Shane Goodwin, the associate dean of executive education and graduate programs and a professor of practice in finance at SMU Cox School of Business, was in for a surprise about two months ago.
“My kids were asking questions all of a sudden about GameStop,” Goodwin says. “I was actually very perplexed about why they were asking, because I know they’re not watching CNBC or Bloomberg.”
It seemed as if the whole world was asking questions about GameStop. As the price of GameStop stock climbed from around $100 to $483 in three days, many hailed the “Reddit Rebellion” — a David vs. Goliath story in which the retail traders of Main Street battled the hedge funds of Wall Street. But “this wasn’t just about a couple of people on a chat room trying to prop up a stock,” Goodwin says. “There’s actually a lot of things that happened behind the scenes.”
So What Happened?
Back in January, GameStop was one of the most shorted stocks on the market. Hedge funds such as Melvin Capital had borrowed stocks and sold them. This was a logical strategy, Goodwin says, since GameStop’s EBITDA (earnings before interest, taxes, depreciation and amortization) was negative $129 million in the fall of 2020, and the management team had failed to substantiate its e-commerce business transformation. But Redditors realized that if they bought enough GameStop stock, they could spike the price and spark a short squeeze.
It worked. As the price climbed, shorted hedge funds had to buy shares to cover their positions, causing the price to continue climbing. Hedge funds Citadel and Point72 had to infuse nearly $3 billion into Melvin Capital, which was caught in the squeeze and suffering huge losses. Then Robinhood, the trading app beloved by amateur retail investors, restricted the purchase of GameStop. The price of shares plummeted. Redditors cried foul and collusion. Citadel Securities, one of Robinhood’s clearing firms, is under the same management as Citadel — one of the hedge funds that was losing billions. Redditors wondered whether Citadel Securities had asked Robinhood to pause purchases to help Citadel.
Politicians weighed in on the fray, and the U.S. Securities and Exchange Commission began investigating the squeeze. The U.S. House Committee on Financial Services held hearings on short selling. Meanwhile, the price of GameStop stock tumbled to around $50 over the next few weeks.
The GameStop saga became a topic of animated discussion around the country and at SMU Cox in the days that followed. Professor of Practice in Finance Don Shelly points out that “this wasn’t just a GameStop phenomenon. The investors targeted many stocks with a high percent of the float shorted, including AMC, Bed Bath & Beyond and Tootsie Roll.”
To help make sense of what occurred behind the scenes as well as the implications the event might have on the future market, Goodwin, Shelly and Distinguished Accounting Department Chair Hemang Desai share their top takeaways here.
1. No Fraud Was Committed
Did Robinhood act wrongly in restricting purchases? Did the Reddit Rebels commit fraud? What does this all mean for the stock market and the business world? These are the questions that politicians, the SEC, retail traders, the media and academics at SMU Cox alike are asking.
Goodwin’s answer with regard to wrongdoing is — neither. Fraud is not so much being naive and misleading as it is being knowingly and intentionally manipulative, Goodwin explains. On the other side, Goodwin points out that Robinhood may restrict purchasing per its customer agreement and, indeed, needed to pause purchasing to meet its capital requirements.
He notes that the SEC’s anti-fraud statute sets a high bar — and therefore was not met in this case. Desai and Shelly add that they don’t believe any laws were broken. The SEC will weigh the evidence and judge accordingly.
“Many practitioners believe it’s going to be challenging to prove that this was a coordinated, manipulative pump-and-dump scheme,” Goodwin says. “There are a variety of securities laws that make pump-and-dump schemes illegal. This could’ve been just a lot of people saying a lot of silly things — whether it was manipulation, they might not really meet that threshold.”
2. Short Sellers Aren’t the Bad Guys
Goodwin, Desai and Shelly agree on the importance of short selling to the stock market. Desai recently co-authored an opinion piece with Quinton Matthews, MBA ’11, explaining the role of short sellers in the market and discouraging Congress from further regulating short selling.
“Short-selling practitioners make easy scapegoats since they profit when the share prices of targeted companies go down,” Desai wrote. “But this oversimplification obscures the important and positive role short sellers play in our capital markets. If anything, their actions are an important mechanism by which stocks are prevented from deviating significantly from their fundamentals. … Markets need a mechanism to correct severe overvaluations in stocks, and this is where short sellers come in.”
Short sellers, Desai and Matthews wrote, reveal corporate malfeasance, correct overvaluation of stocks, set price floors for free-falling stocks and facilitate efficient resource allocation. Clamping down on short sellers and short selling would consequently “make prices less informative and markets less efficient.” Societal resources, they argue, would be better spent on educating investors about how financial markets function, the risks involved and the role of all market participants.
“I sincerely hope that the SEC resists the temptation to restrict short selling, as that would have negative consequences for the overall market and the economy,” Desai says.
3. Short Selling May Change
“Short squeezes aren’t new,” says Shelly, “but they are new to every generation that hasn’t seen one before.” He cites a classic example, the Volkswagen short squeeze that took place more than a dozen years ago:
- In 2008, there was a massive short squeeze in the shares of Volkswagen.
- A buying spree by Porsche, which already owned 31% of the company, triggered the squeeze on this low-float stock.
- Over two consecutive days in October, the price increased more than fourfold.
- One month later, the shares were down 70% from their peak.
“I suspect most of those buying shares of GameStop and the other heavily shorted stocks never heard about the Volkswagen short squeeze,” says Shelly.
Goodwin wonders if all the Reddit-GameStop phenomenon might lead to systemic changes in how short selling works.
Short sellers borrow your shares and sell them to someone else to make money, Goodwin says. “Think of it as you basically let your friend stay at your house for the weekend. Your friend didn’t stay, but he turned around and rented it out for the weekend to other people and took the money.”
Lenders already receive fees for lending their shares for shorting, Desai says; short sellers do more than make a profit — they keep the market running efficiently. But, according to Goodwin, some parties have begun to say that the people whose stocks are borrowed ought to be compensated — and while Congress’ decisions and the SEC’s investigation are still ongoing, he thinks this kind of nationwide financial discussion is a win.
4. Increased Financial Awareness Is a Good Thing
With so many players, so many moving parts and so much data, it’s difficult to say what the GameStop saga’s precise impact will be on the stock market and the business world going forward. “During the dot.com era there were internet chat rooms, but the speed at which information spread was nothing like today,” says Shelly. “The number of members on Reddit’s WallStreetBets board went from fewer than 2 million in December 2020 to more than 8 million in January 2021.”
“There’s a lot of complexity around this,” Goodwin says, “but I think there are going to be some things — from a Main Street, retail perspective — that I think could actually be very good for everyone as this unfolds.”
Goodwin is particularly glad the event encouraged people to talk more about finance. Desai hopes retail investors learned that there is no such thing as a free lunch — and that short selling is best left to professional investors. Both believe awareness of how the market works, raised by the GameStop phenomenon, may be a net positive in and of itself. Only the numbers and the future market will tell.
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