We thought we’d write a brief article today on 2 June 2021 to address the pattern of panic and plunder we have witnessed in the financial markets lately.
If you read good personal finance books, you’ll think of the stock market as a place to sit and invest for the long term in the hope of earning 5% – 8% per annum in returns.
It’s all about meme
However, a group of equities coined as ‘Meme stocks’ are seeing extreme price fluctuations which tear up the stat tables within corporate finance textbooks.
The share price of companies such as Gamestop and AMC are trading at eye-watering premiums to their underlying earnings. Their value becoming totally detached from the metrics you’d see listed in the best valuation books. Gamestop was trading at a share price of $4 in May 2020. However, it’s now trading between shareholders at over $250.
These changes in share price aren’t the result of a dramatically changing outlook for the business. Instead, they’re based on the viral fever of online retail investors, energetically swapping tips and trading onto the bandwagon on online investing forums.
As you can infer from the jump in share price, many traders have made a killing. Others have lost small fortunes. What began as a small punt with loose change, soon evolved into a more serious affair as online users began to write about the life-changing sums that they have staked in these meme stocks.
This bravado was applauded on the forums, but became toxic when during the first few days of February 2021 the share price fell by more than two thirds. The price has since recovered, but this has only provided solace to those who stubbornly held onto their almost-worthless shares for an entire month, as the rebound took weeks to take shape.
The downfall of the 1%
Hedge funds (See books) are believed to have lost $ billions of dollars on Gamestop, as several had taken large short positions against the companies stock before this mania kicked off. Gamestop is a highly shorted company, and in fact this formed the core part of the ‘investment case’ in the Reddit-fuelled buying frenzy of Gamestop shares.
The traders planned to pull off a ‘short squeeze‘. This is where intense buying power bids up the prices of shares, causing paper losses for highly leveraged short sellers who are eventually forced to either double-down or exit their position at a loss. The very act of exiting a short sale involves buying back shares on the open market – an activity which provides further upward momentum.
The Gamestop saga has played out somewhat like a digital version of David v Goliath, with many small retail traders teaming up to take down professional investors. If this sounds like market manipulation to you, you might be onto something. This type of activity is legally risky, particularly where individuals aggressively promote their strategy and encourage others to buy. This resembles the ‘pump and dump’ investment scam. Although the general vibe on Wallstbets is different, and users, in theory, are entering into trades with their eyes wide open, one cannot help visualise the intense squirming of officials within the SEC at this point in time.
Opportunities and challenges for stockbrokers
The UK investing apps and stockbrokers favoured by younger investors have had mixed success during this period of intense trading. The media storm has led to waves upon waves of new sign-ups, driven by young investors willing to stake a sum on this piece of action.
However, the sheer volume of trading in single security has lead to chaos behind the scenes. US-only broker Robinhood has suffered outages and has on occasion resorted to trading restrictions as its own back-office trading mechanisms simply couldn’t cope with the volume. Trading212 opted to close the doors to new investors in March 2021 which allowed it to focus on its existing client base. However, eToro (read our full review) has managed to maintain fairly reliable uptime in contrast, keeping the doors open to new customers, while only placing restrictions in very rare occasions.
A frightening indicator
Is this a bubble? A ‘bubble within a bubble’ might be the apt term, considering that these companies are rocketing upward as outliers within an already frothy market, particularly in the growth investing category. Interest rates at a decade-low, fiscal stimulus and household saving during the pandemic have turned up the heat on an already fully-valued market in the US, where P/E ratios of major equity indices no longer look healthy.
The best economics books will paint a useful picture of the business and financial cycles. If one wished to look for signs that we are approaching the type of a financial cycle, look no further than the mania surrounding Gamestop. That’s not to mention Cryptocurrencies.
Of course, if one is trading with free shares or money one can afford to lose then there is little lost in a small punt on an excitingly volatile asset. However, let us dispel any illusion that this is ‘investing’. It’s gambling, and the adrenaline pumping around the veins of the WallStBets board on Reddit is the same feeling felt by those in a casino or down by the racecourse.