The disconnect between a stock’s share price and the company’s performance were writ large during the GameStop (GME) stock price surge at the end of January 2021. The combination of irrational exuberance and a concerted buy effort promoted on the WallStreetBets Reddit channel boosted the stock to astronomical heights untethered to more mundane fundamentals like price-t0-earnings ratio.
But as day trading, technical analysis and retail investment apps like Robinhood explode onto the market, investors are increasingly making money off of the rules of how the stock market works rather than the actual strength of the underlying businesses. This may seem like a new phenomenon, but it is how the market has operated for decades. It’s just hitting the mainstream now. Ultimately, the metoric rise of GameStop’s stock and its subsequent humbling free-fall – which has apparently forced the closure of at least one hedge fund – can be an object lesson in understanding how the stock market actually works and how it’s manipulated. In short, those boosting GME did so not because of their belief in the company but in their ability to exploit market momentum in their favor.
As you unpack the newfangled social media-driven market swings, exercise caution and seek out trusted experts: An experienced financial advisor in your area can provide hands-on guidance.
GameStop Stock Price Spike: A Pump and Dump Phenomenon?
The GameStop stock price run-up essentially resulted from a pump-and-dump scheme.
In such a scenario, an investor or investors buy heavily into a low-value stock, something that they can get cheaply and in volume. Then they begin a promotional campaign to get other investors buying in as well. This flurry of new purchasing activity drives the stock price up, as the rush of new investors makes the asset seem more valuable.
At some point during the stock’s rise, even while they’re encouraging others to invest, the original investors sell their shares. This is called “dumping” their stock. These original investors then stop their recruitment campaign, which was “pumping” up the price of the stock, and generally vanish into the night with their profits. Now that no one is artificially inflating its value anymore the stock price then tumbles back to its original value (if not less), leaving most of the new investors holding a pile of depreciating assets.
Even though it’s technically a felony, the pump and dump is a very common scheme on Wall Street.
GameStop is a small retail company that sells video games and accessories, with a particular emphasis on the secondhand market. It has struggled in recent years. The video game industry has moved to online delivery, largely eliminating both the physical retail market and the secondhand market in a single blow, and the shopping malls that GameStop built its physical brand around have increasingly vanished. (GameStop is and has always been the kind of place you go between trips to Hot Topic and the food court, a lifestyle about as relevant to modern life as MySpace pages and a Prodigy account.)
Many professional investors and hedge funds had long expected that this company would continue its downward slide. Backing up those bets, many traders placed short sales on GameStop shares. One of those was British hedge fund White Square Capital, according to published reports. During a short sale, the investor borrows shares of stock from a third party then sells those borrowed shares on the open market. Some time later, the investor buys back the same number of shares and returns them. If the share price falls, the investor can buy back the borrowed shares for less than he or she originally sold them and make a profit.
In a nutshell, short sales are a bet that the company will struggle and its stock price will go down. They help push prices down when a company’s stock gets overvalued, because an increase in shorts signals weakness to other investors.
But here’s the thing: When you make a short sale, at some point in the future you will have to buy that stock back. When a lot of investors make short sales at the same time, it guarantees a coming surge in purchases. All of those investors do have to eventually return that borrowed stock after all.
It was this detail that Reddit investors from the forum WallStreetBets seized upon. Understanding that a rush of short sales meant that those hedge funds would need to buy back GameStop stock, Redditors decided to crush their profits – and book huge gains themselves – by pumping up the value of this stock. Fueled by zero-commission apps that turn investing into a cross between Tinder and Angry Birds, these investors bought enough stock and options in GameStop to drive the company’s share price from $19 in January 2021 to nearly $500 the same month at its height. But by mid-February, it was trading for less than $50 per share.
As with all pump and dump schemes, the GameStop frenzy has led to mixed results. A few Redditors, particularly those driving the frenzy, have made a fortune. They led the charge and cashed out at its heights. Most will lose their money. The people who bought in during GameStop’s rise are now left holding worthless options or stocks whose prices have fallen.
Just as importantly, for many investors this has been a teaching moment in how investors make money by manipulating the rules of the stock market. The hedge funds that shorted GameStop did so because they believed the underlying company has a weak business model. And several of them paid a colossal price for that calculation: For example, White Square Capital, which reportedly suffered double-digit percentage losses shorting GameStop, announced in mid-2021 it was closing its doors, according to published reports. Meanwhile, the Reddit investors looked at how a short sale works. They didn’t invest in GameStop; they invested in the mechanics of investing itself.
And this is a problem because, increasingly, this kind of technical investment drives stock prices on Wall Street.
Stock Prices Increasingly Reflect Investor Behavior Rather Than The Strength Of Underlying Companies
To comprehend how prices work, it’s critical to understand that the stock market is almost entirely a “secondary market.” This means that on markets like the NASDAQ and the NYSE investors primarily trade assets among themselves. This is as opposed to a primary market, in which investors buy financial assets directly from the institution that issues them. As a result, except in relatively rare instances such as an IPO (an initial public offering), prices on the stock market are set almost entirely by supply and demand among private traders.
As an investor, when you buy or sell stock, you generally don’t have any relationship with the company that actually issued it.
Technical analysis is the practice of investing based on the trading data between all of these private parties. An investor will see price changes, volatility metrics, short sale volume and countless other data points and make a decision about whether to buy or sell. It’s the counterpart to fundamental analysis, in which a trader makes their decisions based on the strengths and weaknesses of the company that issued those shares.
Long-term investors need to understand the strength of the company underlying their stocks. If you intend to hold these shares long enough to collect dividends, receive stock splits, participate in a stock buyback, or (as an institutional investor) participate in corporate governance, the health of this company is essential to your returns. Historically this fundamental analysis tended to drive, or at least play a crucial role, in most investment decisions.
However in recent decades this has changed. Modern investors tend to hold their assets for less than six months, a figure that is trending steadily downward as holding times get ever-shorter. Algorithmic trading, day trading and the explosion of retail-oriented investment products have all contributed to this trend, making it ever more popular and profitable to buy and sell stocks quickly.
An investor who doesn’t hold the stock for long, or who invests in one of the roughly half of all companies that now don’t pay dividends, won’t make money off the company’s performance itself. Instead he or she will make money off capital gains — in other words, the difference between what that person paid for the stock and what the next investor pays them for it. As a result technical analysis tends to drive modern market prices, as investors increasingly trade based on the strength of the stock rather than the company underlying it.
Rather than reflecting the returns of corporate ownership, to an increasing degree stock prices reflect casino-like predictions of what the next trader will pay. This has modern equities behaving more like sections of the commodities market, such as gold or silver, than traditional equities.
The Change In Trader Behavior Is Reflected in the Stock Market’s Separation from the Economy At Large
While it has always been true that the stock market was a secondary market driven significantly by capital gains, those realities have not always dominated investing. This was demonstrated most clearly by the alignment between stock market performance and the companies, consumers, workers and productive capacity that make up the economy at large. Until the early 1980s, the stock market tracked closely to most (if not all) major economic indicators.
However over the past 40 years several factors have unraveled this relationship. Some are well-studied, such as deregulation, the rise of computerized trading and the prioritization of shareholder value (in which companies adjust their business model around share price), while others remain poorly understood. Whatever the causation, the result is that the stock market now correlates very poorly with the overall economy.
Market gains have exponentially outpaced measures of economic health at large. While median wages have remained largely flat indices like the S&P 500 have grown by more than 500%. In 2010 and 2011, when unemployment remained at near-historic highs from the Great Recession, the Dow Jones Average regained most of its pre-recession value. And while 2010 – 2020 productivity gains were historically low, the stock market’s gains were historically high.
Economist and New York Times columnist Paul Krugman has summed this up with his three rules of stock prices: “First, the stock market is not the economy. Second, the stock market is not the economy. Third, the stock market is not the economy.”
This is the environment in which the GameStop rollercoaster took off. While the antics of a bunch of Reddit traders drew headlines, the truth is that their technical analysis-driven approach to trading matches the modern stock market quite well. These investors saw a stock that was low and could go high, one with guaranteed purchases driven by outstanding short sales, so they bought it. The relationship between GameStop’s business model and its stock had nothing to do with it.
The main difference is that these investors gathered around a Reddit board and Robinhood instead of Wall Street and a Bloomberg Terminal.
That’s how the stock market has worked for more than a generation now. It has made the stock market a poor vehicle for economic data and capitalization. Perhaps more importantly, it has created a dangerous environment for individual investors. As stock prices increasingly split from the performance of underlying companies, and the market at large diverges from the economy as a whole, what is left is the casino-atmosphere of Reddit and day traders. For someone trying to manage their money, how can they know what to buy when the honest answer is “whatever might go up tomorrow”?
The GameStop story is a classic pump and dump. It will draw investigations, although it’s unlikely that the SEC will ever find the intent necessary to make a case.
But prosecutions or not, it is also a warning to investors. The market is a technical environment, increasingly driven more by trading data than corporate fundamentals. As gamified trading takes off, that’s likely to get worse.
The Bottom Line
When judged by any mainstream indicator, from median wages to productivity, today’s stock market bears very little relationship to the actual economy. The result is a speculation-driven market that leads to behavior like Reddit’s GameStop investment surge.
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- Economic indicators are the core of modern economic research. You can learn what researchers look for, and how they use that data, in our article on the subject.
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