Market Update – The Reddit Revolution

Market Update – The Reddit Revolution

Short squeezes in a number of stocks recently, have caused significant volatility and large gains in companies that are being touted in the Wall Street Bets group on the Reddit online message boards. Traders who “short” a stock, borrow shares from another investor for a fee, and then sell them at the current market price and pocket the proceeds.  Their success depends on the stock’s price dropping so they can “cover their short” (buy it back) at a lower price and keep the difference.  Sometimes, though, shorted stocks go up instead of down, forcing the shorts to buy the shares back at a higher price, losing money in the process.  When there are multiple shorts in a stock, the buying of one forces buying by others, driving the price up faster and causing a snowball effect known as a “short squeeze.”  This type of situation, often forced by margin calls, causes further sharp price spikes, as has happened recently.

The Reddit traders seem to have inflicted some damage on some Wall Street firms and hedge funds, as is their stated goal. Table 1 shows some of the companies currently targeted with the most prominent being GameStop (GME). GME’s “short interest” (number of shares sold short) relative to its total shares was very high at 141.7%, providing significant fuel for a short squeeze. Short sellers have lost approximately $24 billion on GameStop alone, and the recent losses on the 100 most shorted stocks total nearly $55 billion.

Table 1

GameStop

Using the most prominent stock as an example, the shares of GameStop were up 1,744% year-to-date through January 27 and the trading volume has increased significantly (Chart 1, Panel 1 & 2). Setting aside a detailed discussion of the firm, which operates electronic game and PC entertainment software stores, the sharp rally in shares have caused it to be valued at a large premium to the S&P 500 and only a small discount to Amazon (AMZN) despite reporting negative earnings in five out of the last six quarters. Our valuation analysis (chart 1, panel 3) shows GME’s enterprise value (market capitalization plus net debt) at almost 11 times sales while it had historically traded at less than one time. Arguably the best retailer in the world, Amazon, currently trades for about 14 times sales.
Chart 1

In the end this is likely to end badly for many speculating on the continued rise in many of these stocks, as their share prices appear to have markedly diverged from their fundamental business values. Given that some of the speculation is happening via options trading and using borrowed money, the eventual losses could be acute for some.

While this Reddit Revolution does not pose a large systemic risk to the markets in our view, it seems likely to add to market volatility. While the short squeezes have inflicted losses on some Wall Street players, many on Wall Street and at hedge funds have likely benefitted as well. Brokerage firms have earned large profits on the trading volume and some hedge funds have likely joined the Reddit short-squeeze wave. The volatility can spill over into other stocks when funds or individual speculators suffer large losses and are forced to liquidate what they can, which are often unrelated and high-quality companies with significant liquidity. Our recommendation is to remain focused on asset allocation and knowing what you own, since the fundamental value of those assets should provide solace and long-term safety when volatility strikes.

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