Quote of the Week
“An investment in knowledge pays the best interest.” — Benjamin Franklin
Last week was the worst week for the markets since last October. The Dow was down -3.27%, the S&P 500 was down -3.31%, the Nasdaq was down -3.49%, and the MSCI-EAFE was down -1.83%. The year to date, the Dow is down -2.04%, the S&P 500 is down 1.11%, the Nasdaq is up +1.42%, and MSCI-EAFE is up 0.56%. The good news is that our investment model was up last week. Be sure to check your January end of month statement.
The big thing in the news was the rocket performance of a stock called GameStop, symbol GME. GameStop is a storefront company that is primarily in the business of buying and selling computer games. “Gamer’s” can buy or sell hard copies of video games in a real store.
GameStop’s price went from $119 at the beginning of last week to a high of $483 on Thursday. As of today, Tuesday, it is selling for $109. What happened to cause this crazy price swing?
Let me explain how short selling works. Shorting a stock you think is overvalued and should go down in price is called “selling a stock short.” Shorting a stock is done by borrowing the stock through a broker from another investor and then immediately selling it. The hope is that the stock will go down in value and be repurchased at a lower price and then returned to the original owner.
For example, assume the stock is priced at $100. The short seller borrows the stock and immediately sells it for $100. Assuming the stock then drops in value to $50, the short seller buys the stock in the open market for $50 and returns it to the investor from whom he borrowed it. The short seller just made $50 on the transaction. He sold the stock for $100 and repurchased it for $50, thus a profit of $50.
What happens if the stock goes up in value? It’s not good for the short seller. He borrows the stock at $100 and immediately sells it for $100. Remember, he has to replace the stock he borrowed at some point. If the stock goes to $150, the short seller must pay $150 to replace the stock. When the short seller buys the stock in the open market for $150, he has lost $50.
Why did GameStop’s price go all the way from $119 at the beginning of the week to $483 on Thursday? A group of investors on the Reddit website, a chat room, got together, and they all started buying shares of GameStop, which began to drive the price up. Short sellers were heavily shorting GameStop. The short sellers began to panic and started to buy the stock to “cover” their short position. Meanwhile, the group of investors on Reddit also kept buying the stock. So, what is happening? As the investors on Reddit keep buying and the short sellers are also buying “cover” to stop their losses, there is increased demand for the stock. As the price continues to climb, the demand for the stock rises both from the Reddit investors to “get in” and the short sellers to “cover” their losses.
When the number of short positions is high, relative to the shares outstanding, the stock’s move higher can create panic buying by the short sellers. The increased buying contributes to higher and higher prices and is often referred to as a “short squeeze.”
I think it was very clever of the investors on Reddit to pull this off. In the last few days, they have used this same tactic on the movie theater company AMC Entertainment Holdings, Inc., American Airlines, and the Silver market. The short sellers in these companies and the Silver market were acutely aware of the Reddit investors’ tactics and “covered” their shorts before things got out of hand.
Just so there is no misunderstanding, we are not recommending buying or selling any of the stocks mentioned above.
So What Is Short Selling? An Explainer
Last week was one of the more interesting times in financial markets in recent memory. It involved a process called short selling. The following is an article from National Public Radio (NPR) by Rafael Nam that provides a simple explanation of short selling. Here is the link: https://www.npr.org/2021/01/28/961619848/so-what-is-short-selling-an-explainer Enjoy.
By now, you’ve probably heard that an army of amateur investors ganged up on short sellers, causing them painful losses while sending shares of the beleaguered retailer GameStop soaring. You also may be asking, OK, but what is short selling?
Short selling has nothing to do with summer wear or workout gear. It’s a common but controversial way of trading in financial markets. Let’s say an investor decides a company’s share price is overvalued and likely to fall.
Markets provide a way to make that bet. The investor borrows shares of the company, normally from a broker.
The short seller then quickly sells the borrowed shares into the market and hopes that the shares will fall in price. If the share prices do indeed fall, then the investor buys those same shares back at a lower price.
The short seller then returns the shares to the lender and makes a profit by pocketing the difference.
So what can go wrong?
A lot. Markets are often unpredictable, and short sellers can wind up on the wrong side of their bets.
When a share starts gaining, instead of falling, that’s trouble for the short seller. Losses are theoretically infinite since there’s no limit to how high a share price can go.
Of course, in reality, shares don’t climb forever. But the higher they go, the bigger the loss the short seller sustains.
When that happens, short sellers are in a bind. They need to return the shares they borrowed from the lender. But now, they find themselves buying them back at a higher price, not a lower one. The bet has backfired. In markets, it’s called the short squeeze.
How much the short seller loses depends on how much the shares gained since the short seller borrowed the stock.
Take Tesla. Some investors believe the electric-vehicle maker is overpriced, and many tried their hand at shorting the stock last year. It didn’t go well for them. Financial data provider S3 Partners estimated Tesla short sellers lost a whopping $40.1 billion last year after the automaker surged more than 700%.
So why short sell?
Short selling is a fairly common feature of markets. It’s mostly done by hedge funds and other professional investors.
Some short-sale trades have entered market lore. George Soros, for example, famously shorted the British pound in the early 1990s, making a $1.5 billion profit in a single month, according to one estimate.
But companies obviously hate it when short sellers target them, and short sellers have often been accused of profiting from somebody else’s misery.
That’s not how short sellers see it, of course. They argue that short selling is an essential part of markets, wringing out inefficiencies and warning others about risky stocks.
There are examples of short sellers who have been proved right in cautioning about corporate wrongdoing or impending doom.
Take the 2008 global financial crisis. In his book The Big Short, author Michael Lewis portrayed a cast of characters who warned of the impending housing crash.
Or most recently, there is the example of Wirecard, a once hot German financial technology company that was repeatedly accused of fraud, sparking strong denials from the company.
The short sellers were proved right. Last year, Wirecard collapsed after disclosing a massive accounting fraud.
Lof Advisors does not engage in short selling.
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These are Larry Lof’s opinions and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Past performance is not indicative of future results. Due to our compliance review process, delayed dissemination of this commentary occurs.
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