflows. The suspense builds, he pounds his drums listening to heavy metal music, his staff begins to panic and the audience squirms in their seats with shared anxiety. Then, in early 2007, borrowers start defaulting en masse, and the MBS market crashes. Our brilliant star is exonerated and he and his clients are filthy rich. We applaud, and that’s The Big Short. In Hollywood lingo, it was a “7th Calvary” arrival at the last possible, gut-wrenching moment. (By the way, we highly recommend both the movie and the book by Michael Lewis.)
So, what was the story with GameStop?
Hedge fund managers often act as short sellers. Sometimes they do this to hedge risk in their portfolio, other times they do it purely for profit.
In January, hedge fund managers at Melvin Capital held significant short positions in the brick-and-mortar video game outlet GameStop, likely believing that the internet would make it obsolete, and that the pandemic would hasten its demise. Unbeknownst to them, an independent group of investors were reviewing the financial statements of many publicly traded companies looking for short squeeze opportunities. A short squeeze occurs when a shorted company’s stock price goes up, way up, forcing investors with short positions to face sharp, increasing losses, or to bail, which can drive prices even higher as they scramble to buy back their shares. In the case of Melvin Capital, some forensic accountants, who were among the 2,000,000+ investors loosely organized through the subreddit channel r/WallStreetBets, scoured SEC filings, financial media and social platforms for hedge funds who sought to capitalize on struggling companies with aggressive short positions. WallStreetBets found that Melvin Capital was shorting a number of such companies, including AMC movie theaters and Bed, Bath & Beyond, and most notably, that they held 5.4m put options on GameStop. In a wrinkle of fate, puts are shorts that are publicly disclosed in filings with the SEC. Acting collectively, often using small accounts and low-cost trading apps like Robinhood, these individual investors began snapping up GameStop shares, and quickly drove the price up.
Since GameStop was not widely traded, the surge in buyers (the demand side) drove up the price (small supply side) to ludicrous heights (from $12/share in December to a high of $483 on January 28). This blew up Melvin’s short sale strategy and left them stuck between a rock and a hard place - cut bait and take massive losses or deposit billions more in capital to keep their bet alive. After a few weeks, Melvin cried uncle and took the losses – to the tune of over $3 billion. The social media crowd rejoiced as they stuck it to a hedge fund by outplaying them at their own game.
Despite the entertainment provided by the GameStop stock opera, the underlying value of GameStop as a business did NOT change. Most likely, its days are numbered. And the investors who heard about the latest get rich quick opportunity and bought GSE at its peak face significant exposure as the stock continues to fall back to Earth. So, while many Reddit investors capitalized on the short squeeze they successfully executed, there were many others who bought in late and were left holding the bag when it turned and fell. Still, this is one of the craziest stock charts we’ve ever seen.
All told, the behavior of speculators these days boggles the mind. As Charlie Munger mentioned in his recent Daily Journal annual meeting, it seems really stupid to have a culture that encourages investing by people who have the mindset of racetrack bettors. For the record, Wright Associates does not advocate short selling, put options, margin accounts or employing any speculative approach to investing. For long-term success, we firmly believe that integrating a disciplined, goals-based investing approach with tax efficient financial planning will pay the best dividends.
The old saying “Buy low and sell high” is like a short in reverse, “Sell high and buy low.” The fatal flaw in this assumption is that the investor has some special insight or knowledge that will allow them to time the market. Here’s a counter question: Q) What do you call someone who tries to time the market? A) A loser. While there will always be a small percentage of winners in the timing game, the vast majority end up being losers. Which makes sense, since they are placing bets on outcomes that will be determined by variables of which they have no unique knowledge and forces completely outside of their control. The most basic, sound advice we can provide about short selling is that it’s very risky, and should be practiced only by those who can afford to lose.