The Outlook: February 2021 Economic Commentary

A company called GameStop has been in the news in recent weeks. What’s been going on?

The share price of GameStop – a struggling high street video game retailer – showed wild swings in January, rising from around US$19 at the start of the year to a peak of nearly US$348 on 27th January before falling back to current levels around US$50.1  This happened as a group of retail traders, collaborating via a Reddit forum called WallStreetBets, sought to drive the price higher. They did this by buying shares in the company and ‘squeezing’ institutional investors, such as the hedge fund Melvin Capital, which had made big bets that the GameStop share price would go down via a process known as ‘short selling’.2

What is ‘short selling’, and how does a ‘short squeeze’ work?

Short selling is when a trader seeks to make a profit from the fall in the price of an asset - in this case, the shares of GameStop.  A short seller pays a fee to borrow shares in the company from a broker, and then sells them in the market. If the company’s share price subsequently goes down, the short seller can then buy back the shares at a lower price, return them to the broker, and pocket the difference as profit.

The problem for the short seller comes if the share price rises rather than falls. For example, if a share is sold short at a price of US$10 per share, the maximum the short seller can make is US$10 per share (less fees) if its price goes to zero. However, if the share price rises, there is unlimited potential for losses. In our example, if the share price jumps to, say, US$30, the short seller would incur a loss of US$20 per share (i.e., 30-10). The higher the share price goes, the bigger the losses.

Faced with a rising share price, the short seller is forced to buy back the shares he/she has borrowed (a process known as ‘short covering’) before losses become unsustainable. In turn, this increased demand for the stock can push the price higher still, forcing other short sellers to cover their short positions. For a share that is heavily shorted – as was the case with GameStop – this cycle of buying can cause the price to spike sharply higher. By targeting a company where a large number of shares had been shorted, the WallStreetBets traders sought to instigate such a ‘short squeeze’, i.e., force short sellers to start buying GameStop shares, push the price up and realise a fat profit.

 

Have companies other than GameStop been targeted by these retail traders?

Reports suggest that shares in several other companies – including AMC Entertainment, Blackberry and Bed Bath and Beyond - have been targeted by WallStreetBets traders and experienced dramatic price swings.3 More broadly, the share prices of US companies that have been most heavily shorted have outperformed the broad equity market in recent months – a trend that has probably been helped by hedge funds reducing their short positions to reduce the risk of a ‘short squeeze’. One measure of the proportion of shares currently being shorted has recently fallen to a 20-year low.4

How can small retail traders have such a big impact on the price of individual shares? Is it right to see this saga as a ‘David and Goliath’ type battle between retail investors and hedge funds?

Although retail investors do not individually have the buying power of professional fund managers, recent events have demonstrated that a large number of small accounts can have an impact on an individual company’s share price, especially if that company has a relatively small market capitalisation. Retail trading volumes have risen since the onset of the pandemic, as people stuck at home and deprived of their regular pastimes have turned to day trading to while away the hours.5The advent of commission-free trading apps such as Robinhood has made access to markets cheaper and easier. Meanwhile, social media forums have facilitated the coordinated buying of individual stocks and so-called ‘swarming’ behaviour. Moreover, retail traders have become more sophisticated in the way they trade, with some leveraging up their bets by using derivatives, such as options.6

This said, it is doubtful that the recent volatility seen in some share prices has solely been down to the weight of retail money. There has been some evidence to suggest that institutional investors have been scouring message boards such as WallStreetBets and co-opting trade ideas.7 In this regard, the notion of a ‘David and Goliath’ type battle between retail investors and big institutions might not be entirely accurate.


Do short sellers perform a useful function? Could the exit of short sellers from the market have a downside?

Although some people see short selling as nefarious speculation that seeks to profit from a company’s troubled circumstances, there is evidence to suggest that it improves the process of price discovery and market efficiency i.e., the process by which the price of an asset reflects all available, relevant information. 8 Some observers describe short sellers as the investigative journalists of finance, who scour through company reports to unmask bad management and fraud.9

In this regard, it might be argued that the existence of short selling serves to keep markets ‘honest’. Indeed, in recent years short sellers played a key role in exposing scandals at Enron, Carillion and Wirecard. A high degree of short interest in a company can act as a warning to long-term investors and provide a check on valuations. Conversely, in the absence of short sellers, it might be easier for a company’s share price to become overvalued relative to fundamentals, thereby raising the risk of a sharp fall at some stage in the future. In light of these considerations, it is perhaps telling that as short sellers have exited the market in recent months and loose monetary policy has fuelled increased risk taking, the share prices of companies with weak balance sheets have outperformed.10

Taking this idea further, if share prices become divorced from reality, there is a risk that capital will be allocated less efficiently. One of the key tenets of capitalism is the idea of creative destruction: the notion that inefficient, unresponsive companies go out of business and are replaced by more efficient, dynamic ones. If market signals become less ‘honest’, and capital is allocated to ‘weak’ companies at the expense of ‘strong’ ones, then there is a risk that innovation and productivity will suffer, with negative repercussions for long-term economic growth.


Could the GameStop phenomenon cause broader financial instability?

Some of the volatility in global equity markets witnessed in late January was attributed to hedge funds reducing their market exposure following losses on their short positions.11 And yet, although some high-profile hedge funds took large hits from short squeezes in January, problems at individual businesses did not trigger a chain reaction of losses that threatened financial stability akin to those associated with the failure of Long-Term Capital Management (LTCM – a hedge fund) in 1998.

Although one can never rule out more serious disruption going forward, there is evidence to suggest that systems are being modified to reduce such risks. The ratings agency Fitch notes that banks, clearing houses, securities firms, and retail brokers have implemented risk management adjustments in recent weeks to mitigate counterparty risk, including raising margin requirements (i.e., limiting the use of borrowed funds for trading) and restricting certain types of trading strategies.12

While retail traders carry the potential to produce extreme volatility in the share prices of individual small-cap companies, their capacity to prompt broader market contagion appears limited. Barclays reckons that the value of shares for the most heavily shorted companies targeted by day traders amounts to less than 0.001% of the US$43 trillion stock market.13 Against this backdrop, the ‘GameStop phenomenon’ seems unlikely to shape the direction of the broad equity market in 2021 and its impact should remain localised. As regards the bigger picture, the dominant narrative in 2021 is likely to be that of broad-based reflation in the global economy based on the rollout of vaccination programmes and ongoing monetary and fiscal stimulus (see our commentary of December 2020).

16/02/2021