Roving Bands of Pretend Capitalists

January 29, 2021

If anyone is following the news, you may be very aware of one of the most interesting phenomena in investing in a long, long time. The GameStop short squeeze. This is really big news for a lot of reasons but for many it is a completely foreign event, like the discovery of a cache of coins in the English countryside, so rare and magnificent that it must be meaningful. Alas, it is interesting, not because of it’s occurrence, but because of the people and processes behind it.

Perhaps the best way to think of this event is that it highlights gaping holes in regulation that have existed for decades and massively favour the moneyed class.

There are a number of ways to approach this event and I have mulled how to write about it and describe it for many days now (it’s THAT unique), but let me highlight some of the ways that this can be viewed:

  1. It’s a social statement about little guys vs. capitalism
  2. It’s a very unique confluence of events in the investing world, where things are getting out of hand
  3. It’s a sad story of misallocation of capital by dimwitted investors who don’t know what they’re doing
  4. It’s war between idealogues.

Which one is true? Which one is the right way to look at it or perhaps the best way? Well, they are all true in some manner and none are the best way to look at it, because there are very large portions of the population that can claim to being part of one or more of the camps affected by the surge.

Perhaps the best way to think of this event is that it highlights gaping holes in regulation that have existed for decades and massively favour the moneyed class. The problem is that social media has offered investors a way to combat these regulatory errors and they are weaponizing them. This is not a solution that suits investors at all.

First to begin with the problem. Short selling is the process of selling something you don’t have in the hopes of buying it back later at a lower price and profiting from the difference. It has been done for a very long time. This process is far more common in markets for commodities for example where someone sells their corn or their beef for a price before the product is actually harvested. The same process can happen with houses, where a builder sells the house before it is built. It happens on the stock market as well, where you sell a share you don’t own, but instead of producing it, you simply buy it later and ‘return’ it to whomever you borrowed it from originally.

There are many important bits in there:

  • A company has a set number of shares available to be sold in the marketplace, known as their ‘shares outstanding’ and some of those are readily available for sale, called the ‘float’. These numbers are tracked by the Securities and Exchange Commission and are reported regularly (the differences in reporting will become very, very relevant to this discussion).
  • Shares are sold to investors. Modern methods have brokerages holding the shares on behalf of shareholders. (We used to keep stock certificates in our basement, walls, a safe, or safe deposit box, this became very risky and expensive so we let brokerage houses do that. Today, they are mostly digitized and few certificates move around, but again this history is important to the discussion).
  • After a company sells the shares, they trade on a stock exchange. NO MONEY FROM THE INCREASE OR DECREASE IN VALUE IS ATTRIBUTABLE TO THE COMPANY. The shares transfer between ‘investors’ and all of the gains and losses are attributable to the investor in those shares. Using a brokerage house (i.e. Interactive Brokers, Robinhood, or TD Ameritrade), the investor is shielded from the mechanics of shipping share certificates around, registering them with the company, safekeeping, and other regulatory and technical requirements.

In the case of GameStop, the company has about 70 million shares outstanding and about 47 million in their float. Math can be helpful here so keep these numbers in mind.

But GameStop isn’t a very successful company by most standards. This is different from being a good retailer or employing good people, or providing a helpful service. There are arguments to be made about the nature of a company all the time (is Eli Lilly a good company when they make massive profits on Insulin by pushing the price up on a product that was given to them for free (less manufacturing costs)? Well, they are a very profitable investment, but their moral standing may be less appealing). GameStop offers a service to clients but they don’t make a lot of money doing it and their business is not ‘healthy’ by most standards.

This is where the short sellers show up. They have sold (work with me on the math) about 62 million share short as of January 15th (68 million on December 15th!), making a bet that the shares of the company would be worth less in future than they were when they sold them. That is 132% of the shares in the public float. HERE WE FIND THE FIRST SIGNS OF REGULATORY INSANITY. (I will come back to these later).

On January 4th, the company’s shares were trading at about $17. That was up very sharply (more than 500% from a low in April 2020 of less than $3). But the crazy was just getting started. On January 13th, the company’s share shot up from $20 to $31. This is not such an unusual move, it happens a lot more than most people realize and particularly with ‘small cap’ stocks (a small capitalization stock has a relatively small market value relative to the names you know best such as Wal-Mart or General Electric or Apple).

But this is where THE SECOND SIGNS OF REGULATORY INSANITY comes in. The volume on that one day of trading was more than 144 million shares of trading. Note that the company has just 47 million shares in their public float and 70 million shares in total outstanding. This sort of trading volume is highly, highly unusual.

That first day, publications such as the Wall Street Journal highlighted the social media angle to explain the run up, and likely many other news outlets did the same. This is where the ‘socialist’ angle starts to fall apart however. Let me explain. There is an undercurrent of ‘the little guy’ taking on the ‘fat cats’ of Wall Street, however if you continue with the math, it seems this is not likely the case.

GameStop’s Crazy Ride

If we assume that 144 million shares traded hands that day at $25 (they started at 20.03 and ended at 31), then about $3.6 billion of money was transacted. I looked through my change jar, then my bank account, then my investment account, and I didn’t have $3.6 billion. In fact, I wouldn’t have put $30,000 into GameStop, even if I had it (but I have some pretty firm ideas of what a company is worth and lots of experience at valuing them).

We also know that the average American has less than $30,600 in savings (this may not include their investment accounts of course) but the idea that 10 or 20 million of them all bought 1,000 shares of GameStop on January 13th is foolish.

GameStop on January 13 and 14, 2021 – Average transaction prices were close to $30

From there the story has become ever more crazy. At the time of this writing, GameStop shares were trading at $311, which is ten times higher than when this story got started. 100 times higher than in April of 2020 and if you were an investor in GameStop, what a fantastic win.

Now the conversation has turned comprehensively toward the fairness of the system and pitted the unfettered romping over average citizens by large corporations and investment houses, versus the rights of little guys to gang up on those same capitalists and romp all over them. This is a knock em down and drag em out fist fight where someone brought in a gun to settle things. Unfortunately the Wild West didn’t turn out well for many and it likely won’t this time either, but the response by regulators needs to be thoughtful and comprehensive, not a slapstick protectionism of the moneyed class.

The actions of the reddit crowd are not something anyone should aspire to, nor should we have ever allowed the regulatory framework that continues to protect short sellers to work in the shadows.

Neither of these is good for America or capitalism and I will continue this further another time to discuss the regulatory insanity and possible cures.

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