What’s Going On in the Stock Market? An Expert Explains.
The past few weeks have been a journey “to the moon” for stocks like GameStop and AMC Theatres – and it has nothing to do with space exploration.
Dubbed “meme stonks,” shares of several companies have soared to astronomical highs on the stock market, and tensions between retail investors, brokerage firms, and hedge funds have followed suit.
On Jan. 27, shares of GameStop closed on the New York Stock Exchange at a commanding $347.51 – a more than 8,000 percent increase from the price a year ago of just $4.28. Several other companies, including Nokia and BlackBerry, have seen similar volatility on a smaller scale.
Although the prices have come down in recent days, this is the result of highly influential social media chatter – including Reddit thread r/WallStreetBets – that’s pitting the power of the people against big-time investors.
At the same time, several investing platforms faced criticism from users when they temporarily limited trade activity around these stocks, citing compliance with regulations and requirements. Users on the other hand, saw this as an attempt to stifle their ability to freely trade.
So, what’s going on in the stock market? And what does this all mean? Frank Apeseche, an industry practitioner and Professor of the Practice of several finance courses across Tufts Gordon Institute and the Tufts Entrepreneurship Center, explains.
What Happened: Explained Simply
In order to begin understanding what happened in recent weeks, Frank pointed to the traditional way of investing for insights; after a company offers its shares to the public, traditional investing works like this:
- Purchasers of a company’s outstanding stock now own a piece of the company.
- This piece, or percentage, is represented by the shares one owns divided by the total shares outstanding. In other words, the company is now owned by multiple investors.
- If a new investor wishes to own part of the company, they’ll approach a broker to purchase shares from another investor. These transactions normally take place between outside shareholders without the involvement of the company itself.
- Their brokerage firm, through a scalable trading infrastructure, approaches the other holders of the stock and inquires if they will sell.
- If the stock price is high enough, they should want to sell. After the new investor okays the transaction, the brokerage firm executes the trade.
“That’s the way people traditionally buy and sell stock,” said Frank. “It is with an orientation that an investor wants to own part of a company for a longer period and that they believe the stock will increase in value over time.”
Investors who previously owned shares can profit by selling their stock at a higher price than what they originally paid. Their return comes from the difference between their purchase and sale price plus any dividends they received while they held their investment.
Where the recent saga on Wall Street begins is when hedge funds (or large, pooled investments that use intricate investing strategies) effectively bet against the success of companies like GameStop by leveraging tools such as put options and/or short selling.
Transactions using these financial instruments enable hedge funds to capitalize on the decline of GameStop’s stock price. This contrasts traditional investing where shareholders expect the company’s stock to increase over time.
“Put options work when the stock price goes down in the future, allowing you to synthetically sell the stock tomorrow for today's price,” Frank noted. “If the stock starts going down, that put option itself becomes more and more valuable, because the expectation that you thought was going to happen is now materializing.” Call options are the opposite.
Shorting a stock, or short selling, is a transaction that also occurs based on the prediction that the value of a stock will go down in the future, similar to buying put options. With short selling, however, an investor typically sells borrowed stock (at today’s price) and repurchases it later at the lower price. In the end, they net these two transactions and profit from the difference between today’s price minus the future, eroded price (less any associated fees). The opposite happens with long purchases.
Frank explained, “If I'm a large hedge fund and I believe the stock price is going to go down for a company like GameStop, I'm either going to short the stock or I'm going to buy put options. If I'm right, I'm going to make money. If I really want to gamble, I will use debt to leverage this transaction and make even more money.”
But with short selling and the buying of put options, investors only make money when the price of the stock truly declines, affirming their bet. That’s no longer the case if the price goes up.
And that’s where this rallying group of individual, retail investors came into play.
Retail investors caught onto the strategy that hedge funds were employing, planting the seeds for a battle that has resulted in significant financial impact to the pooled investments. One key hedge fund at the center of it all, according to the Financial Times, was Melvin Capital. As news spread on social media threads, calls grew to take stocks like GameStop “to the moon,” and the portrayal of hedge funds as antagonists prevailed.
“A number of retail investors started buying GameStop, for motives that went beyond economics, and then became very active on Reddit, building an influential pyramid,” said Frank, discussing the situation from an economic lens.
He continued, “They developed a large enough coalition of similar investors, through social media influencing, to drive up the stock price, primarily by buying call options or purchasing long positions. Hedge funds, meanwhile, took out short positions betting that the stock price would plummet. As the price climbed, these hedge funds began to rapidly lose money on a daily basis. The retail investors, socializing their enthusiasm through Reddit, basically drove the hedge funds to being between a rock and a hard place.”
Many retail investors took action primarily as a rebuke to hedge funds. From their perspective, they found a way to win in the midst of an industry controlled by giant Wall Street firms, where the rules stacked in favor of the big money. The retail investors who got out early, and cashed in, won. However, time will tell how the other individuals will eventually do.
After the prices of “meme” stocks skyrocketed, trading activity around them became temporarily limited. Robinhood, a popular trading app and one of the participating brokerage firms, found itself in the midst of controversy when it had to severely restrict trading. This was because of a liquidity shortfall suffered from the accelerated trading activity.
Now, regulators are looking into the lack of capitalization firms like Robinhood were allowed to trade with.
Conditions Leading up to Today
Frank mentioned three considerations that he believes came together in the months and years leading up: changes in the economy, social media influencing, and COVID.
“First and foremost, let’s go back and understand what happened with the COVID economic environment,” said Frank. “It drastically eroded world economies. To compensate, the governments of these countries purposely flexed their fiscal and monetary tools to drive interest rates down to zero. The USA 10-year treasury rate, for example, is about 1 percent today, but if you go back in history, its normal range is somewhere between 4 and 5 percent.”
With very low interest rates, taking money out of a bank account and investing it into companies seems like an attractive option, suggested Frank. This combined with stay-at-home fatigue, and secular changes in the social media, where the ability to influence without strong evidence or facts, provided perfect conditions for a disruption to come together.
“Institutional investors, prior to this, were not attracted to GameStop as part of their portfolio holdings. Instead, they were holding companies like Google, Apple, Amazon, etc.,” Frank highlighted. “Now, you have a situation where a company’s valuation is heavily influenced by small, retail investors who bought the stock because they wanted to beat the hedge funds at their own game.”
To the Moon … and Back?
Retail investors have made their voices heard and shown the impact they can create in the market. For companies like GameStop, though, all this activity surrounding their stock might not amount to much internally.
“Unfortunately, these stock purchases have not provided GameStop with more money because the company itself wasn’t selling stock. The trading, which elevated the stock price, took place between external shareholders, not between the company and its investors,” pointed out Frank, who has taken four companies public as an industry practitioner. “On one side, I’m sure the executives are asking themselves if they can possibly issue more shares of company stock at this high price so attractively valued capital can flow into the business. Normally, however, you have to go through the process of a ‘secondary offering’ which takes about 60 to 90 days and includes heavy marketing to institutional investors, backed by strong future support for revenue and earnings.”
But many are wondering what this all means for them – should they invest in GameStop? Not necessarily.
“A lot of people might be looking at GameStop and saying, ‘Should I invest now?’ Unfortunately, I think this has a high probability of being a shiny object and then becoming fool’s gold for investors buying at abnormally elevated prices,” Frank indicated.
He continued, “If you are analyzing companies, first look at the industry. This particular industry is moving away from physical purchases of games to online purchases. Then look at the competition and finally, at the strength and history of the company.”
Cautioning about the risk of owning stock in a company that has an inflated valuation, Frank said that many new investors could lose money and experience very high daily price fluctuations.
Without a doubt, all eyes will be on the increasing trend of volatility in the investment industry. The industry will need to double down on efforts to look introspectively and address issues of inequality between retail investors and advantaged wall street firms, whether perceived or real.
In Frank’s finance courses, students gain the skills to look deeply into industries and companies by scrutinizing the underlying trends and forces at work. In addition, they study the competitive landscape, companies’ fundamental competencies, and financial prospects. His courses are part of the MS in Engineering Management and MS in Innovation & Management programs at Tufts Gordon Institute as well as the Tufts Entrepreneurship Center’s offerings, including the Entrepreneurship minor that’s open to all undergraduate students.