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Reddit, GameStop and Robinhood's Wild Ride

Robert M. Wyrick, Jr. - CIO

Watching the market’s wild ride with Reddit, GameStop, Robinhood and others

Last week was the worst for U.S. stocks since last October, with the S&P 500 Index and Dow Jones Industrial Average both falling more than 3%. The primary culprit for the slide was a stock that’s not included in the well-known large-cap indexes but a small firm—GameStop (GME), a brick-and-mortar retailer of video games.

GME made headlines because of its wild ride over the past month, rising from $17.25 per share at the start of January to $325 by the end of last week. Driving the stellar rise in GME’s stock price were retail investors, most of whom had congregated on social media platforms such as Reddit and traded primarily on smartphone-based apps like Robinhood, which offers low- or no-cost trading.

The motives behind the Redditors on the r/wallstreetbets message board are opaque. Their ostensible purpose is to force institutional investors that have significant short positions on Game Stop’s stock to take losses through a “short squeeze”. By driving GME’s share price higher, the “shorts” must unravel the bets they made that GameStop’s stock value would fall. GameStop came into focus only because of the large number of outstanding short positions on the stock. Other heavily shorted companies also drew the attention of Reddit traders, including Blackberry, Bed Bath & Beyond and movie-theater chain AMC Entertainment. On Monday morning, the Redditors’ target range broadened to the silver market.

There’s a swagger among these traders. Some of their calls sound revolutionary, expressing a frustration with Wall Street and a financial system that favors the wealthy institutions over individual investors. Professional money managers label this activity as “dumb money”, which is true but also demeaning to small investors. Other traders are eager to “stick it to the man”, even if they’re unsure who “the man” really is. Some are doing it for fun or the “lolz”. Some are in it just for a quick profit. The mainstream press has positioned this battle as small investors vs. big Wall Street, but because Reddit users are by and large anonymous posters, it’s really unclear who’s behind the surge in these stocks.

This battle of wills between small investors and big institutions is stressing the financial system. The surge in activity among GME and other stocks tested Robinhood’s trading platform, so much that the brokerage restricted trading on GME shares and options on Thursday last week. That decision caused the stock price to whipsaw, plummeting on Thursday only to snap back on Friday when the GME trading restrictions were lifted.

The decision also fueled conspiracy-minded speculation that Robinhood was colluding with Wall Street to protect the institutional short sellers. An enraged online mob sought to “cancel” Robinhood using one-star reviews, aiming to demote the app on Apple’s and Google’s mobile platforms (until Google deleted over a thousand of these poor reviews.) The real reason behind the trade restrictions was more mundane; stock clearing firms demanded more capital from Robinhood to maintain orderly processing of their trades, a standard procedure that’s part of the financial market plumbing. For their part, Robinhood could have done a better job in communicating the regulatory requirements for additional capital.

By the end of last week, two distinctive views of what happened began to emerge. On one side are the proponents of free markets, who see a financial system working as designed and meant to be left alone. By all accounts, no one is violating existing market rules (unless any of the Redditors on the message boards have engaged in price manipulation, which is a serious crime.) There’s nothing inherently bad about shorting stocks; in fact, short sellers have been beneficial in exposing poorly managed companies and financial fraud. (See: Enron.) Nor is anything wrong with engaging in a short squeeze. Everyone from the institutional short sellers to the individual traders fully understand the risks they take in the markets, or they should. If an investor gets crushed and loses a significant amount of money, that’s the price they pay for assuming all the risk.

On the other side are those calling for increased controls and regulation that essentially protect investors from themselves. Inexperienced and unskilled investors tend to fall prey to this kind of stock-trading mania and are most likely to be hurt by the adverse consequences. Some GME investors really don’t know what they’re doing; they may lose their entire initial investment and then some. Online platforms have made it easy to invest with options or trade on margin, but these are sophisticated strategies that can be costly if not used appropriately. Social media and low-cost trading have permanently altered the way financial markets work, and we should consider whether the regulations as written make sense with the way financial markets have changed.

I personally applaud how Robinhood and other low-cost trading platforms have democratized market information and access and introduced a new generation to opportunities to produce wealth. While many inexperienced investors will be left with scars when some of these trades finally unwind, experience is often the best teacher. Those who may get burned in this bout of mania will likely emerge as better and more informed investors.

We know how this bubble is going to end—the prices of GME and other stocks will pop and sink, threatening to wipe out many unwitting and unskilled investors—but we don’t know when that will happen. The decline may have a huge psychological impact on investors and could ripple across markets. As a case in point, the drama among this handful of small stocks overshadowed the positive earnings news for many tech heavyweights including Apple, Microsoft and Facebook.

As February begins, this story remains ongoing. While it may contribute somewhat to market anxiety, I am perhaps more enthusiastic about the markets than ever before; it may help create a new generation of engaged and informed investors. For our part, Post Oak and our portfolios will continue to favor earnings-driven companies and industry sectors that will create opportunities in an ever-evolving global economy. We do not engage in crowd-driven speculation, but we will continue to monitor this activity closely. The best course of action for individual investors is to keep your cool and stick with your existing strategy through any volatility that may follow.