While I’m No Fan Of Fat Cat Hedge Fund Managers, I’m Also No Fan Of Poking A Stick In The Eye Of The U.S. Economy

Image from GameStop’s corporate website also kind of describes what’s going on

There may be more real danger than we realize in the trading scheme that’s been dominating the stock market for the past little while…

Most stories I’ve seen are treating day-traders sending GameStop and other stocks and options soaring like a fun pastime during COVID-19, which somehow really took off and took on a life of its own. And continues to gain traction as it combines trolling with potentially huge profits for small investors. 

I’m not ready to brace for economic collapse, but I think we should take it a bit more seriously than that. After all, the Dow Jones Industrial Average just had its biggest single day loss in months.

What’s happening, as simply as I can express it, is bunches of investors are finding each other online and teaming together to buy up stock and options in companies that are the biggest targets of short-sellers. Doesn’t sound bad, and mostly it maybe isn’t. And I’ll explain what short-selling is in a sec.

Because those stocks are usually cheap, and not that widely traded, their prices are soaring due to lack of supply created by more and more people buying, and even more piling on and buying on top of them. Since the people or funds that hold the short positions have promised to buy back the stock at some point, and since their potential loss is unlimited, they now are being forced to sell blue chip stocks they own in order to raise cash to buy back the stocks they’ve shorted, in an attempt to stop the bleeding. And of course that makes the stock price go up even more.

This is going on right now with many stocks. The prime example of which is GameStop. It was at just over $17 a share earlier this month. A year ago it was around $3. This Wednesday it went to $380.

Thing is, no one’s really buying GameStop right now because they think it suddenly has great potential as a company. And the fast and furious buying does nothing to help ensure GameStop’s future success as a company; might even hurt it if it goes on for too long. (Except maybe by enriching some of the company’s executives beyond their expectations, if they’re selling whatever stock they own right now, which they should be.) 

But is what’s happening manipulation? I don’t know. On the one hand, there’s nothing illegal about lots of people buying a stock or telling you to buy a stock, as many people are pointing out today on Twitter, Reddit and elsewhere. On the other hand the sole reason lots of people seem to be buying it or telling people to buy it is to manipulate its price. So how is that not manipulation? Which seems not totally OK. Even if you justify it by saying it’s to screw over hedge fund managers.

Because if it ended there, I’d agree. But it doesn’t. Not necessarily, but eventually this scheme has the potential to screw over everybody. Including a large percentage of the people who are doing it.

Short-selling involves selling a stock you don’t own, with the expectation that you’ll be able to buy it back in the future at a lower price. So you’re betting the price of a stock will go down.

What happens when you sell a stock short? Immediately, you get paid. Because you just sold something. Even though you don’t own it. Which is weird. But you’re also promising you will buy it back at some point. 

So to sum up, when you sell a stock short, you don’t get any stock, you get cash. But in exchange for that cash, you must promise to buy that stock back, with cash, at some indeterminate amount of time later.

Selling stock short is considered extremely risky. Why? Because when you buy a stock, the most you can lose is 100% of your investment. If you buy a stock for $100, and it goes down to $0, that’s what you’ve lost: 100%. But when you sell a stock short, and it goes up, not down, your potential loss is unlimited. So if the stock you short at $100 goes up to $200, you’ve already lost 100%, because it would cost you 100% more to then buy it back. But what if it goes up to $500? Or $1000? Or infinity? You could be wiped out.

So why would anyone short any stock in the first place? Hedge funds often try to identify companies that are in trouble, and then short them in order to try to ride the stock down to zero. Is this a “noble” thing to do? No. Nobody likes you at the craps table either if you’re betting against the shooter; the person rolling the dice. But there’s almost always someone at the table doing that. And they can, because it’s part of the rules.

Still, there are tons of restrictions on how stocks can be shorted, and there probably will be even more after this. But there are few restrictions on buying stocks that are short-seller favorites, mainly because in most circumstances doing so in large volume would be stupid.

So why would a stock in an ailing company that doesn’t seem to have updated major parts of its website since last July, be worth anything at all in the first place, giving these hedge funds room to short? Some of it has to do with the popularity of index funds or ETFs, which buy the whole market, or whole sectors of the market. So in some cases, index funds are buying these stocks, not because they’re good buys, but because their purpose is to buy the whole market, or the stocks in some index or sector they’re trying to replicate.

At the same time, as hedge funds sell blue chips in order to raise funds to cancel our their short positions in GameStop, AMC and others, those same ETFs also have to start selling, because again their objective is to match what’s happening to whatever index or sector they’re tracking. So that puts even more pressure on the market as a whole.

I’m not saying yesterday’s market plunge, or even a continued rout is just because some hedge fund managers are being forced by some internet investors to sell some stocks. The stock market has been way, way too high for a long time. No way it should’ve ever risen above pre-COVID-19 levels. So it is long overdue for a big drop. And if that happens, maybe it would’ve happened anyway. But having that decline triggered by a bunch of people acting in an unprecedentedly disruptive way is worse than if it had been triggered by a bad earnings report or something. Because it makes it look like the U.S. cannot stabilize its own financial markets. Which is part of the whole point of the people doing the trades, in addition to making money.

The big problem right now isn’t that hedge funds are losing lots of money because they’re being forced to sell long positions in solid stocks they own, in order to pay the crazy high prices at which they now have to buy back the stocks they shorted. Perhaps this activity will lead to some hedge funds going under. Yay. For most financial companies, while it certainly won’t help them, it might not end up being the blow a lot of people we see on Twitter and Reddit today seem to think it is: they’re making good profits on the stocks they may now sell, so even though some of them will have to pay ridiculously to cover shorts, many of them are still playing with house money.

For the “average” investor, it’s creating instability at an already incredibly unstable time. And whatever you want to call it, the present day wildness may not be able to balance itself out easily.  Yes, there’s some sense that soaring short-target stocks leading to an artificially-triggered plunge in blue chips is a crazy, but temporary show of force. And will not involve—like so many things these days—a race against time to head off an acceleration of real damage to the economy as a whole. And everybody.

Is what we’re seeing a potent enough disruption to the stock market to have real negative lasting impact on the real economy? And real people? 

I can see why it’s tempting to see the action over the last couple of days as revenge on greedy hedge fund managers. Because it’s really putting their balls in a vise. But it goes beyond that, to the point at which this may end up being as much a political story as economic. Or more. Many internet voices saying things like the “capitalist class” alone should not be able to manipulate the market and profit from it; the “working man” should too!

As true as that may be in the short term, the people who are going to make the most money off this scheme are still going to be the people who can afford to take the most risk: that is, rich people. Elon Musk, seems like (or at least he’s egging it on)… Another example: Chamath Palihapitiya, known as a rule-skirter and market maverick. And already a billionaire according to Business Insider. What’s his advantage, since this scheme doesn’t seem to have been his idea, and he’s just jumping on the bandwagon like everybody else? He already has a ton of money to pump in.

Best I can tell, based on his own Tweets, he bought about $125,000 in options Tuesday. They would be worth more than $1-million to him if he still owned them at the end of Wednesday. That means every $5,000 turned to $40,000 in 24 hours or so. That’s crazy. So, many smaller investors may be thrilled he’s along for the ride. And even happy to carry him along on to inflate their own windfalls. I get it. 

Still, so far, at least as far as we know, his gain is only on paper. At some point, he’ll decide to unwind, and others like him will get out too. They have to in order to actually cash in on this. And as always, it’ll be the “little guy” left holding the bag. 

Maybe they won’t all care. Because this doesn’t seem to be just about money but also power and proving a point and they will have proved it. And will move on, victorious, to the next thing. OK.

And if the people participating are mostly the same ones who are ultimately going to get screwed, is this something that really needs to be prevented or slowed down?

The answer to that lies maybe in another question: how many other working people will end up being collateral damage? And I don’t only mean those who are among the eager investors. Just regular people minding their own business. With the wealthy ready to swoop in anyway at the end to pick up the pieces.

Just like always.