2021 sure picked up from where 2020 left off. As if things couldn’t get any crazier than a global pandemic, a group of retail investors seemingly organized an epic short squeeze in GameStop Corp’s stock (GME) so violent that it bankrupted a $12.5 billion hedge fund. To be sure, a lot has been said on the topic. I certainly learned a lot about the technical aspects of what transpired. However, I learned a lot about myself too. The GME event triggered some strong emotional reactions. These helped surface some deep-seated biases which was an opportunity to analyze them and improve my thinking process.
Markets have a way of expressing the culture’s dominant philosophies. After all, they’re just collections of human behaviors. Today, postmodernism and nihilism are commonplace. The recent episode with GME illustrated just this. Specifically, a nihilistic narrative took root early in the absence of facts. It was a telling sign of the times.
GME is, by far, this young year’s biggest investment market story. GME is a video game retailer. Faced with many fundamental challenges, its stock was heavily shorted and declining since late 2013. However, something incredible happened. GME’s stock price rocketed up from $17—where it began the year—to nearly $350 in a matter of weeks; hardly normal behavior! However, this dramatic move did not result from some surprise strategic shift. Rather, the exploitation of a volatile stock market structure uncovered by some savvy retail investors (allegedly) on the Reddit social media platform, r/wallstreetbets (WSB), was to blame.
On the surface GME is a modern-day tale of David versus Goliath. It’s a story of the underdog, individual retail investors, taking down a mighty, short-selling hedge fund. The WSB crowd played David; Melvin Capital Management LP (Melvin Capital) was Goliath.
The WSB plan was simple: buy large quantities of GME stock and call options. The heavy short interest meant that as GME’s stock price rose the short sellers would be forced to cover their trades and compound the upwards pressure. Buying call options supercharged the effect (by creating a gamma squeeze). It was a tried and true strategy. (I explained this more in a recent interview found here.)
The maneuver worked like a charm. Within a couple of weeks GME’s stock price exploded upwards: to $50, $100, $200, $300, and flirted with $350! The shorts looked trapped. As the share price climbed so too did their loss. Soon, Goliath was mortally wounded. Two prominent hedge funds, Point72 and Citadel, stepped in to rescue Melvin Capital from insolvency.
GME’s stock price exploded upward from around $17 at the start of the year to nearly $350 as the short squeeze intensified
However, shortly after thrown this lifeline, the strangest thing occurred. Without warning, Robinhood, the WSB crowd’s brokerage of choice, restricted trading in GME (and others with a similar dynamic). This practically ended the WSB maneuver and profits. What possibly could be the cause for such a surprise? It was The Suits! They had had enough losing. It was time to step in and protect their turf.
“The Suits” is a phrase popularized by the founder of Barstool Sports, David Portnoy. It’s a metaphor for the connected cronies whom seemingly control the global economy from behind the scenes. You see, Goliath rigged the investment markets. He always defeats David. The little guy never has a chance. Here, this view postulates, Citadel and Point72 were using their connections to stop the short-squeeze and protect their new investments in Melvin Capital. What else could it possibly be?
Emergency Press Conference – Everybody On Wall Street Who Had A Hand In Today’s Crime Needs To Go To Prison pic.twitter.com/aKr8aPbB3Z— Dave Portnoy (@stoolpresidente) January 28, 2021
This narrative quickly took off. I’ll admit, my mind went there too at first. Remember, the financial markets are heavily regulated. This wouldn’t be the first instance of an entrenched institution weaponizing regulatory capture against competition.
However, I was quick to catch myself, and I’m glad I did. There simply was no evidence of foul play yet. In fact, there were no facts available at all to evaluate. Might there be other explanations, I thought?
Sure enough, this popular narrative was exposed as patently false. No, there was no conspiracy. The Suits hadn’t pulled any strings to manipulate trading. Rather, commonplace risk management practices were at play.
GME’s explosive stock price move sent its volatility through the roof. Volatility is statistical description of a stock price’s range; the greater its move, the larger its volatility. GME’s rapid price change wreaked havoc throughout the “plumbing” of stock trading operations. Because of the various time lags involved in trading stocks, firms providing the vital services that enable stock trading assume various forms of credit risk. They employ risk management strategies to protect their businesses and ensure smooth operations. Volatility is a critical input for these risk models. As GME’s volatility rose so too did margin requirements. Tony Greer of TG Macro expertly explains what happened here.
GME’s stock volatility exploded, leading to margin calls throughout the “financial plumbing” of stock trading operations
Robinhood’s predicament was commonplace. It was short on cash due to GME’s volatility. Connected hedge funds and The Suits played no part.
Khakis, Not Suits
So there you have it. There is no cabal of well-connected financiers tipping the scales in their favor (at least not in this case). However, the extent to which this narrative took hold surprised me. Don’t get me wrong, I’m a sucker for a good David versus Goliath story. I wanted to “go there” too. Thankfully though, I caught myself before getting too wrapped up in the seductive narrative. Quite frankly, it didn’t take much digging or time to debunk it.
Why did so many and well-intentioned people leap to this conclusion? To me, philosophy is the answer; the GME situation highlighted the huge impact it plays in our thinking, whether we know it or not. Humans are conceptual animals. Our mind’s function is to integrate facts into ever-widening concepts. It seeks to create order out of a seemingly disorderly world to expand our efficacy and ability to thrive. An unfortunate side effect is that we’re prone to mistakes.
Nihilism is one of the dominant philosophies I’ve observed this market and its participants to express. This negative worldview subconsciously leaves us vulnerable to accepting notions of futility. Narratives of rigged investments markets fit neatly into nihilism’s doctrine: What, you didn’t actually expect David to beat Goliath did you? By hook or by crook, Goliath always wins, remember; always.
Personally, I find such nihilistic views to be empirically wrong. History is riddled with people beating the odds by using a better analysis, understanding, or framework to earn fortunes. While rare, they are nonetheless real and possible in this world.
Check Your Premises
In my experience, nihilism is wrong, both in the markets and in life. Given how prevalent it is, I try to keep extra vigilant to my mind wandering in such directions. This can be difficult when it’s so commonplace. Like a fish in water, it’s hard to discern the philosophy in which we’re swimming.
What transpired in GME’s stock over the past few weeks was truly astonishing. The short squeeze was of epic proportions and Robinhood’s sudden trading halt came as a surprise. To be sure, it captured many imaginations. However, the facts ultimately proved the nihilistic narrative that took hold false. Markets weren’t rigged. Rather, commonplace operational decisions underpinned Robinhood’s decision to limit trading in GME’s stock.
For me, GME was an educational moment. It was another chance to test my emotional intelligence. Luckily, I passed this time and my awareness will only make me better for the next situation … and there will be a next time. Hopefully, then too I’ll recognize my biases and either avoid a losing trade or enter one profitably.
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