(As you read this try to imagine you’re hearing the voice of Rod Serling)

Consider if you will…a world in which there are no actual truths. No objective truth, just subjective truths. A world where reality can be created simply because enough people believe in something for just long enough to induce a behavior change in the larger community. Just long enough to push stock prices up by thousands of percentage points without the actual value of the underlying companies changing at all. All one needs to do is operate in a world of alternate reality for long enough to make a pile of money and then escape back to the real world, bringing the cash with you.

We are talking here about GameStop. An explainer follows in today’s Market Minute.

Ron’s Market Minute – GameStop: If something sounds too good to be true…

Every fifteen or twenty years something particularly speculative affects (infects?) the markets and spills over into the actual economy. I’m pretty sure that anyone reading this remembers clearly the housing bubble of the mid 2000s and the subsequent collapse which triggered what became known as the Global Financial Crisis of 2008. Many of us at the time saw the housing bubble was in large part simply a rotation of the dot-com bubble dressed up in drag and making a new appearance. (If it walks like a bubble and talks like a bubble…it’s probably not a duck.)

Now, let’s think about financial bubbles for a minute. It’s no secret that all types of assets may be over (or under) valued at various times. Normal market pressures usually see to it that these things get ironed out in the normal course of life in the big city. However, there are times when the insidious side of a bubble takes over and things get treacherous. This condition almost always occurs when the buyers KNOW they’re buying a bubble, but continue to buy. Their motivation is known as the ‘Bigger fool’ theory: ‘Yes, I know I’m paying too much, but the next guy will pay even more.” At that point supply and demand breaks down; buyers are not buying an asset; they are focused only on expected appreciation. ‘Expected appreciation’ is not limited by scarcity so there are no natural controls on supply. With all that said, let us consider if the brouhaha surrounding the Gamestop trade is being correctly labeled as a bubble – or is it something quite different?

If you have not been following the Gamestop thing, here’s a quick rundown: A bunch of guys in an internet chat room (on the Redditt website) got the idea that they could challenge the large institutional hedge funds, beat them at their own game, embarrass the dickens out of them and make a lot of money at the same time.

Hedge funds typically profit by a method called ‘shorting’. Here’s how that works: Say you borrow ten shares of some stock (from someone willing to loan it to you). You immediately sell the 10 shares for a thousand dollars – which you put in your pocket. Remember that at some point you must return the ten shares you borrowed – but no longer have – so you will have to buy them back. If things go as planned the shares you bought will fall in value making your cost to recover them less than that thousand dollars in your pocket. Say that the shares fall by 30% so you buy them back for $700, return the ten shares to the lender and keep $300 as your profit on the deal. Perfect! But suppose the shares do NOT drop in price and instead go up in value? Well, you now have what is called a ‘short squeeze’. And that is exactly what the chat room guys set out to do with GameStop (ticker $GME). From the Wall Street Journal:

On Jan. 19, a Twitter account identifying itself as moderators for Wall-Streeters’ posted that the forum had long been dismissed, but “we are also now a powerful force to be taken seriously.” Some users have expressed concern that the Securities and Exchange Commission would act if users appeared organized. On Discord, in a chat room linked to Wall-Streeters’, a user on Tuesday posted, “Guys, we need to pump $GME. Everyone buy 1000 shares in exactly 60 seconds.”

Question# 2: What if the stock goes WAY UP? And a third question- what if there are no shares available for you to buy and the price keeps going up? In theory your losses could be unlimited! 

The chat room guys are being described by some as ‘little guys’, even Davids to the hedge fund Goliaths. Do not be fooled. These are not little guys. One chat room fellow dropped 50 grand on GME on short notice. Little guys cannot do that. He did well, he sold his shares for a reported 50 million days later.

What the chat guys have done is create an element that is not present in a normal bubble. Through the short squeeze, they have forced their adversaries at the hedge funds to push the values of the targeted stocks – making money hand over fist for themselves and causing the funds to lose billions of dollars and not an insignificant amount of face.  

Now, of course, it has become political. Every politician is screaming “There ought to be a law!”

AND, there is another danger: There are a LOT of ‘newbies’ trying to trade themselves into a fortune. In many cases, I believe that this strategy is being treated like a video game in which there are no real consequences. In aggregate if you roll all of these smaller companies together, they might have a value about the same as ONE mid-cap company in the US market. Not a big deal, in aggregate. But for the smaller investor who thinks she’s found the golden egg it can be a disaster. She could end up needing to replace shares of (let’s say Gamestop) that had a cost basis around $20 with replacement shares in the market that now cost $190 (a price from Thursday’s market). That’s a loss of $170 per share. What if it was a 100-share lot that needs to be repurchased and replaced?

You can see this could be pretty disastrous for the small player. But then small is a relative term also. 

SO, how does this affect you?  For the most part it doesn’t. As long as you are not the one shorting the stock. Although it takes over some headlines with comments about the ‘little guy’ beating the big guy, for the average or normal investor, it will most likely have no consequence …. Unless the regulatory authorities decide that they need to ‘fix’ the problem.  

In that case we might look to more over-regulation and additional costs involved in normal trading. And in my opinion, that’s NEVER a good thing for you and me. 

Ronald P. Denk, CFP®
Investment Advisor
Denk Strategic Wealth Partners
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Phoenix, AZ 85051
Phone (602) 252-8700
Fax (602) 252-8701
Toll-Free (877) The-Denk
www.denkinvest.com

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