The Big Short (Squeeze)

On February 1, 2021, in Past Morning Briefs, by David

I first learned about the “short squeeze” while following the machinations of Tesla stock. Despite the occasional babblings of Elon Musk, Tesla makes a fairly excellent automobile, and I was shocked by the level of rancor online opposing everything to do with Tesla, electric cars, Elon Musk, etc., by what are often referred to as ICE-lovers (fans of Internal Combustion Engine vehicles). Those proclaiming loudly and proudly that they were short Tesla would predict the stock would go to $0 soon from whatever price it was at, and Tesla Shorts would be the richer for it.

Having looked at investing as a way to support and promote businesses and ideas I liked, not so much as a way to bet against companies or stocks I didn’t, shorting never really appealed to me, although it’s important to understand how it works. Happy to try to explain it to you, and you will find plenty of great videos on YouTube breaking down shorts and options. Perhaps it makes sense to allow bets on both sides of the fence, so to speak, although some markets ban shorting stocks at times of volatility. Whether or not short bans work is another story.

By the time I noticed the anti-Tesla sentiment, middle of 2019, Tesla stock was around $200 a share. Tesla was the most shorted stock in the world for most of 2020. Tesla shorts lost over $40 billion last year (more than the next 10 top shorted stocks combined) betting against a stock that rose from $200 to $1000, split, then propelled by short interest skyrocketed to $4500 last month. Split adjusted, that $200 share of stock is now worth almost $4000. That’s called a 20-banger (20x price increase).

Without the persistent, angry, even self-righteous shorting of the stock, and the unwillingness of shorts (who believed, and still believe, Tesla will come back to earth) to throw in the towel – even as Tesla executed on its business strategy – I don’t think the stock could have ever attained such heights. But it did, and it’s living proof of the incredibly timely adage:

The Market Can Remain Irrational Longer Than You Can Remain Solvent.

If that saying was a song, it would have been Number 1 with a bullet last week. Maybe this week, too. As a rag-tag crew of discussion board compadres pooled resources to improbably elevate GameStop stock to levels well above what just about anyone would find mathematically and economically viable. But it happened. Propelled by a short squeeze utilizing the legal if questionable market behaviors of shorts against them, squeezing the price higher and forcing many aggressive short sellers to close (or pretend to close) positions to cap their losses.

This is the point where, if you want to understand more about shorting, it would be a great idea to do a video primer on the topic. Or feel free to do it later and just go with it, as hopefully some of my soon to be rendered analogies will make up for skipping past the breakdown.

GameStop stock last hit its all-time high of $62.30 in 2007. Based on post-pandemic optimism, GameStop rose from $3.80 in July 2020 to $20 on January 12, 2021. At that point, GameStop shorts elected to bet against a sputtering company at a difficult time, with a ceiling of $20 max to be won on each shorted share.

GameStop 20 Year Chart

When a stock is shorted, the most to be made per share is the difference between the shorted price of the stock and $0. By comparison, when a shorted stock rises, the maximum amount of money that can be lost per share is infinity. There is no ceiling when a shorted stock skyrockets. Given demand, market conditions, short volume, and much, much more, the price of the stock can rise as high asthe market will take it. And because, at some point, shorts must “close out” their position in the stock buy purchasing the shares, they are on the hook for every dollar of that elevated price.

That means hedge fund managers bet they could make up to $20 per share, while risking a loss of infinity dollars on each one. Infinity being more than, say, $27,203,384,382,989, the current National Debt as I write. When you look at it that way, kind of a risky bet. Though, to the hedge funds and other shorts, it looked like easy money: betting against a beaten down company that loses $4.22 per share, nearing the end of its lifecycle. Then the cavalry stepped in.

And by cavalry, I mean people. People decided to invest their money in GameStop. Yes, they had the advantage of knowing it was, by then, the most shorted stock in the market. And yes, there may have been some “premeditation” or strategic combining of resources to push price demand higher in hopes of a short squeeze on the stock. On that surface, nothing at all seems in any way illegal, or even unethical, about it. Certainly nothing remotely close to some of the predatory practices hedge funds use against stocks and the rest of us all the time.

There are approximately 69.5 million shares of GameStop stock outstanding. It takes more than a few people buying a handful of shares to move the price from $20 to $483, where it went on Thursday. With momentum and motivated buyers on its side, a solid slot atop the news cycle, a ton of short interest against it, and, my guess, even more new short bets and active shorts believing they can weather the storm, the stock still sits improbably at $325, and it’s anyone’s guess where it will go next.

You’d think, and this is me speaking from my experience, this type of hand-burned-on-a-hot-stove experience would serve as a lesson to future shorts, hedge funds, and hopefully even retail investors to factor in such risks in the future. If we weren’t living in a country and a time so completely hell-bent against the principle of “learning from our mistakes.”

As historians well know, one factor accelerating the Great Depression was “investing on the margin,” or gambling with borrowed money. That idea is part of the story here, as short interest in GameStop amounted to 140% of the float. Thus the number of shares short sellers were gambling on were 40% more than the total shares in the entire company. And you don’t have to buy the shares now, only when the options expire. So now that shorts are under water, to close their positions they are competing to buy fewer shares than are available to buy in the open market. Demand squeeze. Price zooms higher.

Now people want to know if this is a good time to get into the market and buy these booming, highly shorted stocks. With stocks like GameStop moving up 2400% in two weeks, it seems like everyone’s winning the lottery. The stock market is about managing risk, betting your insight about one stock or business succeeding is as good as or better than everyone else’s.

The way it usually works is, the people who get in early make the biggest gains. And the late comers have less to gain, or even wind up “holding the bag.” Which, as you can guess, isn’t good. And there’s no way to know if GameStop is on its way to $1000 a share, back to $20 or lower. Maybe “the next GameStop” will be born this week, month or year in AMC, Bed Bath and Beyond, Nokia, BlackBerry, the silver commodities trade, or ???, here are a few things to consider before you jump into the fray:

(Please read each recommendation below with the precursor, I believe…)

  1. The best investments are made from a combination of understanding, legitimate insight and conviction in a strategy, idea or business. Go with what you know.
  2. The stock market is not a toy. Real money is made and lost every day. It’s in everyone’s best interest when people place investments with sensibility and sobriety.
  3. No one knows where the stock market will go tomorrow, the next day, the near short term, or the long term. If they do, they either really know their shit, or they have inside information, which isn’t legal.
  4. The most reliable way to make money is to earn it. Get paid for your hard work, selling a great product or service, owning an income-generating entity. Markets work in abstract, not fully dependent on conventional applications of math, logic, or even economics.
  5. If you are intrigued or excited by the recent developments in the market, let it be an incentive to start reading up on principles, researching businesses and markets, doing a deep dive on how things work so you understand well enough to find the rational in what seems irrational or even magical. Knowledge is the best place to start.

When I was a kid, I would listen to politicians speak, or the nightly news, and marvel at how complicated everything seemed. The word vomit, the run-on sentences, the jargon. Then I embarked upon a life-long journey of de-coding words, politics, economics, the media, the arts and more, and I realized almost everything can be understood if you take the time to listen or read, re-listen or re-read. If necessary, if you don’t understand it, look it up. And you still don’t get it, chances are you need to do a little more digging, or else, and this is always a possibility, it’s bullshit. Bullshit will always be more or less at play in public and private discourse. So, caveat emptor. Buyer beware.

That’s the advice I’d give to hedge funds right now – think twice before going short. Think twice Citadel and Robinhood before re-rigging the game against retail investors pumping GameStop, Koss, Bitcoin and more into bubbles of optimism and short-term gains. No one forced you to bet Don’t Pass. Billionaire investor Lee Cooperman, whined on CNBC about Reddit traders using stimulus checks to hammer GameStop shorts. Mr. Cooperman wasn’t whining when the government bailed out mortgage bankers who blew up the economy with credit default swaps, or when many of those responsible for the 2008 meltdown had their bonuses paid by the government, aka, the rest of us. What is the white, male, billionaire equivalent of a Karen?

We’ll know soon enough whether events of last week are a blip or a trend. It will take much longer to see if this was a real correction in the balance of power, and/or an historic misappropriation of capital. Or something else we haven’t thought of yet. Ideas are being floated to help stranded hedge funds salvage underwater positions. Affected companies like GameStop would offer private sales of shares to funds in exchange for financing or retiring some of the company’s debt. This would, in theory, allow hedge funds to close their short positions for far less than the market rate. A helpful trade-off for hedgers, but seemingly quite unethical, unfair, and dilutive to current stockholders and retail traders.

Hopefully, because there’s always hope, this could turn out to be a Robin Hood / Now You See Me moment of market power redistribution. Like the end of Field of Dreams when cars line up to hand over their $20. There’s no reason it can’t be a learning experience for the hedge funds, who at times can bully an otherwise beaten down entity past the point of fairness, often being quite nasty about it.

Retail investors continue to learn the power of their collective dollars (i.e., votes). Legislators, can add market machinations and the logic of allowing short volume to reach 140% of a stock’s outstanding shares to government’s need to understand, manage and monitor high tech, social media, privatization, and socioeconomics. These disciplines have powers that can reach infinity left unconstrained.

Or we can be a world where no one learns from anything, caught in a Churchillian loop (or George Santayana, if you prefer) of History Repeating.

It’s up to us. Hope we choose wisely.

 

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