What to Make of GameStop Corp (GME)’s Parabolic Move

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Berna Barshay’s email to investors discussing what to make of GameStop Corp (NYSE:GME)’s parabolic move.

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GameStop Corp (GME) Stock Up 145%

At its intraday high this morning, shares of video-game retailer GameStop (GME) were up 145%...

When trading started to level out earlier this afternoon at around $80, the stock had retraced much of its big move to $159 and was back to up "just" 23%, but today's gain comes on top of a 51% jump on Friday... which follows a 100% gain in the prior week. In fact, the once-left-for-dead retailer is up roughly 325% this year.

Was the stock bought out at a huge premium? Did the company report fourth-quarter earnings that blew away all expectations?

The answer to these questions is no... yet GameStop Corp (GME) – which spent much of last year with a sub-$300 million market cap – suddenly sports a roughly $5.6 billion market cap and is up around 31 times from last April's all-time low of $2.57. Take a look...

https://www.valuewalk.com/wp-content/uploads/2021/07/clost.png

The move wasn't driven by anything fundamental, but rather the largest short squeeze we've seen in a long time.

Because investors believed GameStop to have greatly diminished prospects, they sold GME shares short en masse – making a bet on a continued decline. When investors short a stock, they borrow shares from an owner, sell them, and hope to buy them back later at a lower price to return to the lender.

GameStop (GME) used to be a great business. It was the largest retail player by far in a category that enjoyed decades of secular growth: video games. The company's healthy and high-margin used-games business complemented its sales of new games, consoles, and accessories.

But as digital migration took hold in the industry – with digitally-delivered games replacing packaged media – many investors thought that GameStop was just a few years behind DVD rental shop Blockbuster and music retailers like Tower Records on a path to bankruptcy and life as an historical footnote.

The bears were largely right in their predictions. In calendar year 2017, GameStop earned more than $800 million in operating profits. By calendar 2019, these were down more than 90% to $62 million. As a result, GameStop was trying to shrink its way into maintaining profitability. The company has closed more than 2,000 stores since early 2017, although 5,000 still remain.

Short Interest In The Stock

Betting against GME shares became so popular that more shares were shorted than actually exist...

The stock's short interest by year-end 2020 had reached 71 million shares – essentially all of the shares outstanding and over 140% of the approximately 50 million shares free floating. Free float calculations exclude shares held by insiders and investors holding over 5% of shares outstanding, as these holders may opt to forego the income they could earn by lending their stock in the interest of reducing the amount available to be shorted.

A short squeeze happens when everyone runs for the exits at the same time – similar to a run on the bank.

A rapid and unexpected increase in the price of a highly shorted security is usually the catalyst for a squeeze. As traders rush to close their shorts in great numbers after the initial move up, it creates even more upward pressure on the stock due to the rush of buyers. The further sharp rise in price sends more shorts scrambling to cover... and the squeeze gains force.

Often the initial price increase that triggers the squeeze is prompted by some kind of fundamental event... better than expected financial results... rumors that a company will be acquired... a change in management, or a new product or joint venture that is favorably received.

But in the case of GameStop (GME), something more nefarious was at play...

Some smart people were telling me last summer that GME shares were too cheap, but there is no way to fundamentally justify what has happened here...

GameStop traditionally rose and fell according to the gaming console cycle. When Sony (SNE) was releasing a new PlayStation, or Microsoft (MSFT) was introducing a new generation of the Xbox, traffic to GameStop stores would soar. Selling consoles was lower margin than selling other goods, but it was high ticket. More importantly, new consoles would drive interest in the video game category... driving consumers to buy more high-margin games. In this way, GameStop was a classic razor-blade business.

Prior video-game cycles peaked in 2007 and 2013... but GME shares are now trading around 25% higher than at prior cyclical peaks, and those occurred when digital cannibalization of packaged video games was some far-off threat as opposed to a day-to-day reality.

Take a look at GameStop (GME) in the context of historical trading levels... It's crazy!

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The idea of an epic GameStop short squeeze had been brewing with retail traders in the WallStreetBets forum on discussion website Reddit for months.

After a series of fundamentally rooted, deep value posts about GME went largely ignored in the online forum, a post about the potential for a short squeeze by a user with the handle Senior_Hedgehog sent shares soaring 53% in two days last April... but they were still trading for less than $6 then.

Shares would rise 42% in two days in late August and early September, when Chewy (CHWY) co-founder Ryan Cohen announced a 5.8 million share position in GameStop. The stock was still trading for less than $8 per share at the time.

Throughout the fall, WallStreetBets periodically lit up with chatter about GameStop short interest and various trades that could take advantage of the coming short squeeze.

GME shares rose 182% over the last four months of the year. In fairness, a good bit of that move might have been justified, as GameStop (GME) had made it to the next console cycle with the release of the PlayStation 5 finally happening. But what happened since then has little connection to fundamental reality.

The GameStop (GME) frenzy is no accident...

WallStreetBets posts cautioned holders to never sell and to call brokers to revoke securities lending rights, which could cause shortages that would spur some shorts to involuntarily cover their negative bets. Users exchanged ideas about the best way to get the short squeeze going.

Popular among the suggestions for ways to send the stock soaring and get rich quick was to purchase short-term, out-of-the-money call options. Buying these options – which give the right to purchase shares above the current quote – causes market makers to buy GME shares as a hedge to the calls they sold... adding further upward pressure to the shares. The more the stock goes up, the more call sellers need to buy – thus adding more pressure. And the original, short-term out-of-the money call options have low absolute prices... They usually cost only a few hundred dollars, sometimes even less than $100 for a contract.

Banding together, the amateur traders beat the professional shorts on Wall Street. And not only did they make tons of money, they enjoyed a healthy dose of schadenfreude in watching the pain inflicted on professional investors. GME shares had been such a great short for so long, complacency had set in, and the pros were sucker-punched by the retail-driven short squeeze.

When it became clear that Gabe Plotkin's Melvin Capital – one of the most successful consumer-focused hedge funds in the world – had fallen victim to the GameStop (GME) squeeze, WallStreetBets users showed glee in sticking it to the 1%. The sentiment had a Robin Hood aesthetic... The retail traders were not only thrilled to be making big money, but it was exceptionally sweet because they were stealing from the rich to give to the poor (themselves), and of course most of the profitable trades were happening on the aptly named Robinhood app.

Trading gains are apparently sweeter when they have the side effect of inflicting pain on billionaires...

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Source: Bloomberg, Reddit

The WallStreetBets crowd also had a field day toying with Andrew Left of Citron Research, who they had formerly wrangled with over shorts in machine learning company Palantir (PLTR) and Chinese electric-vehicle maker Nio (NIO), which I highlighted last week as a "FinTwit" favorite.

One member of the Reddit group has even self-reportedly turned a $54,000 investment in GME calls into more than $11 million. And Wall Street has been generally hypnotized for the last two days by the circus act that GME trading has become...

The Top Ten Most Shorted Stock List

The GameStop short squeeze has been so successful that it's having an effect on other highly shorted names...

While some of these of names have surely had recent news that I can't delve into here in the interest of length, consider some of these recent moves in other stocks that grace the Top Ten Most Shorted stock list (GME shares sit at the top)...

Small-cap medical products company Accelerate Diagnostics (AXDX), No. 10 on the list, is up roughly 45% today. Solar company SunPower (SPWR) – No. 8 on the list – is up roughly 60% in two weeks. National Beverage (FIZZ), which makes LaCroix sparkling water, is No. 6... and is up nearly 40% in two weeks with no news whatsoever.

The stocks that round out the top five most shorted – space-tourism company Virgin Galactic (SPCE), movie theater chain AMC Entertainment (AMC), home goods retailer Bed Bath & Beyond (BBBY), and pharma company Ligand Pharmaceuticals (LGND) – are up an average of 74% so far in 2021, which is only 15 trading sessions old!

The power of the online mob is apparently in full force, prompting this headline that made me chuckle this morning from Canadian business newspaper Financial Post: "Apparently all you need for a stock to soar these days is an emoji on Reddit." The emoji in question? The rocket.

Financial Post cautioned, "If a post on a Reddit Wall Street message board contains icons of rocket ships pointing upward, you best pay attention." I agree... if you actively short, I caution you to check that you aren't in a crowded trade or one where the shares available to be borrowed are constrained. Be careful.

And if you own a stock that's up an inexplicable amount and it seems too good to be true, check the short interest. If it's really high, you may have your answer. Short squeezes don't last forever... so you may want to take some profits now.

Also, I want to remind readers that pooling or collusion in the markets is illegal. If you have profited from an orchestrated squeeze, enjoy your winnings. But be careful about what you post about or engage in online.

My old friend Herb Greenberg, a former journalist who long covered short-sellers and their targets, this morning tweeted a post from WallStreetBets that clearly skates the line of legality. (I won't post an excerpt due to the offensive language, but click here to see it.)

Revisiting The FinTok Mailbag

Given today's related topic, revisiting the FinTok mailbag seemed appropriate...

Have you benefitted from being on the long end of a short squeeze? If so, how do you decide when to sell your stock? If you've been stuck on the wrong end of one of these, how do you decide when to cover? Do you think this kind of collusion and ganging up activity on social media needs to be better regulated? Share your thoughts in an e-mail to [email protected].

"I was recently 'the beneficiary' of this crazy speculative behavior. Earlier in the week, I noticed CRNT – Ceragon Networks – a 5G stock, was going up 90%, and then closed up 64%. I happened to have Yahoo Finance open and I thought it was an error. I am not a trader, just an investor (subscriber to Empire) but happened to have that page open. I refreshed the browser thinking it was an error and realized it was not. I searched for news on the company to explain this price surge and came up short. I was so perplexed I went to my brokerage account and sold half my position thinking this was going to come crashing down. I had purchased shares in the late summer and was already up nicely on the position. I then later found out through a post from Motley Fool that CRNT was being touted on social media as the next great 5G stock and being a ~$3.20 stock a perfect target. Anyway, the share price went up another ~24% the next day and I sold all my shares.

"So, while I am happy that I was able to get such a great return on this stock, it was also very unsettling... like we are living in some super dystopian world. I do not follow any of these groups on social media.

"I think this needs to be curbed by the SEC. Not sure how but it needs to be addressed – many people will lose all their money, destroy their lives and maybe even their families' lives if they are trading with leverage. We live in truly interesting times.

"Thank you for all of your thoughtful emails and great research." – Kelly C.

Berna comment: Kelly, it looks like you were wise in getting out... at least so far. I agree that this kind of market won't end well for many folks, and the ones holding the bag in the end may be those least able to withstand losses.

It's such an overused saying... but your wisdom in getting out of Ceragon Networks (CRNT) on the spike reminded me of the old phrase "Bulls make money, bears make money, pigs get slaughtered." It's always smart to take gains when they don't make sense, even in a hot tape.

"Berna; I enjoyed your article on Fintok and I have been investing for several decades now. When I got an MBA in 95, the most interesting class was taught by an ex-investment banker who spent a semester showing us how he analyzed companies. My main takeaway was how labor intensive that was, so I have gladly paid for good advice from various investment publications like Motley Fool, Stansberry, Matt McCall, and Empire (lifetime member). I originally did very well on my own but far better in the last few years with professional advice.

"Back in '95 we had a class discussion on how the internet would make the world better with the free flow of information, but I commented that it would also become a platform for propaganda and false information. I think the last few years have proven how dangerous that can be on so many levels. The sad story of the young man who killed himself after running up huge losses on Robinhood brought that home to me. So now, the only social media I partake in is LinkedIn for the above reason.

"So, to answer your question: yes, I think all this financial propaganda should be subject to some ethical standards as enough of it can have a level of market manipulation. I also think the media should be held to some objectivity and accuracy standards, although some will claim that this tramples our first amendment rights. Democracy is always complex!

"Keep up the great thought-provoking and informative articles." – L Richard.

Regards,

Berna Barshay

January 25, 2021