"There is nothing more risky than the widespread perception that there is no risk" (Howard Marks).
For this reason, the GameStop case is destined to make history. A social phenomenon, even more than a financial one, that between 2020 and 2021 has become a mainstream issue and on everyone's lips, experts or not. At the beginning of 2020, after a long descent, GameStop's share price was around 4$ and was the most sold short on Wall Street. Company unable to generate profits since 2015 and anchored to a business model now in the twilight of its best days, the historic Texan reality, which with its stores has accompanied entire generations of fans of the gaming scene, no longer seemed able to give us great emotions. In our world, however, sometimes rationality falters, and so in January 2021 GameStop's stock rose by 1844% in a few days, reaching the price of $347, but then, predictably, collapsed again and then experienced a new growth in March, confirming the high volatility of the stock following the events of January. What has happened? Who is responsible? What are the consequences? What does the future hold for us? Let's find out together by analyzing the phenomenon a few months later.
Gordon Gekko in the famous movie "Wall Street" claid "greed is good".
The army of retail investors who have flocked to GameStop stock must have taken Gekko's famous quote particularly seriously. But you know, where populism, social media and cheap money combine, interesting things always happen..
Let's start by defining the typical profile of the retail investor. We are talking about savers - including companies, corporations or other entities - who do not qualify as professional clients. They usually have small amounts of money to invest and a rough knowledge of the financial markets. They often turn to specific intermediaries looking for the best combination of cost/availability of securities.
In this case, aided by brokers' zero commissions, the possibility to invest in very small amounts, the word of mouth on social networks and the considerable free time allowed by covid, retail investors organized themselves in real bullish locusts. Add to the recipe the massive purchase of deep-out-of-the money options, exercised on stocks heavily shorted by institutional investors and...
Les jeux sont faits, rien ne va plus, as in the most dangerous of casinos, an unwise bet on the upside becomes a financial accident of global proportions..
If you look closely, the last mini financial bubbles have been generated by a massive intervention of retail investors (see cryptocurrencies, Hertz, Blackberry, etc.)
Bank of America and Credit Suisse confirm, in their reports, an unusual relevance of the retail segment in the rise of prices in recent years. This is probably due to the great increase in downloads of trading apps (Robinhood in primis) and the great amount of liquidity recently injected into the market, which has gone to flow into equity returns rather than negative bond rates.
On the other hand, we have several large hedge funds and financial institutions forced to close short positions worth billions, due to the stock's continued baseless rises.
It became famous the case of Melvin Capital Management, which betting on a collapse of GameStop lost in January $6.6 billion, and was saved thanks to the injection of $2.75 billion from the hedge fund Citadel, which allowed it not to have to liquidate its other investments as well.
The financial world is not a game, and savvy players (hedge funds) started with the logical and realistic consideration that GameStop at $40 was overvalued.
Small investors on Reddit, evidently of the opposite opinion, started from the consideration that hedge funds should be stopped, regardless of a logical reason, without thinking about who would pay the consequences.
This is where the "clash" between small investors and large funds, small versus large, begins.
But let's take a step back.
A recent research by Valentina Semenova and Julian Winkler has highlighted the presence of a phenomenon called "social contagion" or, more commonly, hype: in the paper, it is estimated that among the users of WallStreetBets the probability that an individual starts a new discussion about an asset is about 4 times higher if that user has previously been involved in a discussion about the same asset. In addition, the historical intent of groups such as WSB to obtain large gains with high risk operations generates the so-called "narrow framing": this theory, part of Behavioural Economics, argues that the choice of the individual investor is dictated by the exposure to a specific position (in this case within the forum), which leads the individual not to assess the risk independently (and using their own information) but rather to rely on the (non-)perceived risk.
In two words, the infamous "herd behavior" manifests itself in all its (ambiguous) magnificence.
In this case, however, the dynamic took on a different connotation, almost subversive, from the revolutionary objective.
From a social point of view, in fact, the phenomenon has taken on an unusual relevance: the "redemption" of small investors who join forces against the "strong powers" of finance, manipulating the market as the big funds have been doing for decades. In a David versus Goliath perspective, retailers have banded together (perhaps illegally) to manipulate the market and bring down the giant. Why is this happening at this moment in history? Why has a practice that has been widespread for so many years only now received such an attack? One possible reason is again given by Behavioural Economics, and in particular by the simil-Newtonian Reciprocity Theory, which argues that individuals are inclined to respond to a negative action with an equally negative one. It is possible that an unprecedented situation such as the pandemic has made, in the eyes of some investors, the actions of hedge funds unacceptable and therefore deserving of punishment, thanks also to the aforementioned increasing accessibility of markets and interactions with other investors made possible by social networks. In this regard, Chohan (2021) argues that this behavior can also derive from ill-concealed revenge for the 2008 financial crisis, in which hedge funds would have played a fundamental role. According to this theory, David would have filled his slingshot with all the anger he had felt over the years and would have hurled his revenge at the giant with all his might. However, biblical comparisons are often destined to remain only on paper, and it matters little that the major entities operating in the financial markets offer liquidity, market making and guarantee services, as well as being highly regulated and controlled.
In these cases, perspective makes all the difference in the world, and most investors operate in a complex system of asymmetric information.
We therefore analyze the different perspectives to better understand the phenomenon in its entirety:
1. The small investor: happy with his incredible earnings with minimal capital, he feels satisfied and fulfilled by his genius. While thinking about how many Ferraris he will buy in the next few days, however, he ignores a small detail. Within those billions of dollars burned by investment funds is his own retirement fund and that of his family members. The big funds like Citadel and Point72 for example have many of the most common pension and insurance funds under management. Unaware of this he continues to buy GME stock until the stock crashes miserably, ending his dreams of living a life like "The Wolf of Wall Street."
2.Hedge funds: burned by the lost bet are running for cover through their hedging instruments. The Risk Management division has some bad nights ahead, and some heads will probably roll. The next time they open a short position a more thorough analysis of short squeeze risk will be done. The losses are severe but recoverable. A few funds will be recapitalized through internal and external capital injections. And some executives will probably forgo their million dollar bonuses this year.
3.Gamestop's big shareholders: here the best of paradoxes comes into play. Among GameStop's largest shareholders we find in fact besides Ryahn Cohen, founder of Chewy.com who owns 12.9% of the shares and triggered the first upward speculation, Fidelity (13.6%), BlackRock (13.2%), Vanguard (12.9%), State Street (3.7%), Norges Bank (2.6%), Invesco (1.5%) and some of the world's top pension fund institutions. These funds are estimated to have earned about $16 billion in capital gains, due to rising stock prices.
Based on JPMorgan's calculations, it can be assumed that behind the "GameStop phenomenon" there was the paw of institutional investors, much more active than has been said so far. No David against Goliath. It could simply have been a war of "Wall Street against Wall Street".
By analyzing the different perspectives, we understand how the "social anger" that has generated the roller coaster of the last few months has proved counterproductive first and foremost for the small investor, not possessing sufficient capital to cover the risk and the adequate knowledge to close the position at the appropriate time. The origin of these movements is to be found in a process of "democratization" of finance that has been underway for some years. The number of brokers where you can trade almost free of charge is increasing and the financial markets have never been so accessible.
This, in addition to positive aspects, also has many downsides. Just as envy, social anger and a sense of revenge exist in society, easier access to financial markets has led to the spread of financial "populism", transferring the struggle against the establishment to a different and more dangerous plane. The idea of exploiting capitalism for the struggle against capitalism is now well known, as are its poor results.
Meanwhile, GameStop's major shareholders are giving thanks and selling their shares at substantial profits (list below).
Predicting how an event of this magnitude will impact the financial markets is undoubtedly an ambitious mission, but we want to give you some food for thought anyway. One fact to be mentioned is the increasing fraction of capital held by private individuals, compared to the decreasing fraction of shares held by large institutions: this tends to imply a greater weight of the emotional part of the price of a share, that part which is not linked to the analysis of the value of a company, but rather to the instinct and the general sentiment with respect to a given stock. Certainly, also thanks to new data analysis tools, an emerging trend is the one that sees the monitoring and analysis of data coming from social networks, particularly with respect to information about stocks, in order to connect emotional aspects to market movements. These innovative tools are already being adopted by regulators and will become increasingly important in detecting irregularities in the market, although we believe that today their media relevance is amplified by recent events, which have attracted the attention of even those who had never looked closely at Wall Street.
Despite the fact that the GameStop case underlines the growing relevance of social phenomena, it is difficult to imagine a financial system governed by them, in which the authorities do not set clear limits and punish the promoters of mass speculative actions, which are in fact market manipulation by a mass and which undoubtedly reduce the efficiency of the system. Shouting for justice and recalling common values, such as the revenge of the small against the big and powerful, is not enough to justify actions that risk, if repeated cyclically, to undermine the proper functioning of the markets and to affect a mechanism that, although far from perfect, is the basis of our economy, since we base on it an important slice of the collection of capital by companies. Breaking this mechanism, which also has the task of selecting the companies that can offer more value to the country, is certainly not a desirable objective, since the damage it would cause would be unquantifiable. In underlining this point, it is also important not to overestimate what to date is an isolated phenomenon, of a viral and transient nature, which more than worrying us, should make us reflect on how even "financial markets" (and those who regulate them) must be careful observers and evolve over time, precisely to keep up with the phenomena of the world to avoid them becoming problems in the future.
Written by Edoardo Alberto Donolato, Marco Massobrio, Luca Mocci and Jacopo Carlo Canale of the VGen Mi – Bocconi Students Innovation Hub
