Can the Gamestop Saga Crash the Stock Market?

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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.

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On a wall in our apartment is a section covered with post-its that both FIRECracker and I use to store potential article ideas. On one pink post-it are the words “Robinhood + Gamestop” I had put up there a few weeks ago when I had noticed something strange happening on the financial markets. Back then, there was a strange amount of chatter and interest in a random stock, Gamestop, for seemingly no reason. Similar things had been happening to other companies like AMC and Blackberry, and it was causing their stocks to spike to the complete surprise of the people running those companies. And I thought: Oh, that might be an interesting idea for an article.

Jeez Louise, that story blew the Hell up, didn’t it?

As of the time of this writing, the trading frenzy on Gamestop (GME) has made it one of the most heavily traded stocks in the US.

And on top of that, this story has taken on an almost mythological feel, entangling a fascinating cast of some of the most influential people in the investing world, including Michael Burry, Elon Musk, Wall Street hedge fund traders, a fintech company called Robinhood, Alexandria Ocasio-Cortez and Ted Bloody Cruz. To be honest, I’m kind of surprised Trump’s not involved, because when a story is this bizarre, he’s usually in there somewhere.

Ooookie dokie. So how do we even start untangling this mess…

How Did This Start?

In 2020, Gamestop became one of the most shorted stocks in the entire market. At the time, Gamestop, a video game retailer, had already been experiencing declining fortunes because of the video game industry’s transition away from physical distribution into digital downloads. Then the pandemic hit, shutting shopping malls down all around the world. So when hedge funds started taking up short positions and betting that Gamestop’s stock would go down, they did it for fairly rational reasons.

Enter Michael Burry.

Michael Burry is the hedge fund trader who famously predicted the 2008/2009 Great Financial Crisis by shorting the US housing market. He also had his story adapted into a movie The Big Short where he was played by Christian Bale.

In April 2020, Michael Burry invested $15 million in Gamestop’s stock, with the intention of restructuring the company into a digital distribution hub. He was joined later on in the year by e-commerce CEO Ryan Cohen, who invested an additional $76 million into the company. By the end of the year, against all odds, Gamestop’s stock price had doubled, then tripled. Despite the fact that very little about the company had actually been changed.

So already, this is an interesting story. Remember that this is the same Michael Burry who claimed passive investing was distorting the market because nobody was actively investing anymore. So of course he then turns around and actively invests in this stock, inadvertantly setting into motion one of the biggest price distortions in the history of the stock market. Suuuure, Michael. It’s the indexers that are screwing the market up.

But the story doesn’t end there. It’s just getting started.

At some point, a Reddit user named DeepF*ckingValue noticed the trading volume on Gamestop and agreed with Michael Burry and Ryan Cohen, dumping his entire life savings into Gamestop. He then documented his bet on the reddit subforum r/WallStreetBets. That’s when the story took on a whole new leg.

These three initial players were arguably just doing what any value investors do. They saw a stock in decline, believed that the company could be turned around, and bet accordingly. But when this story hit Reddit, it somehow morphed into an epic battle in class warfare.

One one side of the trade were the big, rich Wall Street hedge fund fat-cats who were trying to manipulate the stock to their benefit. And on the other were the plucky Joe Everymen sick of the stock market only benefitting the rich. The Redditors started egging each other on, convincing each other to plough their life savings (known as YOLO-ing), causing the stock’s price to continue to rise and denying the short sellers their payday.

To everyone’s surprise, this tactic was so successful that it created a situation known as a short-squeeze. Basically, when an investor shorts a stock, they borrow the share for a specific amount of time and sell it (hence the term short sale). Later on when the borrowing period expires, they have to buy their share back to return to the lender, and if the stock is trading at a lower price at that time, they’ll be able to pick it up for cheaper than what they sold it for, pocketing the difference as profit.

But now there were so many Redditors buying the stock and pushing it’s price up that when the short sellers were forced to re-buy their shares, they were forced to buy at a higher price, which caused them to lose money. It also inadvertantly pushes the stock’s price even higher, which made the situation even worse for their other short positions. The hedge funds started hemmoraging money to the tune of millions, then billions of dollars.

Then Elon Musk, who famously hates short sellers (because of what they tried to do to Tesla’s stock), saw what was happening as the hedge fund managers started whining to the media, thought it was hilarious, and gleefully piled in, tweeting out the following:

Gamestonk!! https://t.co/RZtkDzAewJ

— Elon Musk (@elonmusk) January 26, 2021

Classic.

Following that tweet, the stock instantly doubled in value again.

Why Did it Become Such a Huge Story?

At the time of this writing, in 2020 Gamestop went from $6 to $325, or a gain of over 5000%. It got so crazy that at one point the hedge funds managed to pressure the trading platform Robinhood into locking out their users from buying any more shares of Gamestop. They were still allowed to sell, but not buy.

Then all Hell broke loose. The Redditors were screaming that Robinhood was blocking them from making money. The hedge funds were whining that the government should step in and regulate the Redditors.

It got to a point where an unholy alliance formed between Alexandria Ocasio-Cortez and Sen. Ted Cruz to force Robinhood to unblock trading, but for completely different reasons. AOC objected to Robinhood placing their thumbs on the scale in favour of Wall Street over retail investors. And Ted Cruz objected to any disruptions of the free market.

The poor were literally robbing the rich, all via an app called Robinhood. You can’t make this shit up.

What started as an esoteric trade between a famous value investor and Wall Street hedge funds somehow turned into…well, whatever this is…

WE’RE IN THE ENDGAME NOW from r/wallstreetbets

I honestly can’t decide what part of that video was my favourite. Is it Elon Musk floating in like Space Jesus? Is it AOC buzzing around like a goddamned firefly? Or is it the Wakandans yelling “DIAMOND HANDS”? (Diamond Hands, by the way, is their bizarre way of saying “Hold your positions.”)

Also, did Captain America grab a Stimulus Check back there before going into battle? Are people throwing their pandemic relief payments at this? Hoo Mama…

How’s This Going To End?

Here’s the thing. At GME’s current stock price of $325, it implies a market cap of $23 billion. Gamestop is not a $23 billion company. Not even close.

There is no universe in which the stock simply stays at this level and everyone just goes back to work. It’s going to have to crash back down.

But this is no longer a story about valuation, it’s a story about emotions. Both the Redditors and the Wall Streeters can’t back down, and both are poring money into their respective trades hoping the other side backs down first. This is now a dick-measuring contest, and the winner will be forever crowned as the BSD, or Big Swinging Dick. I didn’t make that term up, by the way. That’s their terminology, not mine.

So who’s going to win? Who knows? The only think I know for sure is that the stock’s going to crash. But I have no idea when.

How Does This Affect You?

Well, first of all, to all the readers of this blog who’ve followed our advice and invested the majority of their money in passive index-hugging ETFs, there’s good news. It turns out the death of the active investor has been, as they say, wildly exaggerated. Remember that passive investing actually needs people betting on individual securities to work, so this past week has, if anything, been a ringing endorsement that indexing will not only continue to work but is the only safe way for retail investors like you and me to invest in the stock market.

Secondly, does Gamestop have the potential of destabilizing the entire stock market?

In short, no. While it might cause short term volatility, these kinds of bets just don’t have the volume to affect the stock market as a whole. Even if Gamestop were to cease to exist and wipe $23 billion off the face of the earth, the S&P 500 alone is worth a total market cap of $32 TRILLION. Gamestop isn’t even worth 0.1% of that.

However, just because the indexers won’t be affected, you may be. In the shorter term, everyone can expect to be bombarded with messages from all directions to abandon index funds and instead put as much money into GameStop as possible. Here’s why.

While the hedge funds have a clear exit strategy (wait until the Redditors capitulate and then ride the short wave all the way down), the Redditors don’t. Let’s say the hedge funds all throw in the towel and stop shorting Gamestop. Then what?

Then a whole lot of these people will be at first cheering, seeing their multi-million balances in their Robinhood account in way, way, way overvalued GME stock. But if they actually want to realize their gains and cash out, they will have to sell them. But to who?

Nobody actually believes Gamestop is worth $325 a share. The main reason that people kept piling in was because they believed there was money to be made by maintaining the short-squeeze position against the hedge funds. After that position disappears, the minute one person tries to cash out, everyone will rush to the exits and the stock will crash back down to earth.

The only exit strategy for these people that makes any sense is to continue spreading rumors after the short sellers are gone that the share is going to continue to skyrocket in order to keep bringing new buyers in. At the same time, the existing owners will secretely sell to those new buyers behind their backs to cash out, leaving their new owners holding worthless shares. So while Phase 1 of their “plan” is to engage in a dick-measuring contest with the hedge funds, this will eventually transition into Phase 2, which is to turn the stock into a giant Ponzi scheme while quietly exiting their positions.

Don’t be fooled by the narratives being pumped by the media. There are no good guys and bad guys here. Everyone’s a bad guy. The hedge funds are trying to screw the retail investors, and the retail investors will eventually try to screw other retailer investors (i.e. you).

While Gamestop seems like a runaway freight train, us indexers are more like a peaceful blimp, floating above the fray and looking down at the mayhem with binoculars. As long as we stay up here in the clouds, we’ll be fine. But make no mistake: there’s only one way the Gamestop saga ends and it’s in a train wreck. Do not under any circumstances get on the train.

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