Major retailers run loss leader sales simultaneously on toilet paper. Consumers buy to stock up at a bargain price. A week later, these companies find their reorders are cut or refused. It turns out, manufacturers oversold toilet paper by 140%. Word gets out of a severe shortage, and People bid up the existing supply and hoard it. The price of toilet paper soars. The manufacturers face very costly lawsuits for failure to deliver. This scenario sounds familiar. That’s because we just had a toilet paper shortage with sharply rising prices during our present pandemic.
Keeping this in mind will help us understand what happened with GameStop and other traded stocks. Some individual investors felt these beaten-down stocks were selling below their actual worth. They bought and shared their reasons for buying with others on the internet. They may or may not have been aware of large short positions, but it would become apparent in any case as the share prices jumped.
Short selling is a widely used method of selling something today for delivery or liquidation later. Futures markets exist for most of the things we need. A farmer looking at the corn vs. soybeans price for delivery next November chooses the more profitable to plant. The farmer then sells corn contracts for delivery at that time. The farmer presently has no corn but will have by fall. By what we call hedging, the farmer locks in his profit. People needing corn in the future are on the buy-side. We do this with everything from copper to U.S. Treasury Bonds. We’ve done this for a long time. The Chicago Board of Trade dates back to 1848.
Other people see the November price of corn as too high or too low, and they buy and sell contracts simply hoping to profit from the price movements. These traders have no corn now or use for it in the future. These speculators are welcome to give liquidity to these markets.
Selling something you don’t own is nothing new and is needed to facilitate commerce. However, stock trading has an added wrinkle. Because of settlement rules, short-sellers have to borrow the stock to settle the trade. Generally, brokers facilitate this between their clients, but not having enough supply to borrow is always dangerous for the short seller.
Mel Brooks’ movie (and later play) “the Producers” revolves around producers’, Max Bialystock and Leo Bloom scheme to wildly oversell ownership shares in a Broadway play. If the play is terrible and immediately closes, they pocket the money, and nobody is the wiser. Unexpectedly, the production is a great success, and the investors want their profits. Max and Leo go to prison.
Somehow, the short-interest in GameStop was 140% of the total. The Hedge Funds sold far more stock than was ever available. Max and Leo would understand. So long as GameStop was falling, nobody cared, but once it rose from the deathbed, like Max and Leo’s play “Springtime for Hitler,” the jig was up.
Naked Short selling, a sale without delivering a borrowed certificate, has always been limited to particular circumstances. Market makers come to mind, but this was still limited. According to Investopedia, “Naked shorting is the now-illegal practice of selling short shares that have not been affirmatively determined to exist.” At 140%, some non-existent shares were sold short. How did the Hedge Funds get away with something Max and Leo couldn’t?
How destructive is the ability to sell an unlimited amount of a particular stock? There was a time when Apple without Steve Jobs was floundering. What if hedge funds relentlessly pushed Apple’s price down? Tech stocks attract top talent with stock options. Apple would lose out. Stock prices often figure in financing. Again another avenue for a turnaround is blocked. Instead of Apple getting its act together with the return of Jobs, it might be gone. One of the Historic turnarounds might never have happened.
The hedge funds that over-shorted the stock on borrowed money lost bundles as the stock rose; they had to buy, forcing the GameStop ever higher. The price had nothing to do with the company’s prospects and everything to do, like the toilet paper with a shortage. Paper this time called electronic stock certificates.
The individuals buying these stocks did absolutely nothing wrong. They shared their research based on publicly available data and acted on it. The information, including short positions, are on the internet. Their analysis was correct, and they are entitled to their profits.
The brokers they dealt with thought otherwise. They stopped trading in the stocks. Trading stops often occur to allow the dissemination of information when there are sudden imbalances. When the news is out, trading resumes. However, in this case, trading resumed with only sales allowed. This one-sided action favored on-the-hook hedge funds over their clients. This maneuver is just not fair. Just like Max and Leo, people have to pay for the errors of their way.
This story isn’t of some mob conspiracy hatched in chat rooms in the internet’s dark corners. With the internet, information is readily available to everybody. Rather than a uniformed mob, the widespread use of options, with their known limited loss, shows plenty of sophistication. Somebody in their basement has useful data, just as a highly paid hedge fund analyst. It took a certain amount of arrogance by some prominent people on Wall Street to ignore this change.
In my series “The Long Journey to ‘More,” I pointed out that the printing press’ introduction destroyed the elite’s monopoly of knowledge. It changed the balance of power between people forever. The internet has made information widely available in real-time. Some big-time elites on Wall Street failed to notice. They and their enablers should pay for their ignorance.