A signpost for a permanent change in the operations of financial markets, or is it just another footnote in the absurd history of social media’s growing influence on our daily lives?
The fascinating events of the last week over in the United States, where an online mob were able to shake out shorts on a bricks and mortar computer game retailer, have caught the imagination of journalists and practitioners alike.
We will argue that this is more a harbinger of things to come, a world in which, information is disseminated instantly, and private armies are mobilised on digital platforms. This world will be absolutely a lot tougher for short sellers, and investors with short investment horizons; it will however, provide ample opportunities as capital misallocation, and security mis-pricing are left in its wake. Modern markets have just become a lot tougher for investors with short time horizons, however in the long term patience, diversification and process will be more rewarded than ever.
The stock closed out 2020 on a tepid $18.84 USD share price. This already represented a 500% rally of COVID lows back in April of around $3. The turn of the year however, saw this rally accelerate sharply, with the stock peaking out at over $465 USD (!) at 10am on the 28th of January.
Figure 1 below: Gamestop share price in 2021 (Source: Refinitiv Eikon)
Let’s put the stock price in a 20 year context.
Prior to this breathtaking rally of 1800% in a matter of days, Gamestop’s peak share price was a touch over $60 back in 2006.
Figure 2 below: Gamestop share price over 20 years, currently at all time highs! (Source: Refinitiv Eikon)
Over the same period, Gamestop has seen a structural decline in revenues, as shoppers gravitate towards downloading titles, a stubbornly high cost base, declining margins, despite cutting full time staff almost in half since the peak in 2017.
Figure 3 below: Gamestop Revenues over 20 years, in structural decline (Source: Refinitiv Eikon)
Figure 4 below: Net Income Before Extraordinary Items over 20 years, now loss making (Source: Refinitiv Eikon)
In our view, there can be no fundamental valuation for this stock to warrant a $460 share price.
So, if its not fundamentals driving the stock, then what on earth is going on?
Perhaps its no surprise that the behaviour we have seen so regularly in the political arena would inevitably find its way to financial markets.
The ability to mobilise a private army online, in aid of a cause, has been a common feature of recent years. In this case, the recipe for revolt was, on the one hand driven by a hatred of institutional finance and hedge funds in the US in particular, on the other hand driven by nostalgia for the bricks and mortar retail landscape that struggled particularly in 2020 in the face of lockdowns. Throw in a large dose of boredom and copious amounts of fiscal stimulus.
The private armies are far from naïve of course. The battlelines are clear – regulatory filings provide a day to day perspective on enemy positions. The retreat from the hedge fund community, largely short the name for all the above reasons in the previous paragraph, has exacerbated the mania.
But that’s not all. Throw in in addition a large dose of call options, the risk of which accentuates as the stock rallies, forcing brokers to cover risk, has accelerated the rally.
The private army has effectively achieved what hedge funds have been doing for years, exploiting other participants unique situations for short term profit, by organising, and mobilising on Reddit.
Regulation the Answer?
In short, no. Regulation can assist in the short term, but long term is doomed to fail. The internet will always find method to mobilise private armies, regardless of platform. It is simply too sprawling to regulate effectively. This behaviour is here to stay.
Gravity Always Wins
There are a number of repercussions for markets.
The most prominent impact is on the aggregate behaviours that drive markets and prices in the short term.
It is often said that the financial markets are a giant voting machine, where agents cast preferences based on company prospects of future cashflows.
While this model of participant behaviour still holds over the long term, in the short term there are numerous motivations for trading stocks, beyond just maximising returns.
The most prominent motivation for trading this week has been risk mitigation, specifically short sellers and stockbrokers minimising losses. Short sellers are forced to cover positions, driven by internal risk managers and stop loss rules, and stockbrokers are forced to manage risks associated by the triggering of call options, the writing of which have been at highs not seen since the tech bubble.
These motivations for trading are so dominant in these specific companies that the long term picture on Gamestop’s cashflows are rendered entirely irrelevant. Long term, however, gravity always wins, and there is no question in our minds that Gamestop’s share price will eventually return to something like the $40 target price bandied around by many fundamental analysts.
Whither Concentrated Fundamental Long Short Equity Managers
We have argued that; in the long term fundamentals matter, but in the short term, competing motivations for trading can drive wild fluctuations away from this distant fair value. This narrative has amplified in recent years as a growing proportion of the market liquidity is driven by non-fundamental agents, whether a Reddit army, Artificial Intelligence, or passive/systematic.
This increasingly makes the environment for concentrated long-short fundamental equity strategies toxic. Unless the portfolio is sufficiently diversified, these wild stock price swings inevitably have the potential to drive significant losses, which reverberate through the portfolio. Remember that losses on Gamestop have triggered a broader cutting of short positions across the board, beyond the US market, with a number of highly shorted Australian listed names rallying as the inevitable hedge fund unwind gathered pace.
But all is not lost for long short managers – however, they will require, firstly, more patience from their investors, which will need to ride difficult periods, greater diversification, as stock specific volatility in heavily shorted names is amplified through the roof, and an awareness of these special situations beyond the institutional or corporate players and into the realm of retail private armies that are now to be considered serious players in financial markets on short investment horizons.
Resonant Asset Management Pty Ltd, ABN 41 619 513 076, AFSL No 511759.
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