GME Short Squeeze: Good or Master Pyramid Scheme?

So much has been made of this past week’s financial market events, and the populist narrative is that once again the little guys are getting screwed by big bad Wall Street.

Senator Elizabeth Warren said: "What's happening with GameStop is just a reminder of what's been going on, on Wall Street now for years and years and years. It's a rigged game. And it's been a set of players who come in and manipulate the market. They have turned this stock market not into a place where you get capital formation to support businesses, but more into a casino."

I don’t often agree with Senator Warren, and I don't think the markets are rigged, but I do agree with her on one thing. Some people that treated the markets like a Casino. Just probably not the ones she thinks.

I for one, think the GameStop Merry Men of Reddit are not blameless “good guys.”

So let’s back up to the GME short squeeze:

A bunch of Reddit users decided to capitalize on large short positions in stocks such as GameStop’s GME and in the process “stick it to the hedge funds”; punish the short traders for trying to drive down the price of floundering companies. The Redditors are getting back at Wall Street and “the Man”. This is the popular narrative, and I’m sure to some degree this was a bit of the motivation for some. In reality however, this was really another case of some folks seeing an opportunity to “get rich quick”. To do so they had to band together, and effectively create what amounts to nothing more than a pyramid scheme. By buying GameStop as a group, they would drive prices up, doing so would “squeeze” the short-sellers, which in turn would need to buy more GameStop stock to cover their short positions further driving up the stock.

This isn’t investing. Investing is when you put your money in a company because you think it has a good product, good management, sound strategy, and you believe your money will grow with the company in the long run. This was not that. This was a bunch of guys colluding for the sole purpose of driving the stock up and squeezing the shorts and bringing the price up way beyond rational fundamental levels.

Investopedia defines a pyramid scheme as follows:

A pyramid scheme is structured so that the initial schemer must recruit other investors who will continue to recruit other investors, and those investors will then continue to recruit additional investors, and so on.

Sound familiar? Further, as more people join the scheme, the early schemers make more money. Late coming schemers will require more joiners in order to profit.

What we saw with GME short squeeze and the Redditors is a high stakes pyramid scheme. One person alone couldn't do this. It had to be coordinated and sustained effort in order to drive the shorts to cover and continue to buy, and then convince others to join in (more collusion) and further building the pyramid - driving the price up and up. The problem is, this activity is not based on any fundamentals of the Gamestop business.

This was a coordinated attack on a structural weakness of the market akin to a distributed denial of service attack on a website.

Can you imagine the outrage and outcries if major investment banks like JP Morgan, Goldman Sachs, and Morgan Stanely got together and colluded to drive up the price of a single stock? What would AOC and Elizabeth Warren say then? Oh, the horror - and rightfully so in that case - but that kind of collusion by the big boys would quickly bring the SEC hammer down. So what makes it so good and altruistic when a bunch of Redditors do it?

What about the populist evil doers in this story - the GME short squeezes. What are short-sellers anyway and are they really so bad?

Short sellers are not inherently evil or good. They serve a place in the market ecosystem. One of the main purposes of trading in the financial markets is to identify the true intrinsic value of a company, commodity, etc. Short sellers have a role to play in this goal. If someone thinks a company's stock is overvalued, then they can sell it short, and that action can help bring the value of the stock towards its more accurate price. This does not imply that sellers are good or bad, they just have a role to play in the ecosystem which can be valuable.

Take for example Tesla. By many accounts Tesla’s stock is overvalued by a factor of 5X or more. Still the stock keeps rising and short sellers keep shorting it. Elon Musk doesn’t like shorts - he shouldn’t - they are betting against his company. More accurately stated, the shorts are betting against the markets’ perceived value for Tesla. They may think Tesla is a great company, just overvalued. Put another way, if you believe that Tesla is worth more than Toyota, Honda, Volkswagen (Porsche), GM, Ferrari, and Ford combined (as its current stock valuation tells us today), then you might be a buyer of the stock. If you don't believe this is the case, and further you think Tesla’s profits are driven mostly by expiring clean energy credits than sales, and you also think that their competition is about to dramatically increase as just about every car maker listed above goes all in on electric cars, then you might want to short it. (You can probably guess where I am on the Tesla long/short debate, but that's a subject for another time.) Tesla shorts have been crushed in the past, but they are providing a fundamental value in keeping this stock from floating too far off into the stratosphere. Like others in the financial markets ecosystem, short sellers are not inherently good or evil, just playing a role. For more on Short Selling, check out this excellent write up on the matter by Cullen Roche.

Back to our main story - so who was the original Redditor that rounded up the band of merry trader men?

In this tale, Robin Hood is actually Keith Patrick Gill, also known as Roaring Kitty on YouTube and DeepF***ingValue on Reddit. He is credited with devising the initial scheme and motivating others to join his band of merry men as they attached the rich evil shorts. By some accounts, although not verified, he turned a $748,0000 investment into 48 million dollars. He made $20 million in one day, and other Redditors congratulated and thanked him for it.

“Your steady hand convinced many of us to not only buy, but hold. Your example has literally changed the lives of thousands of ordinary normal people. Seriously thank you. You deserve every penny,” one Reddit user, reality_czech, wrote in a message of congratulations.

It turns out Roaring Kitty isn’t actually a normal “little guy” outsider, but an established participant in the financial market ecosystem himself. He is a financial advisor and a registered broker from Massuhests, and he has been in the financial markets biz since 2012. This is not to disparage him. I don't begrudge him being in the biz, It's just interesting, given the populist narrative, that the instigator of all this is in fact part of the market ecosystem himself. I do wonder if what he did, in getting others to band together to pump up a stock so far from its intrinsic value is legal. You see, as smart as Roaring Kitty was, he alone could never have moved the needle this much all on his own. So one question is, does rounding up a bunch of people to collude to artificially drive up the price of a stock, legal?

The Redditors cried foul when Robinhood shut down their ability to buy more stock hence limiting their ability to continue to drive up the price of GME. This was cited as an example of more Wall Street corruption, and the Twitter politicos all came out crying for a congressional investigation. As I noted previously, it really was just the fact that Robinhood had run out of capital, and its clearing-house put the kibosh on taking further risk. Once Robinhood raised more money, buying was once again allowed and GME rocketed back up to over $300 a share. Every financial analyst that covers the stock says the fundamentals put GameStop’s realistic stock value at about $20 a share or less.

What happens from here?

Well, the answer is just like any pyramid scheme, the folks that got in later will get left holding the bag and get punished. The ones that used the band of merry men to pump up their stock and got in early, will make away like bandits -- or like Robin Hood. It's unclear when this will come crashing down, but it will, and likely very soon.

The notion that the financial markets are rigged is incorrect and dangerous

I want to make clear that I don't really have a dog in this hunt. I don’t begrudge the Redditors. Some of these guys researched stocks and made smart moves based on the data in front of them like this guy. That's all well and good although like I said, the collusion part is sketchy. What I do want to do is squash the populist notion that the financial markets are rigged. Like many things in life and business, there are good and bad people everywhere, but to constantly characterize the financial markets as rigged, is not only incorrect, it's divisive and dangerous. It can create angry mobs that feel justified to get vengeance in some way. As we have seen recently, misinformation is dangerous especially when it comes from those with power.

As always, I would like to hear your thoughts. Write me at edwin@techrides.io

Photo by Steve Harvey on Unsplash