It’s seldom that anything this interesting happens. Web postings by small investors triggered a price rally which got a major hedge fund into trouble and caused it to lose 50% of its assets. This event will have wide-ranging consequences. But it’s important to note that the markets learn and adjust very quickly.
Predatory traders are investors who pick shares or other investment instruments as targets whose current holders may end up in a short squeeze. Since reportedly 130% of Gamestop’s capital stock had been shorted – i.e., in numbers exceeding the actual amount of shares – short sellers were compelled to quickly buy back shares as the price increased. This fuelled the price rally even further.
Gamestop is a bubble
First of all, it is important to note that when the price of Gamestop’s share exceeded USD 300, twenty times its normal level, we’re talking about a bubble. Sooner or later, market correction will bring the price down, one way or another. At the same time, the share price of other companies targeted by predatory traders, such as Nokia, did not increase permanently or to such an extent that it would matter.
Even so, the Gamestop bubble is a rational one. If it appears that the share price starts sky-rocketing, it makes sense to join the party. However, the degree of complexity increases as the price keeps soaring. Some buy the shares too late at too high a price. Before long, they will suffer losses.
Market corrections set things right
An important lesson to be drawn from these developments is that share prices will self-correct automatically. Investors faced with a crisis learn quickly. All hedge funds and other similar investors have taken prompt action to reduce their risks. Small investors, who will suffer as a result of this bubble, will think twice before joining another rally. Other predators, a notch more sophisticated than the original ones, are already prowling the grounds. This will eat into the profits.
Disquieting indications
There are a number of features about the Gamestop bubble that are disquieting. The biggest concern is its potential to undermine financial stability. If short selling is allowed to be stretched too close to the limit relative to the size of the company, the liquidity of the share, the size of the fund, or a multitude of other circumstances, overall financial stability may be jeopardised. The fact is that even if the markets correct the situation, there may always be someone who misjudges the scale. A snowball effect may be triggered very easily. Additionally, security brokers are in a tight spot.
This is nothing new. Similar situations threatening financial stability have occurred earlier in the investment markets, such as in the LTCM crisis in 1998 and during the period preceding the financial crisis and various stock market crashes. The threats served as kindling for the crises.
Strange features
Typical to these developments was the mixed objectives of the investors. Usually, investors seek profit. Things don’t always work out, and not for everyone at all times. However, many succeed in this fairly frequently. Profit-seeking is the engine that ensures the reasonable functioning of the market as well as sound price formation.
One strange feature was a sort of hatred. Hate speech pitting small investors against big ones created a David-and-Goliath situation. Some even mentioned anarchy. However, hate is a concept alien to investing.
Both oddities – lack of pure profit-seeking and the emergence of hate – are forces for which there is no room in the marketplace. Both may lead to losses that erode the capital and drain strength. Such features are extremely unbecoming for a private investor, let alone an institutional investor. Gamestop investment was for many only a game.
In conclusion
The Gamestop phenomenon is a bubble. Some will gain and some lose, as always when it comes to investing. Wounds will heal quickly in the marketplace and many will readjust their risk levels. However, the features affecting financial stability will come under closer scrutiny. The phenomenon serves as a sound reminder of the vulnerability of the financial system, and that’s why it should be investigated.
The writer is VER's CEO Timo Löyttyniemi.
