GameStop: the war between Wall Street vs Main Street heats up

GameStop (NYSE: GME) shares suddenly hit reverse after several US trading platforms including Robinhood and Interactive Brokers banned buying shares in the video game retailer and a host of other shares being pushed on the subreddit forum WallStreetBets.

Effectively, that action removed many of the social media driven small investors who had taken GameStop shares up on a 1700% rally while allowing the hedge funds that had heavily shorted GameStop a much-needed chance to buy shares at a more reasonable price.

Battle between hedge funds and the little guys is far from over

Predictably, the price tanked but this trade is not over yet because so many small traders are involved and they will return, even if they need to sign up with alternative brokers.

It is important to note about what is happening with GameStop shares that this is no longer a battle being fought on proper valuation grounds but an all-out war between Wall Street hedge funds who have been caught out shorting shares too hard and face massive losses as small day traders and retail investors exploit the hedge fund’s extreme vulnerability by sending GameStop shares into the stratosphere.

If the US share market operator had stopped trade in these shares – which has happened numerous times due to extreme volatility – that is one thing, but if platforms suddenly tilt the table to advantage Wall Street, that is quite another.

There are probably some justifiable reasons for the platforms to stop this trade, although for small investors it sends a terrible message that the big guys are still in charge and stand ready to crush you if you make too much money.

Robinhood’s “tough” decision to stop buying for 13 shares

RobinHood in a statement described the decision to stop trades in 13 WallStreetBets stocks as “tough”, claiming that “as a brokerage firm, we have many financial requirements, including SEC net capital obligations and clearinghouse deposits.’’

However, for a firm that prides itself on “democratising finance for all’’, it looks more like stealing from the poor to give to the rich than a reasonable response to volatility.

Complicating that picture is the widespread claim of financial relationships between Robinhood and hedge fund Melvin Capital Management which was involved in shorting GameStop shares and lost plenty in that trade.

It is also mysterious that traders were free to sell GameStop shares but not to buy them – a trade direction that looks like it is specifically designed to help out short selling hedge funds.

Fundamental valuation disappeared a long time ago

It is true that the fundamental value of GameStop shares disappeared a long time ago but that is the nature of a short squeeze where the shares are being desperately pursued by hedge funds that went overboard on their short positions and an eager bunch of small investors who want to send a message that they will send the stock price in the opposite direction to teach them a multi-billion dollar lesson.

Reddit traders had better information

In share market trading there are two really precious commodities – money and information.

What these Reddit traders had was better information – in this case about both the prospects for GameStop and the short positions held by the hedge funds.

Individually, they didn’t have much money but together as a group of four million they had more than enough money to make a big difference and set up a memorable short squeeze.

To the extent that their better information and resources have been stymied by online platforms is a regrettable situation that sends a terrible signal, particularly to younger investors.

It might take them days to set up on rival platforms, by which time their information advantage will be over.

Revenge of the nerds will be good for share markets

However, as a whole, I think the GameStop short squeeze and associated moves on AMC, Blackberry, American Airlines and many other companies is fantastic news for the share market and the financial system in general.

Granted, some of these small investors will make millions and others will lose their shirts depending on when they invested but in the process they will have learned some really valuable lessons about volatility, when to take profits, how to identify trades and how to spot and follow market trends.

These are all essential lessons for the future and it can only be good to see many young investors keen to try to create investment profits on the share market.

They are also a bigger force than many imagine with Swiss bank UBS claiming that online trading packs represented up to 20% of share orders last year.

Hopefully the big hedge funds that are down billions of dollars have also learned a lesson – that you can’t go around manufacturing cash by shorting shares without accounting for the risk of investors waking up and exposing the risk of going short.

It seems likely that the days of easy shorts are coming to an end, which is good news, given that the whole rationale for allowing short trading is to promote good price discovery.

If a company is shorted because it is overvalued or set for lower profits, that is one thing but if it is targeted simply because it is vulnerable and management will find it difficult to respond, that is quite another.

Hedge funds need to be more careful short selling

It is hard to feel sorry for hedge funds that profit from share prices falling if the companies involved and small investors decide to fight back and instead of trashing the company talk up its prospects.

It is also worth remembering that there is always more money to be made in buying good companies and holding on to them for the long term than there is in picking losing stocks and shorting them.

That is because long term investing can actually create value through actual growth while options and futures trading only results in the transfer of cash from one party to another.

There are severe risks in shorting as this squeeze has proved and there is much to be said for going long which can see you multiply your original investment – albeit, nowhere near as fast as the GameStop squeeze allowed.

Markets need to be open, transparent and fair no matter the size of the participant and hopefully that will continue to be the case here in Australia and also in the world’s largest share market, the US.

President Biden being drawn into the fight

The trading turmoil has also created a big political reaction with President Joe Biden’s economic team – including Treasury Secretary Janet Yellen on her first full day on the job – saying they are “monitoring the situation”.

Massachusetts state regulator William Galvin called on NYSE to suspend trading in GameStop for 30 days to allow a cooling-off period – an action that would most likely help the hedge funds.

Complicating the regulatory response is the fact that the ultra-loose monetary policy being pursued by the Federal Reserve is arguably propping up many more zombie companies than anything the WallStreetBets crowd could ever hope to achieve.

Democrats and Republicans finally unite?

Progressive Democrat Representative Alexandria Ocasio-Cortez criticised the trading curbs imposed by Robinhood and other platforms, saying the restrictions on high-flying stocks demands closer scrutiny from US regulators and Congress.

The New York Democrat, a member of the House Financial Services Committee, said in a series of tweets that she would favour holding hearings on restrictions affecting stocks such as the video-game retailer GameStop, which fell as much as 68% after the curbs were first imposed.

“This is unacceptable,” Ocasio-Cortez said in a tweet.

“We now need to know more about @RobinhoodApp’s decision to block retail investors from purchasing stock while hedge funds are freely able to trade the stock as they see fit.”

Her comments were backed by Senate Republican Ted Cruz, who retweeted her post minutes later, adding “Fully agree.”