Could GameStop hurt the bull run?

Unless you've been hiding under a rock for the last week or so, you've probably already heard plenty about this company and why its share price exploded. Let's investigate what's made GameStop such a big deal over the last few days, and just how much an impact it has had, and could continue to have, on global markets.

A short seller is an investor who first borrows, then sells a stock with a commitment to return it to the stock lender when required, or when they have completed their trade. If the price of the stock falls, the short seller can repurchase the stock at a price less than what they sold it at, and the difference is their profit. Naturally, the most a short seller can make on a short trade is the price they sold the stock for - and this would only occur if the stock's price went to zero. This is pretty unlikely, but many stocks have come close, or were suspended and then subsequently de-listed after running into severe financial difficulties. For the most part though, the short seller's goal is to profit from both rising and falling stocks.

Many hedge funds (the term 'hedge' implies a bet each way as a form of insurance) regularly go both long (i.e., hoping to profit from a rise in a stock's price) and short. For most, shorting is essential to manage their long-side risk which is often substantially greater than any short-side risk they may incidentally acquire.

GameStop has been underperforming with respect to its financial performance for some time now. In January 2017, it had 7,535 stores. By October 2020, this was down to about 5,000 stores. Despite the efforts to close stores, shed employees, and cut expenses, the company is on track to generate a net loss for the third year in a row. This made it a natural target for short sellers who assumed that GameStop's stock price would logically continue to fall as a result.

The trade was so popular, that at one stage, more than the entire float of the company's shares were borrowed and shorted. Now, that might sound both ridiculous and impossible - because how can more than all of the company's shares be borrowed, but it is exactly what happened (we'll leave the discussion of why to another blog post!).

In August 2020, a small group of traders on the Reddit WallStBets thread who were already bullish on GameStop got wind of this fact, and they began circulating the idea that the stock was ripe for a short squeeze. A short squeeze is where the price moves up to put short trades in a loss, potentially causing short sellers to close these trades by buying back stock. This buying further pushes up the price, which can induce even more short sellers to cover back. The move can gain significant momentum very quickly, especially when it's being juiced by a frenzied mob of millennials punting their stimulus checks! Around September last year, the share price began rising.



By mid-January, the idea, and the purchasing of GameStop's shares was beginning to go viral. The squeeze was well and truly afoot. The stock had risen from around $4 per share at the time of the first posts in August, to just over $20 per share. Then on January 13, one of the main proponents of the trade stoked the fire by showing his holdings of GameStop, and noting he was still all-in. The masses dutifully followed, and the stock almost doubled in that session alone, before closing up over 50%.

This got the attention of an even wider crowd, but more importantly, the fund managers who were short! The next few trading sessions saw the GameStop price grind steadily higher as more and more Redditers jumped on and the hedge funds scrambled to cover. By January 22, and for the next five trading sessions, GameStop shares exploded! The price of one share of GameStop topped out at $483 per share on January 29 - an increase of over 10,000% since the start of its run back in August.
 

The losses at some hedge funds who were short GameStop were severe. Many estimates are around for around US$20 billion in short selling losses. One fund reported losing 47% of its capital on their GameStop short, and others had to raise emergency capital to cover their losses. You might say, "Serves them right!" But when you look at the price action of GameStop compared to other major stock markets around the world, one cannot deny that they moved in the exact opposite directions for that crazy period between January 22 and January 29.

During this period, GameStop increased by as much as 1000%, whilst the NASDAQ Index fell by as much as 5.4%. Other markets around the world that were considered as high growth bets for 2021, like the Shanghai Composite and KOSPI 200 in South Korea, tumbled 5.2% and 8.5% respectively. Even our own ASX200 fell as much as 4.6%. Also very interestingly, the US Volatility Index, or VIX, spiked as much as 76%, its biggest move up since the start of the Coronavirus pandemic.

It is impossible to say with complete certainty that the GameStop short squeeze was solely responsible for the broader global market sell-off. But in a week where there was very little for markets to fret about, there isn't much else to point the finger of blame at. Put simply, hedge funds control the hot money sloshing around the world. They love to be on the long-side of growth assets, but to manage this risk, they must also make short bets on other assets. Like GameStop. If they're getting hammered on their shorts, they may attempt to cover these losses by liquidating long positions elsewhere. Further, even if your hedge fund didn't have an exposure to GameStop, if more broadly speaking its shenanigans makes you more risk-averse to short trades in general - you may have to dial back on your long-side risk to compensate. And this means selling - or just as bad - not buying.

The question is whether the selling we saw hit global markets between January 22 and January 29 has finished, or whether the GameStop fiasco has permanently dented hedge funds' appetite to use short selling to mitigate their long-side risk. If we are to believe some media commentators who predict the GameStop incident is just the beginning of a more protracted battle between Main St. investors and Wall St., then future massive short squeezes may have significant negative effects on the broader market.

Also read: How to use technical analysis to spot bubbles: GameStop