(This is an opinion article. It contains no financial advice and should not be used to make investment decisions.)
In case you weren’t paying attention last week, a group on Reddit called r/Wallstreetbets targeted short sellers of GameStop and other companies. Using Robinhood investing accounts, this group bid GameStop’s stock price to the moon — at times up roughly 2,500% (that’s not a typo).
The news media began having a frenzy field day, billing it as “David vs. Goliath.” Short sellers were vilified. The Redditors were gleefully sticking it to the Wall Street suits.
As Robinhood halted and then limited trading of GameStop, some in the media moaned about how this was so unfair. After all, “the little guy” should be allowed to gamble on stocks, too.
Conspiracy theories caught fire, and Robinhood and other brokerages placed restrictions on further trading in GameStop shares.
So what is really going on? Are short sellers villains? Is there a Wall Street conspiracy to keep the “little guy” down?
Let’s answer the second question first — are short sellers villains? The answer is no. Short selling, options, and other tools are regularly used by traders and investors. They are the screwdrivers and hammers of the industry.
Both professionals and advanced amateurs use these tools to reduce their risk and amount of loss in a particular stock. In some cases, short sellers actually own the stocks they are shorting, believing that the stocks will rise in the long run. The short sales are simply a way to try and take advantage of expected stock price fluctuations to increase their profits along the way.
Now for the third question, is there a Wall Street conspiracy to keep the “little guy” down? The answer here is also no.
Think about it for a moment. Investment brokerages like Robinhood, TD Ameritrade, Merrill Lynch, and others make money from those who purchase and sell stocks and derivatives. If you were a broker, would you want to reduce your profit by limiting transactions by small traders? Of course not.
The Securities and Exchange Commission (SEC) has many rules that apply to brokerages. Other safeguards apply to the exchanges themselves.
For instance, brokerages must be sufficiently capitalized to support their obligations and meet regulatory requirements. As for exchanges, they have implemented “brakes” to be applied when trading heats up too much on a given stock or in the market itself. These brakes are to provide a cooling-off period for traders and investors to protect the integrity of the market and the trading process.
These and other measures are not intended to “keep the little guy down.” It is not “us against them” — it is the way the stock market does business. It is the way the business of the stock market has evolved since the market crash of 1929 to protect the big guy and the little guy alike.
In certain ways, trading is different from investing. Investing considers the fundamentals: the assets, liabilities, cash flow, free cash, experience of senior management, short-range and long-range objectives, etc. While trading may consider these factors as well, there are those who trade primarily on the technical charts — and momentum traders try to take advantage of short-term stock price trends both up and down.
For both investors and traders, the fiscal health of the company is a consideration. Metrics such as trailing twelve month (ttm) earnings are employed to determine if the stock price multiple (in this case, the ratio of stock price to ttm earnings) is reasonable in light of the company’s current fiscal health and future expectations for the company, and when considering the average multiple for the industry to which the company belongs.
When the stock price multiple is drastically higher than that of the company’s industry, there had better be some really good explanations. Otherwise, Wall Street starts looking for a market correction (price drop) in this stock.
Okay, so what is really going on with Wallstreetbets and its war on short sellers? The short answer, frankly, is that the lemmings are running in reverse. Instead of bailing off a cliff and selling their stock on rumors, they are succumbing to “irrational exuberance” generated by social media and elsewhere to buy more shares — no matter how high the price.
Stock price manipulation for personal gain is illegal. Whether or not the actions by Wallstreebets members are a form of illegal stock price manipulation, they are certainly a bad idea.
A buying frenzy can result in a price bubble. If the stock price multiple becomes unsustainable based on the company’s current fiscal health, future earnings expectations, and other metrics, the bubble pops and the stock price may fall hard.
As the stock falls, those buying at the top of the curve and those who don’t sell fast enough are left holding the bag. At best, they take a loss. At worst, they lose all of their hard earned money.
So what about the media crying that “little guys” should be allowed to gamble on stocks? In my opinion, such discussion does their audience a disservice.
Responsible traders and investors do not always make the correct decision, but they do not gamble with their money. The stock market is not a lottery.
Responsible trading and investing in stocks requires work. It requires doing whatever research fits your particular trading or investing style. It requires discipline. It requires acting on your best intelligent, informed decision based on the resources at hand. It requires assuming no more risk than is within your comfort level, and it requires managing the risk you assume.
I hope the members of Wallstreetbets are informed, responsible traders and investors, but I suspect too many are simply caught up in the euphoria of the moment — at least in their current war against hedge funds. I only hope their landing is not too hard.