The Money Fight: Meme stocks, the short squeeze, and the sharp play

written by Peter Sainsbury

“There is nothing so disastrous as a rational investment policy in an irrational world.”
John Maynard Keynes

In this article I demonstrate how the current financial system can suddenly catapult a company whose future looks bleak, into becoming the most valuable small cap stock in America. It shows why the best investors in today’s financial markets are not always the smartest. How the best investors in today’s financial markets are not always those that study the fundamentals. It shows that the winners are often those that know how to pump a stock with a contagious meme, and are able to rig the system in their favour.

There are signs that investors are getting dispirited now they know the system is unfair. Sports betting offers an alternative in which the smartest, sharpest bettors can and do win big consistently. Sports betting markets in an arena where only those on the pitch and in the ring matter. Sports betting markets are the fairest game out there.

Welcome to the money fight. What side will you pick?

DeepFuckingValue

One of the most famous names in investing, hedge fund manager Michael Burry made millions during the 2008 financial crisis by shorting subprime mortgages. His exploits and that of other hedge funds was dramatised in the movie “The Big Short”.

In 2019 Burry bought 2 million shares in GameStop because he believed the company was undervalued. After disclosing his position to the company’s management, he advised the company of the benefits of undertaking a share buyback of a big chunk of its heavily shorted stock.

By September that year a young American financial advisor uncovered what was happening at GameStop, bought 1,000 call options and posted his position to Reddit under the pseudonym u/DeepFuckingValue.

And then the pandemic hit. Video game consumption understandably surged during lockdown. Nowhere to go. Nothing to do. No way of seeing or playing with your friends. Many of us, young and old, whiled away several hours or more a day plugged into Fortnite, Minecraft or GTA.

For a bricks and mortar retail chain like GameStop that should have spelt bad news for their share price. Why go to the store when you can just download the game anyway? GameStop was the Blockbuster of video games. Founded in 1984 it was a relic of another time.

GameStop’s share price hit a low of $2.57 per share in April 2020 as lockdowns began to spread across the USA, before rising to $18.84 per share by the end of the year. Unknown to the wider public at the time, Burry cashed out of his position in GameStop in late 2020, netting his fund a tidy profit.

By the end of 2020, the pandemic was leading other investors to believe that GameStop was fundamentally undervalued. High-profile activist investors such as Ryan Cohen argued that the market for games consoles during the pandemic was strong and that the company’s management should pursue a more digital direction.

Short stocks

Many of the largest investment firms in the world disagreed with the prospects of a rosy digital future for GameStop, and so they bet heavily, betting billions that the company would go bankrupt. GameStop entered 2021 as one of the most shorted stocks in the world.

But what does shorting even mean?

Typically, shorting a stock is a bet that the share price is going to fall. Short sellers borrow shares from brokers and then sell them into the market, with the agreement that they will buy the shares back and return them to the lender at an agreed upon time. The shares can come from the brokers’ own inventory of shares, or from customers that have allowed the brokers to lend out their shares.

If the stock price has fallen, the short seller can buy the shares back at a lower price than they originally paid for them, locking in a profit. If the price has risen, the short seller must buy back the shares at the higher price, incurring a loss. Until the trader closes their position, the short seller pays the lender interest on the value of the stock.

Here’s where it gets complicated. Once the original short seller has borrowed the shares and sold them into the market the new owner is free to lend them out again to another short seller. In this way it’s possible for more than 100% of the float of a stock to be shorted.

On 4th January 2021 GameStop’s short interest was estimated to be over 140%. The higher the short interest, the higher the risk, since if everyone rushed to exit their positions at once, a sudden surge in demand to buy back stock would push the price up further.

The squeeze begins

On 13th January the price of GameStop shares doubled from a little under $20 a share to around $40. Over the following week very little happened, the price hovering around the $40 per share mark. But all was set to change. Over the next week GameStop shares tripled to around $150 per share.

For a company that had failed to catch the digital wave and was very much an old school CD and video shop, this was a remarkable turnaround. Had they brought out a new innovative product that was going to revolutionise the music industry? Had they suddenly announced the digital transformation that Cohen and other investors had clamored for? No, the answer lay somewhere else.

Reddit users on WallStreetBets noticed that hedge funds, including one called Melvin Capital, had taken large short positions against GameStop. They decided to punish them by launching a co-ordinated buying spree. That began to force the price of GameStop shares up, increasing the losses for the short sellers who had bet against it.

The hedge funds found themselves trapped in a “short squeeze”, a vicious feedback loop that can drive the price of an asset upwards rapidly. This tends to happen when too many traders have bet on the decline of a company. Someone eventually realises that they’ve shorted to such an extent that they can’t physically buy back the shares they’ve borrowed. The lack of supply then forces up the price of a stock. Short sellers start to panic, buying back the shares in order to “cover” their position and limit their potential losses. But that buying pressure forces the share price up even more, which then increases the losses of short sellers who haven’t already closed out their positions.

This isn’t the first time a short squeeze has led to bizarre market outcomes. In October 2008, a short squeeze triggered by an attempted takeover by Porsche, temporarily drove the shares of Volkswagen from €210.85 to over €1000 in less than two days. It briefly became the most valuable company in the world. Meanwhile, as recently as April 2020 the price of WTI crude oil was driven down to a low of minus $40.32 per barrel as traders dumped crude futures in a “long squeeze” prompted by a lack of storage capacity.

The GameStop saga taught us that being short a particular asset in size - especially one that is illiquid and one where everyone else knows your position - means you are very vulnerable to a short squeeze. A concentrated effort by a small group of investors can quickly lead to a short squeeze

It was about to get much worse for the short sellers.

The influencers

“Investing illusions can continue for a surprisingly long time. Wall Street loves the fees that deal-making generates, and the press love the stories that colorful promoters provide. At a point, also, the soaring price of a promoted stock can itself become the “proof” that an illusion is reality.”
Warren Buffett

On the afternoon of 26th January 2021, the boss of a car company sent out an 11-letter tweet, “Gamestonk!!”, while also linking through to the Reddit forum, WallStreetBets.

Gamestonk Elon Musk Tweet

If the same tweet had been sent out by the boss of Renault, Daimler, or Ford or pretty much any other company, nothing much would have happened. But this was Tesla, and the tweet was sent by the company’s founder and CEO, Elon Musk. At the time of writing, the world’s richest man.

On the same day venture capitalist and former Facebook executive, Chamath Palihapitiya tweeted that he had bought $125,000 worth of call options on GameStop; an earlier tweet asked his followers what he should “throw a few 100 k’s at.”

Chamath Tweet on gamestop

The price of GameStop shares soared by 220 per cent overnight to a high of $483 per share. Over the previous 12 months the share price had increased by 12,000%. For a brief period, GameStop became the most valuable company in the Russell 2000 index of small cap companies.

The GameStop saga shines a light on the role that stock influencers have on financial markets. Elon Musk for example already has form in this area. Back in August 2018 he tweeted “Funding secured” prompting a surge in the value of Tesla shares, as investors believed that he was about to take the company private, at a value well above the current market valuation.

His influence over asset markets didn’t stop with GameStop. Weeks later, in early February, Musk steadily tweeted memes about cryptocurrency Dogecoin, proposing ideas for improving the coin and taking credit for the massive upswing in its price. On 4th February Musk tweeted, "Ur welcome," alongside an edited image depicting him as Rafiki from "The Lion King" and Shiba Inu as baby Simba. Over the first week of February the value of Dogecoin rose 10-fold to $10 billion.

Elon Musk Doge Tweet Lion King

It’s worth recapping on the role that memes and meme stocks have in the current financial market. A viral meme stock in today’s investment world is a story that sticks. As I explained in my previous article, one of those compelling investment narratives involves the arc of a protagonist (the hero) that takes on the world with his or her vision, and although experiences obstacles on the way, eventually succeeds.

Elon Musk, Chamath Palihapitiya and others fit the narrative of people that are anti-establishment and have a disdain for financial industry norms. Individual investors taking on the hedge funds – the establishment – and winning is another. It’s a battle between the hero, and the villain. To buy into a meme stock and hold it with “diamond hands” is to become part of a movement, the culture that underpins the investor community.

In a world of low information and even less care about ‘fundamentals’, greed and fear become the dominant emotions driving markets. The meme is how it manifests itself. But it’s not just about the meme - it’s how the crowd thinks the crowd will react to the meme. A meme beauty contest.

A rigged system

“Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited.”
George Soros

The event was portrayed in the media as a battle between retail investors on one side and the establishment on the other. The reality was that hedge funds were on both sides of the trade, some won and some lost.

Some investors such as Michael Burry were early to the opportunity and closed out before the boom reached euphoria. For Burry, the squeeze could have made him over $1 billion at certain points of January. But as it was occurring, Burry was warning about the trading. In a tweet sent on 26th January (that has since been deleted), Burry called the GameStop squeeze “unnatural, insane and dangerous.”

Melvin Capital was the hedge fund at the centre of the frenzy. It is reported to have lost $7bn during January, around 50% of its assets. As the GameStop frenzy intensified, many retail investors suddenly found their ability to execute trades curtailed by stock brokerages. One brokerage, Robinhood was quick to cut off access. You see, Robinhood makes its money from selling the order flow from retail clients to a market making firm called Citadel. In turn, Citadel also owns a significant stake in Melvin Capital. By cutting off access to Robinhood, Citadel was able to stem Melvin Capital’s losses.

The bubble rapidly deflated. Over the first few weeks of February GameStop shares lost over 90% of their value, returning to levels seen in the second half of January. However, that wouldn’t be the end of the affair.

Remember Ryan Cohen, the activist investor who pushed the company’s management to pursue a more digital direction? Cohen became a cult-like figure for investors. His push to turn the retailer into a tech giant has amassed hordes of eager traders. Renewed belief in the future of the retailer following management changes led to a 10-fold rebound in the share price during late February and early March. Gravity would take hold yet again through the end of the month.

GameStop was billed as the moment that the private investor fought back against the establishment and won. For a few lucky investors that might have been the case, but many retail investors will have been nursing heavy losses. For many, it’s been the realisation that things in financial markets are not always what they seem.

The stock market has become increasingly popular for many investors – both new and old – eager to juice their income, multiply their stimulus cheques and build their retirement pots. Despite this, an increasing number of people believe that the stock market is rigged, and the events of early 2021 appear to have reinforced that view. A recent survey of Americans carried out by YouGov found that almost half believe that the stock market is “rigged against individual investors”.

The Mayweather versus McGregor bubble

“My fist is bigger than his head, seriously. I know every single shot he’s been hit with. I know every single shot he’s been hurt with. I know southpaws have caused him a hell of a lot of trouble. I know everything. Trust me, I don’t care what rule set it’s under. Most people don’t know (expletive) about fighting. I’m going to teach him about true fighting and that’s it. I land one anywhere on the dome, he’s going to know about it.”
Colin McGregor

The last decade featured several high-profile longshot winners: Leicester winning the 2015 Premier League title at pre-season odds of 5000/1, the St Louis Cardinals to win the 2011 World Series at 999/1 and Tiger Woods at 14/1 to win the 2019 Masters.

The bookies were taken to the cleaners! It’s us versus the establishment, and we won. That is the narrative most bettors like to imagine. Events like these though, far from being a death knell for the bookmakers are the best publicity imaginable. It may have cost them dear that night, but the marketing it gives them is priceless. Astronomically high odds and grinning punters holding up their winning betting slip. It could be you! You could beat them and take away a fortune.

Yet it is often that the most amazing value can only be obtained at what appear to be very short odds. Only the sharpest of bettors can determine the existence of value in such short odds, and then be prepared to bet in size.

One of the most notable examples of this occurred inside a boxing ring in Las Vegas in 2017. Floyd Mayweather, the 40-year-old veteran boxing champion was taking on Colin McGregor, the UFC champion. Although 11 years younger than Mayweather, McGregor lacked much in the way of boxing experience.

The initial odds reflected Mayweather’s winning streak of being undefeated across 49 bouts, while also factoring in that there might be plenty of backing for McGregor from his fans. The first prices appeared in some Las Vegas bookmakers in February, four months before the fight became official. Mayweather opened as the 1/25 favourite, with McGregor an 11/1 underdog.

The bookies massively underestimated the interest that McGregor was likely to have from his devoted followers in UFC and MMT. Fans showed up in their millions with their dollars, backing their belief that their prize fighter would beat boxing veteran Mayweather. Unlike in financial markets, the collective wealth of fanatical bettors has no impact on the performance of the player, team, or fighter.

By June, the odds of McGregor winning had shrunk to 7/1. Mayweather’s odds were pushed out to around 1/10, implying that he had a 91% probability of winning. However, as fight night approached the odds were about to get even more detached from reality. McGregor was now into 3/1 while Mayweather was a 1/4 shot (80% probability).

The price of Mayweather overcoming McGregor was too tempting for many professional bettors to resist. And because there was so much money backing McGregor, the bookmakers were only too happy to take in money on his opponent to reduce their liability should the Irish pretender beat the undefeated champion.

Mayweather beat McGregor in the 10th round by TKO. The memes quickly followed as fans poured scorn on the defeated McGregor.

Mayweather VS Mcgregor Simpson meme

A wise bet

This article has demonstrated how the mechanics of the financial system mean that a company whose future looks bleak can suddenly be catapulted into becoming the most valuable small cap stock in the USA. We’ve seen how the biggest winners are often those that know how to pump a stock with a contagious meme. Finally, the GameStop saga demonstrates that the smartest investors are not always the biggest winners.

Sports betting is arguably the only market in which the smartest, sharpest bettors can and do win big consistently. At the end of a match, game or race, a result has been declared. Fundamentals matter, and so most of the time betting markets are relatively efficient. However, at certain points the price can deviate from the underlying fundamentals, and this - like it was for the Mayweather backers - is where it can pay dividends for sharp sports bettors.

Betting represents a discrete market. Individuals bet on the outcome of a particular event, that takes place at a particular location, on a particular time. The track record of these discrete events stretches out into the past, and so represents a way for bettors – through Bayesian inference – to estimate the probability of subsequent events. Investing in contrast is not a discrete market. It can in theory be an infinite market. There are no discrete events from which to accurately calculate the probability of subsequent moves in the market.

Financial markets work on the premise of reflexivity, and so it’s not just the fundamentals, but how investors think about the fundamentals that matters. According to financier George Soros, “When events have thinking participants, the subject matter is no longer confined to facts but also includes the participants' perceptions. The chain of causation does not lead directly from fact to fact but from fact to perception and from perception to fact.”

The actions of bettors do not have an impact on the outcome of sports betting. Unlike the financial markets then, this reflexive element is missing. In a world where financial markets are irrational, volatile and rigged, sports betting markets offer a fair game by which the smartest can still win.

Peter Sainsbury

Peter Sainsbury

Peter Sainsbury is the author of The Winning Formula: Betting on F1, Commodities: 50 Things You Really Need To Know and a number of other books. At Material Risk he details his observations from the world of commodity markets, economics, and investing.

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