Everything you need to know about the Reddit / GameStop / WallStreet situation from financial expert and CFP, Aaron Hattenbach.
Warning–long read ahead. You’ve probably heard in some form or another what’s been happening this week in the stock market with Gamestop, AMC and other highly shorted small company stocks. As a financial advisor, I wanted to share my perspective on Reddit users vs Wall Street brokers. This is precisely why I left a big bank to start an independent advisory firm in 2017 to become a fiduciary advisor.
There’s a significant shift happening in the financial markets, and it’s exposing some of the built-in inequities and disadvantages individual retail investors have been facing for far too long. Hedge Funds, Short Selling Activist Investors, and Large Financial Institutions have had an unfair advantage as frequent guests on CNBC, and other financial media networks, using widely syndicated traditional media platforms to promote their investment agendas often profit from them strategically.
In what could become the Occupy Wall Street 2.0 movement and hopefully produce meaningful change, retail investors have decided that enough is enough over the last few weeks. They harnessed social media’s power and reach via Reddit’s Wall Street Bets Group, to attack Melvin Capital’s wallets and other Activist Short Selling Funds) that have long profited from short selling (betting against) the shares of struggling companies. Companies that are teetering on the verge of bankruptcy, in industries (specifically retail) were already hanging on by a thread pre-pandemic.
The net effect of the activities has created what is called short squeezes, which virtually drives the stock price sharply higher, forcing traders who had bet that its price would fall (Melvin Capital, Other Activist Short Selling Hedge Funds) to buy the shares to meet the margin requirements of their broker and to prevent even more significant permanent losses.
Retail traders have been on a tear over the past week banding together and buying the stocks of Gamestop, AMC, and others to stratospheric values that could never be justified based on the underlying fundamentals of these businesses, to put pressure on hedge funds that are shorting the stock to buy and exit these positions at massive losses (in the billions). And it’s working. Melvin Capital officially closed out its position in Gamestop on Tuesday after taking a huge loss. With me so far?
There’s been a lot of chatter about the legality of the action taken by the Reddit traders. I don’t think this rises to the level of illegal market manipulation, but time will only tell, and the regulators might feel differently.
Is this David vs Goliath?
As I alluded to earlier, I see a powerful narrative at play. The small traders are angry at the perception that Hedge Funds and the Wall Street Establishment are using their connections to the disadvantage of retail investors. Every day, retail investors see this as an opportunity to use their strategy to show their influence is just as powerful.
So, should I be investing in GameStop?
Not with money that you can’t afford to lose. GameStop’s share price is massively inflated. People are buying shares to be a part of a historic short squeeze that’s been front-page news all week. And of course, because they believe they can make a quick buck.
We’ve seen frenzies like this many times before. Tulipmania in the 1630s, the Nifty Fifty in the 1970s, the dot-coms in the 1990s, The Financial Crisis of 2008-09, Bitcoin’s multiple bubbles since it was launched in 2009. There’s no doubt we’ll see more in the future.
Why are people angry at Robinhood?
Robinhood and other brokerage platforms suddenly restricted trading on several stocks including GameStop and AMC Networks. Since then they’ve added to this list, now restricting trading in 50 stocks some which include GM, Starbucks and Moderna.
Protests erupted from investors, lawmakers and more, justifiably so. How can a company whose very mission is to “democratize investing and provide access to the financial markets” cut off access to its customers, while institutions and hedge funds still have free reign to trade these securities through their prime brokers? How can the system all of a sudden decide who can and cannot access the capital markets? I think it opens the door to situations where platforms prioritize one investor over another and that’s a massive conflict of interest.
After 6 years of being a trading platform founded on the principle of democratizing investing for the little guy/gal, the ugly truth is Robinhood’s increasingly growing retail customer base which reached 13 million at the end of 2020, is, in fact, its product.
The real customers Robinhood answers to are the market makers that pay Robinhood hundreds of millions of dollars for its customers’ order flow: Citadel Securities, Susquehanna, Wolverine, Virtu, Two Sigma, and Morgan Stanley, among others.
From the early days of Robinhood, we have often shared our concerns about their pay for order flow not being adequately disclosed to customers. Just this past year the SEC ordered Robinhood to pay $65 million in penalties after it found Robinhood gave worse prices to some customers than the investors could have gotten from rival brokers, even after factoring in commission-free trading. Yet the company’s website claimed, in 2018, that Robinhood’s “execution quality and speed matches or beats what’s found at other major brokerages,” the SEC’s order says. Customers lost $34 million from 2016 to 2019 by trading on Robinhood instead of through other brokers, because they could have gotten better prices from the competing brokers, the SEC alleged.
What are the implications of this frenzy?
There’s no crystal ball telling us what the future holds, but I think a few things are likely to happen. If we look to prior market bubbles to provide guidance, the warning signals are starting to flash. As the late legendary investor Sir John Templeton is famously quoted saying, “Bull Markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria.” When euphoria turns to panic and widespread selling, prices on risk assets quickly adjust downwards. Just look at the speed of the Coronavirus Crash of 2020 which signalled the beginning of the COVID-19 recession. From February 20-March 23 2020, in only a month, the S&P 500 dropped 33.54%, only for the market to experience its fastest recovery from a bear market on record.
I fear some traders are going to get caught up in a frenzy and lose their shirts. Just like we saw last year, I expect markets to experience some wild swings, so it’s best to take a long-term approach and stay diversified and disciplined no matter how much temptation and FOMO you have to participate in the frenzy.
The events of last week present some major questions, yet to be answered:
- Will social media traders continue to drive big market moves?
- Are coordinated movements by small investors a danger to markets?
- Do platforms have the right to cut off trading to their customers?
- Should regulators be watching hedge funds more closely?
- Will the practice of payment for order flow be further scrutinized?
This is an evolving situation, so I’m keeping a close eye on markets to see what might happen next.
Questions? Thoughts? Please comment or connect with me on Prox and let me know. Ok, that’s all for now! I hope you enjoy this weekend reading, and that you and your loved ones continue to remain safe.
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