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January 2021 Economic Dashboard

By now, many have heard of the recent drama surrounding GameStop, AMC, and several other stocks making huge moves in the last week. GameStop shares traded from $61 to $483 in the final week of January. Media coverage has been unclear and generally failed to explain some of the underlying dynamics at work, so we will explain what we now know.

To start, one must understand the concept of “shorting” a stock. A short sale is when a market participant (often a hedge fund) borrows stock they do not own and sells it. They receive the proceeds of the short sale and must repay/buyback the stock in the future. By borrowing against the sale of stock, the market participant, or “short”, will profit if the shorted stock goes down (the shares they borrowed against are now cheaper to pay back). Conversely if the stock goes up, they will lose money. Most stocks have a very small percentage of their publicly tradable shares short; among S&P 500 stocks, the average is less than 3%. However, some stocks such as GameStop, AMC, and Express have well over 20% of their shares short.

This past week a popular online Reddit forum called “Wall Street Bets”, featuring several million followers, came up with the idea to seek out heavily shorted stocks and buy them en masse. The coordinated buying drove prices higher and soon triggered a “short squeeze” – a positive feedback loop where market participants who have shorted the stock rush to buy to cover (close their short position), pushing prices even higher. There is nothing new about a short squeeze and they are not rare in small, heavily shorted stocks. Retail investors coordinating a short squeeze through an online public forum is new. Eventually short squeezes run out of momentum as fewer shares are bought to cover short positions (GameStop shares shorted declined more than 50% in a week according to analytics firm S3 Partners).

Amidst the huge price swings (GameStop’s price would swing roughly 100% intraday vs the previous day close) clearinghouses and brokers limited trading in stocks most effected. Following a trade, a clearinghouse validates funds are available, records transfers, and ensures the exchange of securities two trading days later. This ordinarily mundane process can get complicated when prices are swinging 100% per day, and customers are using borrowed funds to buy and sell. Brokers are ultimately on the hook if their customers are unable to pay for losses. To protect the financial system, clearinghouses and regulators require brokers to hold higher quantities of cash as 1) the total value of shares held increases and 2) risk/volatility of the positions they hold increases. Given both 1 & 2 occurred simultaneously, some brokers had to quickly raise capital while limiting trading to meet these requirements.

So how do a few relatively insignificant stocks create turbulence for the broader market? For one, many of the hedge funds who had to cover their short positions likely had to sell a portion of their “long” (normal holdings betting a stock will go up) positions to repay/cover their short position(s). Similarly, some portion of the billions of retail investor dollars buying into the shorted stocks came from selling shares in other stocks. From there, fear can then spill-over.

But we must remember stocks are shares of real companies, not just numbers that go up and down. In March of 2020, uncertainty surrounding COVID gave genuine reason to be concerned many companies were no longer as valuable. Extreme volatility in a few minor stocks is not reason enough to believe an overwhelming majority of companies are suddenly less valuable.

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