Monday 1 February 2021

Gamestop Madness of Crowds and The Bursting of Bubbles

The media has been full of reports recently about what has been happening with Gamestop shares.  It shows that, pretty much as in the days before the Tech Wreck of 2000, the Financial Meltdown of 2008, and every other asset price bubble in history, the bursting of such bubbles are preceded by a period of even greater madness by crowds swept along in the mania.

What happened with Gamestop is this.  Its a company whose business has been suffering in recent years.  The catastrophic impact of government imposed lockdowns on retailers, along with the general downward trajectory of high street retailers has not helped.  Seeing the writing on the wall for the company, hedge funds do what hedge funds do, they got ahead of the market, by using their ability to short sell the stock, something that normal investment funds are not allowed to do, and that most individual retail investors do not do, because they lack the resources.

What shorting means is this.  If you think that the price of a stock is heading downwards, you make a gamble on this fall.  You borrow shares that you do not own, and sell them at today's current price, say $100.  You have time before you have to actually hand the shares back to whoever you borrowed them from.  So, in the interim, if as you expected, the price of the shares falls, say to $80, you can buy the required shares at this price, and hand them back to whoever you borrowed them from.  You now have $20 per share as cash, for every share borrowed.

Now, it makes sense, if you are a hedge fund only to short sell those shares or commodities whose price you think is going to fall, because of some underlying weakness of the particular company.  If, for example, the company is doing well, and its shares rise to $120, then you will have to buy them at this higher price, and will lose $20 per share.  Worse than that, there is no limit to how much you might lose.  If you buy shares - going long - and the share price falls, the most you can lose, is whatever you paid for the shares.  The price can only go to zero.  But, if you short a stock, there is no limit to how high the price might go, and so no limit to your losses, when you have to buy it at this higher price.

So, although hedge funds tend to have a bad press, in general, they have to do more research, and be more aware of what might happen to companies, because if they get it wrong, their losses can be so much greater.  Often, hedge funds, by identifying companies they want to short, provide useful information to the market, about companies in trouble, preventing others from making bigger losses when companies collapse.

Short sellers had identified Gamestop as a company in trouble, and whose shares were likely to drop substantially, and so they shorted the stock.  A consequence, of course, of a large number of funds shorting a stock is that, indeed, its share price does then tend to  fall, both because these funds sell the stock, and because other, long only funds and speculators, seeing the selling, decide to sell too.  Of course, none of this affects the company itself.  It doesn't lose any money as a result of all this speculative activity, though it makes it more open to takeover, and makes it more expensive if it wanted to raise additional capital.  But, basically, if the company is sound, none of this affects its day to day business, and so, when it turns in its profits and sales figures, lots of people will see this, and think the stock is cheap, and jump in to buy it.  Then the short sellers would get burned, which is another reason they tend to only engage in such short selling of companies they identify as having real problems.

What then happened with Gamestop is that someone using Reddit identified Gamestop as being cheap, as a result of being shorted.  They encouraged other speculators that had joined in the day trading trend encouraged by commission free trading platforms such as Robin Hood, to buy the stock to counteract the shorting by the Hedge Funds.  So, when thousands of such small speculators joined in the result was obvious from what has been explained above.  The Gamestop share price rose sharply.  Now, with no limit to how big the losses of the short sellers could be, and with a finite time in which to buy back the shares so as to repay them to whoever they had borrowed them from, the short sellers faced what is called a short squeeze.  That is when short sellers need to buy back the stock, but can't find sellers, so that the price they have to pay for the shares they must have goes up sharply.  The more it rises, the tighter the short squeeze, and the more they must pay to get the shares.

With Gamestop there were other complications, because the Robin Hood trading platform also has obligations in terms of financial rules, in terms of being able to cover the extent of the outstanding financial commitments, should some buyers be unable to meet their commitments, and so on.  That is because, payment for shares bought is always some days after the actual purchase of the shares, and some shares are bought on credit, so called margin sales.  That meant that Robin Hood had to stop some retail speculators from buying more shares, which then caused the Gamestop share price to fall, as the flood of purchases slowed substantially.

Since then, its share price has risen sharply again.  But, what have we learned?  Short sellers started shorting its shares, because they see it as a business in trouble.  Has that changed?  No.  So, however high the price of Gamestop shares go, it will not change the fundamental health of the business, just as if short sellers short a company that is sound, it will not stop it making profits, and increasing sales, so that, at some point, its share price will rise, and short sellers would get burned.  Here its the other way round.  If as the hedge funds believe, Gamestop's business is shaky, then no matter how high speculators push its share price, it will not stop its sales disappointing, and its profits falling.

The only thing that a high share price could then do would be to allow a failing company to raise capital to keep it afloat, by selling additional new shares at this high price.  Speculators would then be simply throwing money into keeping a failing company going by endlessly lending it money.  Now, this has parallels, because its essentially what speculators have been doing in buying government bonds at ever higher prices, a process that ahs become so surreal that those bonds, now, in many cases, have negative yields.  In other words, lenders are paying governments to borrow money from them!  This is a symptom of a grossly distorted and dysfunctional financial system, and it now exists on a global scale, and to an extent far greater than existed at the time of the global financial meltdown in 2008.

In all cases, what has essentially been created is a Ponzi Scheme, or a Pyramid Scheme.  If we take Gamestop, then all that is required is for someone who understands financial markets to have bought a load of Gamestop shares, when they were very cheap, and then to have persuaded lots of amateur speculators to jump into the market to buy lots of those shares, thereby, driving up the price.  A savvy speculator would know that what would happen would then be a short squeeze sending the share price up parabolically.  In a Ponzi Scheme, or a Pyramid Scheme, those that start it, buy in at low levels.  They offer later members large returns, and for a time, as increasing numbers of people join, that appears to be happening, but all that is really happening is that all these new members are bringing in money that is then paid out to the smaller number of existing members.  At some point, insufficient new members can be recruited.  The flow of money stops, and the scam collapses.  In both cases, those that promote the scheme ensure they sell up and get out before that collapse, and when prices are at their peak.

At its low point, Gamestop shares were at just over $2, and today they stand at $325.  So, someone could have bought say 10,000 shares at $2 costing them $20,000.  If they can then encourage thousands of amateur speculators to buy Gamestop shares, so that the share price rises, their original $20,000 continually increases.  But, the more people who buy Gamestop shares, and the higher its price goes, the more these later speculators have to pay for their shares, just as with a Ponzi Scheme, or a Pyramid Scheme.  This kind of activity, with shares is called Front Running.  Its normally done by investment bankers, who buy shares in companies whose shares they are about to promote, and its illegal.

Here, of course, no one knows who promoted Gamestop shares on Reddit.  If, however, in the example above, they bought 10,000 shares for $20,000, then assuming the stock has a way to run yet, say to $500 a share, thy will be able to sell, when they think its hit this peak.  They will get $5 million for the shares, a capital gain of $4,980,000 or 24,900%.  For those, who buy, say 10 shares at $500, however, costing them $5,000, when the share price subsequently collapses, they will lose all their money.

But, Gamestop is simply the latest example of this manifestation of serial asset price bubbles.  It is simply an example of speculation driving the prices of assets way beyond the value of the underlying, and in some cases, the assets themselves, such as Bitcoin, have no value.   The same is true with land, but also of property build on the land.  Land has no value, but the price of land is being driven up, because inflated property price, have driven up the demand for land.  The owners of land then have a monopoly of it, because no more of it can be produced, unlike, say cars.  What drives the demand is purely speculation, and what drives the speculation is the rising price, and what drives the rising price is the rising demand, and what drives the rising demand is rising speculation, and so on, until such time as this chasing after your tail ends, and the whole thing collapses, leaving those that bought at the end losing everything.

The speculation in Gamestop is no different to the speculation in Bitcoin, which is no different to the speculation in property, and the fact that the lunacy has become even more apparent in recent weeks shows that we are close to the end of it, and a denouement.  The source of all of the lunacy is the actions of central banks that have printed money to buy government bonds so as to push up their prices beyond any semblance of rationality.  From there, the irrational exuberance and mindless gambling has spread to anything upon which speculators can gamble that its price could rise, which itself becomes a self-fulfilling prophecy, until such time as the prices collapse.

In the last few weeks, the yield on US 10 Year Treasury Bonds has risen from not much above zero, to 1.10%.  Its a small absolute rise, but an massive proportional rise.  But, that is just the tip of the iceberg.  Those yields are heavily manipulated as a result of central bank purchases and holdings.  Real interest rates, the rates that businesses, and consumers have to pay to borrow, are much higher.  With governments borrowing at unprecedented levels, with businesses needing to borrow on a huge scale - or governments having to do it for them to bail them out - and with households also needing to borrow massively as furlough schemes come to an end, interest rates are set to rise rapidly.  Lenders, for one thing, will need to cover themselves for huge levels of defaults.  Banks in Britain know that the government backed loans they were persuaded to hand out are likely to have a default rate of around 90%.  In India, a bad bank has now been set up to take on the bad loans of its banking sector, as it foresees large numbers of defaults of borrowers resulting from the effects of its government imposed lockdowns. 

Rising interest rates means falling asset prices, and falling asset prices means that all these bubbles, all of the Ponzi Schemes and Pyramid Schemes are going to come crashing down.  Watch out below.

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