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How the GameStop Trading Surge Will Transform Wall Street

7 minute read
Karabell is an author, investor, and commentator. His latest book is Inside Money: Brown Brothers Harriman and the American Way of Power.

For years, professional money managers and hedge funds have tsk-tsked about individual investors. They have dismissed them as “dumb money” and cautioned that so-called “retail” investors lack the acumen and experience to make the right calls and weather the inevitable storms. That has often been the case, but then came the GameStop phenomenon, when a tsunami of that so-called dumb money flooded parts of the stock market, leaving Wall Street professionals not just scratching their heads but a few of them badly wounded. And while this might be an anomaly, it more likely is the first rumbling of what will prove to be a radical transformation of money and markets.

In less than a week, shares of the company GameStop rose more than seventeen-fold by the end of trading on January 27 after its prospects were touted two weeks ago on a Reddit sub-group called r/wallstreetbets that has several million subscribers. GameStop, a retail chain that started as a hub for video games and has struggled mightily in an era of COVID-19 and streaming, was a much reviled stock until a few days ago, and was heavily bet against by Wall Street pros who stood to make money as the stock went down. When funds bet against a company, however, they become vulnerable when the stock goes up rapidly, forcing them to “cover their shorts” (buy back the stock that they had sold on credit assuming it would go down) which in worst-case scenarios can result in losses just as substantial as those faced by someone owning stocks when markets plunge as they did in March of 2020 or in late 2008 into 2009.

This time, however, it wasn’t the professional managers who profited while retail investors suffered, though for sure some pros have been jumping on – and off – the momentum bandwagon with good results. On Thursday alone, the stock was up 20% and then down as much as 40% by day’s end. But most striking is how those “amateur” investors flocking to a widely read social media message board orchestrated a massive take-down of several marquee hedge funds while profiting hugely in a matter of hours.

Not only are Wall Street players aghast with one pro saying that the moves were “unnatural, insane and dangerous,” but the surge in GameStop from less than $2 billion in market cap to more than $24 billion in a such a short time got the attention of regulators. The Attorney General of Massachusetts William Galvin said he was looking into the matter and called for a halt in GameStop trading, and the White House press secretary said that the administration was concerned about market integrity.

The blow-back against that was swift. On Reddit, one participant summed it up, “So market manipulation by federal pumping $ into falling banks & corporation is OK but Reddit users rallying GameStop is wrong and must be regulated…Funny how quickly the financial press cries for hedge funds.”

What happened in the past few days on Wall Street is akin to what happened in Britain when voters chose Brexit and in the United States when Trump was elected: a mass of people, angry at the privileged few and feeling that the system was rigged to reward the elite and screw everyone else, coalesced into a potent phalanx that upended a status-quo. And, in similar fashion, the elites being challenged were caught off guard by the suddenness and intensity and responded by denouncing those forces as misguided, misled and destructive.

Whatever the political merits of those movements, as applied to Wall Street, the masses have revealed some uncomfortable truths about the investing world: anyone can play, and yes, retail investors have made money, as have pension funds and foundations. Even so, the most excessive profits have largely gone to a few thousand hedge funds, private equity executives, professional investors and their rich clients. That creates its own clubby inefficiencies and unexamined corruption. Before this run, the bets against GameStop exceeded the entire capitalization of GameStop by 50%, which meant that a few funds stood to make more money from the collapse of GameStop than GameStop shareholders could lose. To put it more simply, if you owned $100 of GameStop and the company went bankrupt, you could lose a $100. But those funds could make $200 in the process from the same shares. If that math seems wacky, it is, but leverage, arcane financial instruments and access to those by only a few is what makes it possible.

Those Reddit boards identified that, not just in GameStop but in multiple other stocks, and they recognized that if a whole bunch of people started a buying frenzy, those institutions would lose billions while tens of thousands of small investors could reap the rewards. That is precisely what has happened.

Add to that the fact that the funds are betting on a company’s failing profit when stores close and jobs evaporate. That’s long been defended as a necessary facet of dynamic capitalism, that weaker companies are forced by markets to change or die and that in the end, it is healthier for society overall if zombie companies can’t survive endlessly. There may be some truth in that writ large, but the sight of a few centi-millionaires or billionaire funds pocketing profits while retail chains collapse in the midst of pandemic makes it unpalatable, to say the least. On the message boards fueling the GameStop run, there was no shortage of outrage at those attitudes. “When hedge funds and others loot our markets it’s all good,” said one, “but when retail investors destroy a hedge fund, all of a sudden analysts are calling for regulation.”

The current of rage and nihilism that fueled some of this bidding up of companies that have been teetering – another beneficiary this week was nearly bankrupt movie chain AMC – is a volatile force that can wreak havoc no doubt. Populist anger in politics can lead to reform, but it can also lead to demagoguery and the erosion of trust and democracy. Retail investors flexing their muscle, empowered by social media and by new trading apps such as Robinhood, can be a comeuppance for complacent and arrogant financial elites but also an ornery genie freed from a bottle with no intention of going back in or playing by any rules. As if to prove that the system appears rigged against the average investor, Robinhood proceeded on January 28 to halt trading of GameStop and AMC and several other companies that appeared to be the target of the Reddit mob, which sent the shares of those companies down sharply.

It’s right to be a tad worried when new forces are unleashed: splitting the atom can electrify a city or destroy it. But what we’ve seen on Wall Street is a surge unlike any other before it: the volatile emergence of individual investors, not rich, not privileged, not professional but with the keen wisdom of the crowds able to spot an opportunity and ride it. It’s best not to tut-tut the quicksilver power on display. It’s vital to respect it, to be humble in the face of it, and to start adjusting to the democratization of the markets.

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