What's Up With GameStop?

SMITH BRAIN TRUST – A month ago, few people would have guessed that shares of GameStop, a struggling video-game retailer founded a year before Blockbuster Video, would be Wall Street’s most eye-popping stock to watch.

Back then it was trading around $20. But it has climbed more than 2,000% since, trading this week at a high around $483, and sparking a lot of people to ask the question, “What the hell is going on with GameStop?”

Maryland Smith’s experts explain.

First a little backstory: GameStop's stock saw its first jump higher around Jan. 11, when it announced that the co-founder of pet-supply e-commerce darling Chewy.com would be joining its board. That news was good, but stock analysts who took a closer look at GameStock saw reasons for pessimism. The heavily brick-and-mortar retailer had a debt load of nearly half-a-billion-dollars, revenue that had slid 40% in the past two years, and a central product – physical video games – that’s become mostly irrelevant. Games today are bought typically online, as a download.

Professional investors bought short positions against the stock, betting that it would fall.

Normally, those establishment investors would just sit back and wait to make money when the stock slid. Instead, GameStop’s share price began rocketing higher, as users on the Reddit forum r/WallStreetBets flocked to the stock on their Robinhood trading apps, buying it up in spectacular numbers and forcing the share price higher, deliberately spoiling those hedge fund bets – and creating a short squeeze.

The squeeze happens when a heavily shorted stock rises, rather than falls, forcing the short sellers to buy up more shares of the stock in order to cover their positions. This pushes the price even higher. The hedge funds lost money and the Robinhood traders watched their shares climb.

And that’s how many observers have framed the move, celebrating the developments as “Reddit and Robinhood over Wall Street.”

But it isn't that simple, says David A. Kirsch, associate professor of management and entrepreneurship at the University of Maryland’s Robert H. Smith School of Business. Kirsch, co-author of “Bubbles and Crashes,” explained why to Slate magazine this week. (All the Ways the GameStop Roller-Coaster Could End). The so-called Redditors had described the move as a way to make money while foiling the plans of hedge fund elites. “It’s sort of Occupy Wall Street by the trading desk instead of by Zuccotti Park,” Kirsch tells Slate. “That’s real. It’s a social movement. It’s organized market action.”

But it by no means justifies a market capitalization in excess of $24 billion.

“As with any short squeeze,” he says, “when the music stops, stockholders will lose large amounts of money. The more interesting question is: Does this represent a new market dynamic?"

What’s interesting about the GameStop frenzy, says Maryland Smith’s Joseph Perfetti, is how individual day traders banded together and caught the market off guard by manufacturing their own short squeeze, buying up dozens or hundreds of shares, not the tens of thousands of shares typically ordered by institutional investors.

Kirsch agrees, telling CNET, "We are seeing that three million small investors in a Reddit forum, when acting in a coordinated fashion, can seriously distort regular price movements."

To Perfetti, the situation is reminiscent of a Ponzi scheme. Those who get in early will reap the rewards of exploiting the short-term supply-demand imbalance. Others who hopped in later meanwhile are more likely to find themselves holding the empty bag when the stock price regresses, Perfetti says.

But what’s most troubling to him is that this event is a departure from the lessons learned from the housing crisis or the collapse of Enron.

“Investing has changed a lot over the last 20 years and what I worry about is when I see things like this is that we start to forget about the lessons we’ve learned from previous economic crises,” says Perfetti. “Lessons we learned about diversification or about risk and the individual risk of a stock, especially when we're detached from reality.”

There’s also a reason for Wall Street to be concerned about the long-term implications and fallout from an event of this magnitude, he says. One possibility is how it could dissuade people from participating in the market in the future. “When so many people get burned, trust in the marketplace falls and then they're going to be afraid to invest since it’s never a sure thing.”

Maryland Smith’s David Kass also warns of broader implications and a need for regulatory review.

“The Securities and Exchange Commission, Nasdaq, and NYSE should study carefully what has occurred and perhaps introduce some guardrails or new rules,” says Kass, a clinical professor of finance, who formerly served as an economist in senior positions with the Federal Trade Commission, General Accounting Office and Bureau of Economic Analysis.

Among the alarm bells in this case: GameStop stock equal to roughly 140% of the company’s available shares had been borrowed and sold short, a bearish position showing mark-to-market losses of over $6 billion year-to-date.

“Should short positions exceeding 100% of outstanding shares be permitted?” Kass asks. “Should the uptick rule – in effect from 1938 through 2007– be reinstituted for short sellers? Are there systemic risks from the forced liquidation of long positions of hedge funds in order to raise funds to either cover shorts or add to collateral when a short squeeze occurs?”

Stocks “don’t always go up,” Kass says.

“And the GameStop frenzy will very likely end badly for both the Reddit buyers and the hedge funds with large short positions.”