The Investment Scientist

This May End In A Lot Of Tears

Posted on: February 1, 2021

I promised to continue the GameStop story so here I am. Let me first explain why the broader market dropped about 3% to 4% while the GME frenzy was going on. Remember in the last article, Melvin, a name I will use to denote all the hedge funds that shorted GME, needed about $1.3 billion when GME prices rose from $20 to $30. When GME prices shot up to $420, Melvin needed $55 billion to meet the margin call. Where would they get the money? Well,  they could sell other stocks they hold.  This mass liquidation led to a small drop in the market. Should long-term investors worry? The answer is no, since a liquidity shock like this has no lasting effect. But the saga does reveal a flaw in the system that we weren’t aware of before. More about that later. 

Now in this pitched battle between the retail traders centered around Wall Street Bets and the hedge funds, I am afraid this will end badly for the retail traders. Yes, a few of them may benefit handsomely, turning $50k into $20mm as some of the stories go, but the majority of them who joined the battle when prices crossed $200, $300, and $400 may lose everything. In the end, prices will come back down to the stock’s fundamental value which is likely in the single or low double digits. After all, Melvin was not stupid.

While the price deviated so much from the fundamentals, other hedge funds came in to short the stock. On the retail side, however, it’s much harder to bring in reinforcements. They need someone like Elon Musk to keep tweeting, and the media to keep fanning the flames. But Elon has a day job, and the media has a very short attention span. After two or three days, it won’t be news anymore. 

Talking about Robinhood and other brokerages banning the purchase of GME, a lot of people believe the brokerages are in cahoots with the hedge funds to screw the small guys. Without the ban, GME might have gone all the way up to $1000, but with the ban, the price dropped to $130 in a matter of hours. This must have saved Melvin from being completely crushed.

Robinhood’s CEO, Vlad Tenev, said it was done to protect small investors. This is not entirely disingenuous, since the wave of traders who bought at $400 will almost surely lose everything. Most Robinhood accounts are margin accounts. When a trader bought 10 shares of GEM for $4000, he may have put up only $2000, with the other $2000 a margin loan from Robinhood. When the GME price falls down to earth, say $20, the trader loses everything, and Robinhood would only get $200 back for its $2000 loan. When this is done on a massive scale, Robinhood and other brokerages could be easily bankrupted

That is the systemic risk I mentioned in the first paragraph. When stock prices have 1000% swings, on the way up, they can bring down a few hedge funds; on the way down, they can bring down a few brokerages. Both could produce a domino effect that could crash the financial system since, you know what, hedge funds and brokerages borrow heavily from banks as well. When they go under, banks may go under as well. 

The crux of the matter is the margin system which was not designed for this kind of extreme price swings. But because of social media, it is now possible to amass a horde of millions of small traders to move in one direction.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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