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Feb 01, 2021

New Kids on the Block: The Big Short…. Squeeze

New Kids on the Block: The Big Short…. Squeeze

To say this week has been an interesting one in the equity markets is an understatement. With so many dynamic scenarios and moving parts, it's hard to fully understand what we are witnessing and what could be causing it. So why did GameStop, a company that many consider to be fundamentally flawed, experience a meteoric rise in its share price seemingly overnight? What would cause such a powerful swing in sentiment? There are many factors that influenced this run, and we will touch on all of them, but the main idea to unpack is the phenomenon known as a "short squeeze." To help us sort through the rigmarole, we have our team of experts, Jason Seeb and Vincent Qiao.

Can you explain to everyone the fundamentals of a short squeeze?

Jason: "I'll start by explaining a short. Basically, when you short something, you are making a bet that the stock will drop in value. To do this, you borrow a share of a stock from a broker, sell it on the open market, then you hope the price drops so you can buy the stock back and return the share to the broker. Say that you do that, and the price goes down like you hoped; you buy back the same share for less, return it to the broker and then pocket the difference between the initial selling price and the price you bought it back at. That's when a short goes well. When a short doesn't go well, it can go really bad. Say you short a stock, and instead, the share price goes up, the broker can call you and say that he wants his share back. At that point, you have to pay extra for the stock to buy it back because the price has risen. And theoretically, prices don't have an upper limit. Now, a short squeeze is when a hedge fund or big bank, people with a lot of money, make a big short bet against a stock. Then, for whatever reason, the stock goes up, and the hedge fund is forced to buy back huge quantities of shares at a higher price. That action of investors covering their short positions increases demand, forcing (or squeezing) the price even higher, which is where this phenomenon gets the name short squeeze."

Vincent: "Just to add on to that, the reason why funds are forced to buy back the shares when the price goes higher is that they are facing a margin call from their brokers and could go bankrupt in that process."

John: "Can you explain to everyone what a margin call is?"

Vincent: "A margin call is when your broker notices that equity in your account is less than a predetermined threshold, they will ask you to "post margin" to your account to continue to trade. If you don't, they can liquidate your holding and shut down your account."

What creates the environment for a short squeeze, what are some good indicators that one could happen and how common are they?

Vincent: "The exact cause for every short squeeze can vary case to case. A common indicator is a very high short interest relative to outstanding float. A prime indicator of a potential short squeeze would be short interest over 100% of outstanding float. The idea of short interest being over 100% is confusing but, to put it simply, people are basically borrowing already borrowed shares to short, which can drive the number above 100%."

Jason: "To address the frequency of them happening, the last case we saw on this scale was back in 2008 when Volkswagen was short squeezed. Over the years, stocks will go up, and people will claim that it was a short squeeze, short interest was high and came back down, but most of the time, you don't see it on this scale. These kinds of moves aren't a very common occurrence."

You mentioned Volkswagen as the last big short squeeze; what happened there?

Jason: "It was being shorted by a lot of hedge funds because of its very high debt levels and the cyclical nature of its business. One day it was announced that Porsche had slowly been accumulating a position in VW. It made people think that Porsche was going to buy Volkswagen, which would obviously be good for the stock. That was the catalyst that moved shares up; shorts were forced to cover their positions. As a result, shares skyrocketed. The price started around $40 or $50, I believe it slowly climbed up around $200, then in one day it shot up to $1000 per share and dropped back down into the $200 range again by the end of the day. I'm not exactly sure about the numbers, but if you go back and look at the chart, you'll see that huge spike in a single day."

Vincent: "The shorts were ultimately right in their assessments of Volkswagen's debt levels being very elevated, and obviously those debt levels were that high heading into the recession of '08. The concerns of the hedge funds at the time were very legitimate."

Jason: "Just like they are now probably."

Vincent: "I think, in the case of Volkswagen, Porsche was acting in pretty bad faith, which happens pretty frequently in my opinion. Also, whenever a hedge fund has a position out in the open, especially when it's a short position on a stock with a relatively high short interest, there's always a chance another hedge fund that's not involved in the short can actually orchestrate a short squeeze and really hurt the other fund."

Jason: "As Vincent said, the short position may be justified, but there's still a lot of money to be made when the short squeeze happens. The problem is that the peaks can be short lived, so people who bought on the way up or those that couldn't sell in time can lose a lot of money. It's really risky; even though it seems like easy money, there's no real way to tell when it's going to end. Another interesting note on the Volkswagen short squeeze, when the shares peaked at $1000, it became the most highly valued company in the world. For comparison's sake, the most valuable company today is Apple. If the big short squeeze in discussion today, which is GameStop, were to take that title from Apple because of the pressure of the squeeze, its price would have to run up to $35,000 per share. So probably not going to happen but, imagine if GameStop were more valuable than Apple."

Vincent: "Yeah, they are going to buy Amazon tomorrow, per my proprietary research."

Alright, let's break down the whole GameStop situation. Talk about the GameStop short squeeze; what led people to short it initially? Why did it start moving up so as to put those that were short in danger? How much has it run-up? Any guesses on where it will stop?

What led to people initially shorting it?

Jason: "People started shorting GameStop initially because they thought the retail sector was in decline, especially among the demographic that would traditionally shop at GameStop (being that it's a video game store). Additionally, it's just so easy to buy video games directly from your gaming console that your business model is pretty much obsolete."

Vincent: "GameStop is a very easy to sell secular short, its business model is in secular decline, they are facing multiple headwinds from all angles. Hedge funds have been correct, fundamentally speaking, in saying that their business is going to shrink going forward."

What started the upward move of the stock?

Jason: "I'd say there are two things that started the move up, and Vincent may disagree with me, but the first thing that happened is a guy named Ryan Cohen, who is the founder of Chewy, bought 13% of the GME stock, and at the same time, he made activist suggestions about how they can improve their business. Cohen is a little bit of a Wallstreet darling, as is Chewy, so this got people turning around on the stock. The other thing that happened, which I'm sure is what the majority of our esteemed readers heard about, is the Reddit page Wallstreet bets got involved. People on this page started making the argument that GameStop was actually undervalued because the shorts had depressed the price so much that the core business should have been worth more than what the market was giving it credit for. These people started buying call options on the stock, and this caught a lot of momentum on the page, which started increasing the volume on the stock and began to drive up the price."

Vincent: "I would personally attribute GameStop's initial move up to the new console cycle. The new console cycle was hugely popular. This led to people thinking, if one of the most popular products on the market, which also happens to be one of Gamestop's core business components, is sold out of all their stores, how bad can the business actually be, it may deserve a second look. This led a lot of retail investors to start piling into the stock. On the whole Wallstreet bets thing, as Jason said, it started with people saying that the business was fundamentally undervalued. However, once this Reddit crowd noticed how high the short interest was, they realized they could manufacture a short squeeze and drive the price up. The short interest at that time was roughly 140%, and typically a short interest of 15-20% is considered high."

How much has it run-up, and do you have a thought of where it will stop?

Jason: "About 6 months ago, the stock was trading at about $4 a share, and by January 11th, the stock had risen to $20 a share. 5x your initial investment is a great return for a 6-month period. From January 11th to the 25th, the stock went from $20 to $75, also pretty strong returns. From the 25th to today, a two-day period [recorded on the 27th], the stock went from $75 to as high as $380, multiple thousand percent returns, not only from 6 months ago but also from the 11th. And on that note, I don't think I'm going to make a guess where it will go."

Vincent: "So the price day to day is purely driven by fund flows. You have a bunch of hedge funds trying to squeeze out the other group of hedge funds that are short GME. On the other side, you have many people who are long GME (i.e. the Reddit crowd). So, they are basically trapped and can't get out of their positions without significantly increasing the stock price. There's also a wildcard that GME could issue "at the market" shares and hugely increase the float available. If they were to do this, they could, theoretically, create enough shares that hedge funds plus the Reddit crowd couldn't fill that amount of float in time, allowing the hedge funds that were short to get out from under those positions without a massive price spike. Doing that would create permanent value for GME. It's obviously not worth what its stock says its worth, but all of this should have created tons of value for GameStop."

How has social media and a growing retail investor base affected the likelihood/severity of these events happening, and how much power do retail investors have to encourage a short squeeze on these smaller companies?

Jason: "In my opinion, social media gives people the avenue to act as an institution, but I don't think this will become the new normal where things like this are often happening or even semi often, for two reasons. The first reason is that it's hard to get 5 different people to agree on something, much less the thousands it would take to regularly do this. The second reason is that the hedge funds that are losing in this scenario aren't going to be too happy, and their best friends are sitting in Congress, so I don't think it'll be too long before we see some new legislation proposed to prevent this from happening again."

Jason: "The other interesting thing that I've heard people talk about is whether or not the people on Reddit are engaging in market manipulation? Are they allowed to come together and say that they all want to invest in the same thing? I don't know the answer to that, but what I do know is that lots of hedge funds do things that don't look all that different."

Traditionally, big investors have announced their short positions on stocks, which raises concern and often leads to a drop in price. Do you think instances like this with GameStop will discourage investors from announcing their short positions going forward, or do you see this as a retail counter to announcing short positions?

Vincent: "The answer is no. I think many activist short seller who publishes their findings for everyone to see are acting in bad faith. Not all of them, but a majority of them. They often publish their thesis and see the stock price crash by say 10 or 15% and then cover. You will seldom see one of those be permanently affected. Because of how quickly these shorts are covered, you wouldn't see often see a short squeeze result."

Jason: "I think that's a really interesting idea; I haven't thought about it like that before. I think it's possible, but as I said, I think the structure around all this stuff is going to change, I think Congress will step in, so I don't know if we can really predict what going to happen."

John: "You hinted at this early, Jason, but is it not a form of market manipulation for a hedge fund to publish a short thesis to influence the stock downward and then cover as the stock drops 15%?

Jason: "I would argue that it is, but it's technically legal."

John: "Interesting."

Vincent: "I would argue that it is definitely market manipulation, and I would argue that it is illegal. All the short seller notes are fairly technical. The SEC allows the notes to be published if you are only stating your opinion; that's obviously not illegal. However, if you are fabricating a piece of technical data to make a point, that is market manipulation because you are acting in bad faith."

Jason: "Yes, but I am assuming that they aren't fabricating pieces of technical data."

Vincent: "One might assume that…. However, one might also be horribly wrong…. at least in some cases."

Jason: "Fair enough."

What eventually stops a short squeeze?

Vincent: "Shorts covering."

Jason: "I would agree with that as the technical or academic answer to that question; however, a hedge fund involved in the GME short squeeze reportedly covered their short positions yesterday (1/26), yet GME was still up 130% today. So yes, covering short positions should be what ends a short squeeze, but in this case and cases like Volkswagen, there's a bubble that will eventually pop, but no real way of knowing why or when."

What types of investors are most negatively affected by these?

Jason: "The people who are hurt in a short squeeze are the people that are short and the people that buy at the top."

Do you have any comments on the idea of these short sellers being fundamentally correct but getting punished for it?

Jason: "Being correct but not seeing the results in returns isn't exclusive to people who are shorting a stock. You can have a long position on a stock for a good reason, the company could do well, but the returns do not match that success. Look at Microsoft today, for example. So, I would say that the markets aren't fully efficient. There are lots of factors at play."

Vincent: "Not being rewarded for being correct happens all the time."

Jason: "In stocks and in life."

Vincent: "True."

Vincent: "Fundamentally, investing in public markets are so different than investing in private ventures, for example, because of the reflexive element of prices in the public market. Theoretically, you could short a privately owned game purchasing store, which will probably be free money. But in public markets, you can't do that. You have mark to market risk, you have liquidity risk, the potential reflexes of the price, you have so many factors that go into it that, even though you're correct in your business views, you can underestimate all those risks."

Care to toss out any speculation of companies that could be experiencing a short squeeze in the near future?

Jason: "NOT investment advice… The two most shorted large-cap stocks are American Airlines and Viacom, but the shorts squeezes have been concentrated on small-cap stocks, at least right now. Stocks that fit that billing are Dillard's, Bed Bath and Beyond, AMC, of course, and then Virgin Galactic Holdings. All of those are very volatile right now and being influenced by the short squeezes."

John Grayson

Account Executive

John started at Narwhal as an investment intern in the summer of 2019 while working to complete his MBA at Auburn University. After finishing his schooling, John joined the Narwhal team in a full-time role as a client service associate in the summer of 2020. John has been tasked with servicing a portion of Narwhal’s younger client base as well as expanding the company’s management of outside 401k plans. Along with his MBA, John holds a bachelor’s degree in finance from Auburn.

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