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What is happening with GameStop is pure madness and retail “investors” will pay for the consequences

Last year was unprecedented in many ways. We have witnessed a global pandemic that still looks far from over, governments declaring lockdowns, negative oil prices, the stock market soaring and beating every record in a few months (hauled especially by big tech and pharmaceuticals), and much more. But 2021 did not bring back normal, and the stock market is no exception since it is still witnessing apparently irrational behavior and, in some cases, extremely overvalued prices because of low-interest rates and billions of dollars coming in from inexperienced traders who have little or no financial knowledge. Just when everybody thought we had seen it all, a perfect mix of human stupidity, greed, and power of the internet are creating a “never seen before” scenario.

We are talking about GameStop, the famous videogame retail chain, whose stock price has seen a +1646% increase in just 16 days, going from US$ 19.90 a share on January 12 to US$ 347.51 (today). The price increase is even more massive if we take a 9-month period when the stock was trading at about US$ 4 a share (+8587.75%). The question is, why?

If we look at the business, GameStop posted a net loss for 2019 of 673 million dollars and another net loss of 464.4 million dollars for 2020, which basically means that in the last two years the company has lost approximately 3 times what it has earned in the two previous years (2017 and 2018). These numbers are not a big surprise since GameStop’s business model is outdated and is being replaced by online purchases. Things just got worse with the pandemic, as malls were being closed and people changed their habits, turning to e-commerce or downloading videogames directly from their gaming devices. All these factors, combined with huge amounts of debt that the company is facing, pushed some Hedge funds to short the stock, a decision that thousands of young traders who love the famous retail store chain did not like. So, they decided to take matters into their own hands, as “Investors” on the WallStreetBets Reddit forum and many other online platforms started promoting GameStop very aggressively, with many imagining it as a battle of retail investors versus hedge funds and big Wall Street firms. This resulted in the stock skyrocketing as tens of thousands of traders started buying the stock without looking at fundamentals, price, or any specific reason that would make sense in a context of a wise investment. People basically went crazy because they like the brand, but they show to have no financial knowledge and have no idea that they are inevitably going to lose their money.

When hedge funds realized what was happening, they covered their short positions, which made the price go even higher as traders kept buying the stock nonstop. In the end, hedge funds started closing their positions taking huge losses, like Melvin Capital Management, which lost 30% of $12.5bn under management this year on short positions, including exposure to GameStop. While traders are celebrating like they won the “war” against Wall Street in a triumph, they do not realize that they have just created a time bomb, as the stock price will collapse, soon or later. There is a Warren Buffett quote from the year 2000 which accurately depicts this kind of speculation:

They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

In the end, nobody except a few people will come out of this situation undamaged. It could be that some of this restricted group of people might be a few market manipulators who made the trend go viral, careless about the ones (mostly young with no trading experience) that will lose all of their money in the process. If that’s the case, those who pushed the crusade against Wall Street and artificially inflated the price would be much less ethical than the “unethical” Wall Street hedge funds themselves.

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