How Reddit Seemingly Took Over the Stock Market

 
 

By Andrew Leuciuc

Written Sat January 30, 2021

Updated 4:33 AM ET, Sat February 6, 2021

 
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What happened from January 25th to January 27th has confused the minds of investors and people all over the world. These recent events seem to have in some ways momentarily reversed the roles of Wall Street hedge fund managers and “normal” people. No longer are the rich benefiting by betting on the downfall of businesses through methods like shorting. Instead, a community made up of mostly teenagers has bought heavily into seemingly worthless stocks like Gamestop, Nokia, and Blackberry. To many, it seems as though typical investments like blue-chip stocks, index funds, and ETFs are no longer the best solution to passively make money. Instead, buying a stock that the r/wallstreetbets Reddit forum deems as “taking off” is more viable. This is a major problem for multiple reasons, including the glaring issue that it could cause a market failure in the future or make a market failure much worse than it has to be.

Gamestop (GME) is known to many as a “meme stock” (one that, quite frankly, isn’t going to make anyone any money in the foreseeable future). Perhaps we can trace its recent surge all the way back to August of 2019, when the infamous investor Michael Burry bought a 3% stake in a company many were calling bearish. But the experts who thought the company would fail had good reason to believe it: GME was projected to drop 17% in 2021, after already dropping 22% the year prior. Earnings have declined for four consecutive years and analysts predicted the stock price to drop to a meager $1.86 a share. The company was seen as so awful that many hedge funds even shorted it, Melvin Capital Management and Citron Research being two of them. Shorting is a complicated Wall Street term that’s code for “betting against”. There are multiple ways to short something. Perhaps the most famous short of all time was the few people who shorted the housing market prior to that bubble bursting in 2007. These select few investors bought credit default swaps on mortgage-backed securities, and when the underlying assets in the securities failed, they made a fortune. What’s important to keep in mind is that with this type of shorting one could pull out immediately. It’s also important to note that most investors can’t short companies or markets because they simply don’t have the money for it. The hedge funds that bet against GME did the more common version of shorting in the form of a naked short (meaning they bought more stock than exists, which is illegal). When someone shorts something (a company or a market) like the hedge funds did, there’s limitless possibilities to the amount of money they could end up owing someone else if they’re wrong. To put this in context, if a seller shorts a stock at $500 and the stock price then rises to $2,500,000, the short seller would lose $2,499,950.

 

Hedge funds short companies every year, and they usually make a fortune, but over the duration of the past week, it’s safe to say that Main Street has taken a big win against these large corporations. Redditors in particular have created a massive boom in GME shares. It started when a few people on r/WallStreetBets analyzed the stock and decided that the hedge fund managers were wrong to short GME. Over time these Redditers began buying egregious amounts of stock in the company while encouraging others to do the same. Adding to the craze were celebrities like Elon Musk, who decided that tweeting “Gamestonk” was a good idea. In the process, these Redditers created what’s known as a “short squeeze” (when the stock price of a company increases greatly because of technical failures in the market, rather than underlying fundamentals) and their short squeeze dried up the liquidity of many hedge funds. This wouldn’t be as big of an issue if the hedge funds hadn’t been so confident that they were right and hadn’t shorted more shares than actually existed. Redditers realized this quickly and decided to completely screw over those big-headed Wall Street managers. Not even the SEC (Security and Exchange Committee) could stop the madness in time to save these hedge funds. Earlier last week, Melvin Capital took out $2.75 billion from Citadel and Point72, reportedly to help cover its losses. Yet Redditers were still pushing for more capital. Many believed that GME could be pushed to $1,000 a share (an enormous spike from where it stood at the beginning of the year, at about $17 a share).

 

This frenzy has created hype for stocks that literally have no value - it’s quite hard to explain this situation because it’s so ridiculous that it sounds like a movie. AMC, BB, and NOK are among those stocks that r/WallStreetBets members are hyping up now. And the belief is that the same thing can happen with these stocks that happened with GME; in fact, AMC was up an astounding 301.21% at market close on Wednesday, January 27th. But belief would be a strong word to describe these investors' emotions; the word I would choose to use in this scenario is “desire”. Many young people who are investing right now because of Reddit forums are doing so out of anger; anger at Wall Street for causing a Recession in 2008 and tearing many families apart. My fear is that young investors have misread this situation, and their short term wins could turn into long term losses. Nokia (NOK) has even come out and said that they can’t explain the recent surge in stock prices.

People seem to have the idea that what’s bad for Wall Street is good for Main Street. While this can sometimes be the case, most of the time it actually isn’t because when markets fail, people lose their life savings. This has been the case with every bubble to ever exist, and recent activity has drawn comparisons to the dot-com bubble of the ’90s. Per Jesse Pound of the WSJ, “GameStop’s rapid rise has drawn comparisons to speculative trading during the tech bubble of the late 1990s and led many Wall Street veterans to warn investors about the potential for significant losses.” It’s gotten so bad that even the man who may have had a part in creating the recent frenzy and who also happens to own 1.7 million shares of the stock, Michael Burry, tweeted out that the rise was “unnatural, insane, and dangerous.” 

What’s worse is the extent of the blame that could be placed on Redditors. Many big companies in the market have already had skeptical stock price rises since the dip the market took in late March of last year. According to an E*Trade survey of 904 active investors, 66% of them believe the market is either fully or partially in a bubble, while 26% of others believe the market is approaching one. This is awful news for investors who chose to pump stocks through forums on Reddit, as they could be used as the scapegoats for a future crash. One way this narrative could be pushed is by telling people that because the companies that shorted these stocks lost so much money, they were forced to sell stakes in their other investments, which created a downward spiral. Redditors' “manipulation of the market” will likely be used in headlines by CNBC, the Nasdaq CEO, and the SEC, but the same people who blame them for market manipulation have been doing the same thing for decades. The irony of what this situation could become is quite laughable. As stated by Keith Joseph MacIssac: 

“Some hedge funds manipulate stock prices on key reporting dates. The authors find that the returns of stocks with significant hedge fund ownership exhibit an increase of 0.30% on the last day of the quarter and a decrease of 0.25% the following day. The majority of the increase occurs near the market close and reverses the next day near the market open. Volume and order imbalance information reinforces these patterns, which are more prevalent when incentives to manipulate are stronger.”

 On top of that, there are even rumors started by Redditers of CNBC partaking in market manipulation to combat the sudden spurt of GME. The rumors were started when CNBC claimed that Melvin Capital had ostensibly covered its short position. Redditors and users on Twitter falsify this information, saying that because short interest is still so high, it has to be a lie. While I personally don’t agree with these rumors, there is good reason for Melvin to attempt to showcase a cover. If hedge funds like Melvin fail, the damage done could reach further than just their employees: it could bring the market to a halt. In the unfortunate event of there being a crash, there is no doubt that to some extent it would be the fault of Redditors and everyone else who decided to boost these select few companies up, but the crash has been coming long before many young investors decided to pump worthless stocks to the moon in an attempt to screw over huge hedge funds. 

What’s also comical is considering how much the people on Main Street really won that week, because I can almost guarantee you that the high-frequency trading firms are laughing at all of this while receiving a paycheck bigger than most Americans get in a year. Virtu Financial, Tower Research Capital, and Citadel LLC were probably the biggest winners during the frenzy, due to the fact that they didn’t assume any of the risk involved with these garbage stocks, which indirectly indicates that Wall Street may not have lost as much as we think they did. 

To summarize briefly, what Redditors did the past week is a gamble on many stocks that have no potential, but their gamble paid off. Thousands of people made substantial profits this week and should be happy with their recent investment activity. Make no mistake though: I, along with everyone else, should certainly be skeptical about how good this really was for the market as a whole, along with the implications this could have on future trading. The SEC doesn’t like seeing Main Street triumph over Wall Street, so there shouldn’t be doubts that new regulations will be put into place soon to make sure that what just happened never happens again.

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Andrew Leuciuc

Writer - Mezo Inc.