Jason Gunkel, CFP®, CFA, CAP®, Chief Investment Officer
February 5, 2021
The stock market has been on a relatively tame roller coaster ride to start the year and luckily it has resumed climbing. Despite a drop at the end of January, the S&P 500 Index recovered quickly and is up about 3% year to date.
Perhaps the biggest headline news in the market has been the trade activity surrounding shares of video game retailer GameStop. After a group of investors came together on social media in an attempt to push the stock price higher, the company went from trading around $20 per share to nearly $350 per share in January!
The investors were reportedly trying to make money, while at the same time trying to hurt large hedge funds that were “shorting” the stock (trying to profit from the price of the company falling).
Shortly after the stock price peaked, many of the smaller trading platforms for retail investors, such as Robinhood, placed limits on trading GameStop and a handful of other companies that also saw a significant spike in trading.
This sparked outrage from the retail investment community and some politicians claiming that the limits on trading were a ploy to benefit the billion-dollar hedge fund managers at the expense of smaller investors. As all investors tried to understand what was going on, the stock market fell close to 3% for its biggest one-day drop in several months dating back to October.
Uncertainty still exists as to why the trading platforms such as Robinhood restricted trades in GameStop and other stocks. The average trading volume for GameStop went from about seven million shares per day in 2020 to over 66 million shares per day in January. With the price escalating to $350 per share, that meant shares worth over $1 billion were bought and sold each day.
When a stock is bought on an exchange, there is a two-day settlement period where part of the cost of the trade must be fronted by the broker. The executives of these small brokers explained that they were forced to limit trading because they simply could not afford the cost to settle the trades required by regulators, according to Yahoo Finance.
Another theory is that some of these brokerage companies were afraid of being part of a “pump and dump” scheme. The pump and dump scams have existed for decades and have been popularized by Wall Street movies.
A “pump and dump” scheme involves people trying to spread false or misleading information about a company to try to “pump” up the price of its stock and then “dump” the stock by selling their own shares at the higher price. Ultimately, the price of the stock will drop and most of the people who bought shares will lose money. The market capitalization (total shares times price per share) of GameStop went from about $1.4 billion to $24.4 billion in a matter of weeks.
For a company that was recently on the verge of bankruptcy, even the CEO of GameStop would have to admit the company was not worth that much! Predictably, the price of GameStop shares has already fallen back to $53.50 per share and no doubt many investors have lost money.
The events surrounding GameStop shares pose some regulatory questions. Should regulators try to protect smaller investors from losing money when a stock appears to have been artificially inflated, or should they be free to make their own decisions? Should regulators place more limits on hedge funds that place huge investments on companies to fail?
The U.S. Treasury Department and Securities Exchange Commission have already announced they are investigating the events further, according to the Associated Press.
More attempts by investors will be likely to push up the price of companies rapidly to earn quick profits. The rise of social media and trading platforms have empowered smaller investors to make huge impacts on the market.
The good news is that more traditional, long-term investors should be able to mostly stay away from the chaos of others trying to chase short-term profits that usually result in losses. While we might have to tolerate periods of increased volatility in the markets, the investment strategy of buying good companies based on their fundamental value still usually wins in the long term.