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The #Stonks Revolt of 2021

It was quite a choppy week as earnings announcements were overshadowed by a “mob” of retail investors moving markets in unexpected ways.  If we consider this year so far, it has been anything but boring.  As one commenter noted, the first Wednesday of January saw a group of protestors storm the Capitol.  The second Wednesday had the president impeached, while the third Wednesday was President Biden’s inauguration.  This, the fourth Wednesday of the month, saw a group of retail investors spurred on by a subreddit attempt to sink several large hedge funds. I can’t wait to see what next Wednesday holds.

Let’s start with the big news this week, namely the controversy brewing between hedge funds run by billionaires, and small retail investors. But before we dive into the events of this week, we need to look at the backdrop that precipitated this week’s happenings.

For many years now, hedge funds have employed short selling as a tactic to great effect. The premise is that you think the stock is either overvalued or, frankly, the company is going to go bankrupt. On the surface this it completely legal and some would even argue helps by adding liquidity to the market. However, it is hard to ignore the fact that some aim to manipulate the market by spreading misleading or false information about companies, to make huge sums of money when the stock price falls. Over the years, we’ve watched many hedge fund managers appear on CNBC to make their case why a company was overvalued. Sometimes they presented “research” which purported illegal activity, fraudulent financial statements, or generally non-public information that was detrimental to the company.

How these hedge funds achieved huge profits is by shorting stock positions, which means they sold stock which they did not own, with the intent of buying it back later at a lower price. In 2008, the SEC banned what it called “abusive naked short selling.” However, due to the many technicalities of the law, it remains difficult to prosecute. Due to this fact, the practice of naked short selling continues unabated. In some cases, as we saw this week, more shares of a company can be sold, than exist.  You can see how this might create a problem, right?  Not unlike the collapse of a Ponzi scheme, the clearing companies, custodians, and transfer agents need to prove to regulators that the shares exist.  In ordinary times, the short positions are closed out, meaning shares are bought back and everyone is happy.  But what happens if the price of the stock shoots up, not down. This brings us to what happened this week

Reddit is a popular platform among young, more liberally minded individuals. The platform has many “subreddits” which are essentially forums for people to discuss current issues and ideas. One such subreddit is r/wallstreetbets which decided it would take a little vigilante justice on the aforementioned hedge fund managers. The call went out to buy one of the most shorted stocks, GameStop. To be clear, the company is not a good investment and we would not suggest anyone run out and buy shares in it. However, given the law of supply and demand, as thousands of retail investors began buying shares of GameStop, the price skyrocketed. Other names that were targeted include Bed Bath & Beyond, and AMC Entertainment. In the case of GameStop, the price went from $40 a share to over $444 in just a few days. The hedge fund managers, needless to say, were put into a heck of a squeeze. They had to buy back shares to cover their positions but at increasingly higher prices. While it hasn’t been disclosed yet, for many of those hedge funds it meant losing billions of dollars.

For the first time in my thirty years in this industry, I saw hosts on CNBC lament share prices going up. What typically would be cause for celebration became cause for concern as these influential investors, that Wall Street had glorified, appeared to be losing terribly. We remain in the midst of this event and for now we don’t know how it will end. I suspect the gains in these, otherwise bad, investments will evaporate as quickly as they appeared, but the churn could continue for some time longer. There is another side of this story and that is the trading platform, Robinhood, that enabled these small investors to move the market in such a large way, and the controversy surrounding this same custodian shutting down trading at the height of the frenzy. You’ll have to wait for part two of this story, which I will write next week. There is more than meets the eye and I can’t wait to tell you the rest. Until then, now you know.

P.S. In internet slang, “stonks” is a deliberate misspelling of stocks, as traded in the stock market. It is often used to refer to such stocks—and finance more generally—in a humorous or ironic way, especially to comment on financial losses.

Bruce J. Mason, MBA