Pompea College of Business Members Analyze GameStop Trading Frenzy, its Root Causes, Potential Fallout

What should we make of the Robinhood and GameStop saga? With (a little) perspective provided by some two weeks or so of distance, we can list four key lessons:

1. The Past is Prologue

As laid out by Professor David Sacco, MBA, a longtime Wall Street veteran who retired from that game more than 10 years ago, much of what went on that fateful week or two would have been familiar to money professionals of almost any age… only the names, jargon, and technologies have changed to fit the times. Prof. Sacco emphasizes the need for individual players to remain forever aware of the difference between “investing” and “trading.” Or, as he points out, in his day, professionals spilled oceans of ink discussing the difference between “fundamental” and “technical” analysis.

For this particular moment in time, Prof. Sacco cautions that “the psychology of other market participants has become AT LEAST as important as fundamental financial analysis.”

2. Incentives Matter

Professor Jared Sheffield, with more recent Wall Street experience, focuses on the rapid democratization of investing, as driven by the relentless hunt for profits on the part of big investment firms. Democratization – broadening the base of investors/trader to ever larger pools of individuals – is not only a longstanding goal of brokerages and Wall Street. It was also, universally, hailed as an unlimited POSITIVE. Democratization is ALWAYS good, right?

Prof. Sheffield makes the point that this democratization was a supply-side phenomenon. Big Wall Street houses set out to make investing more accessible to more and more individuals for that oldest and most pervasive business reason… the pursuit of profits. Essentially, firms needed more and more trading by the “little guys” to generate profits as their traditional sources of money dried up or got competed away by startup firms and emerging technology.

Interestingly, Prof. Sheffield ends up in much the same place as Prof. Sacco, with the useful admonition, “The GameStop trade was a great trade. It was a horrible investment.”

3. Technology Magnifies Everything

Nyhsere Woodson, a senior majoring in finance, underscores the importance of the internet in spreading all available information – good and bad, truth and rumor, etc. – at the speed of light. This information is spread, by the way, to all those newly involved “investors (actually, “retail traders”) mentioned above. As Woodson points out, “With the online disclosures of positions, retail traders can follow in the tracks of industry titans.”

All this, then, has led to the birthing of “Meme Stock Trading.”

Yet again, the bottom line is that the GameStop situation “…exposed the difference between momentum trading and value investing.”

4. History Repeats Itself

While we have, perhaps, seen the end of the GameStop mania, we have not seen the end of speculative behavior or psychology trumping fundamentals. Just as tulips were, eventually, replaced in the history of bubbles by “dotcoms,” GameStop will be replaced by…whom, exactly? Ah… there’s the rub. Whom, indeed? All we can say, in Professor Sheffield’s words, is, “Trading is a zero-sum game. There are winners and losers. If someone plays a game and doesn’t know the rules, they are naturally at a disadvantage.”

Herewith, each expert’s position and analysis.

Professor David Sacco

I have been involved in the financial markets professionally and personally since 1985. I grew up in an environment defined by fundamental analysis, both at the individual company level, from a stock trading perspective, and at the macroeconomic level, for a host of other asset classes.

The behavioral-driven trading activity we have seen over the past few years in cryptocurrencies and more recently in the U.S. stock market is not a new phenomenon. Forty years ago, and more, we called it technical analysis.

While the trading in these asset classes certainly exhibit the characteristics of other financial bubbles there are some other differences worth noting.

As recently as 15 years ago financial markets were dominated by large firms for two reasons: the control of and access to information and the regulatory and fiscal limits on market access. The internet, in general, and apps and platforms like Robinhood have completely changed that dynamic.

These developments have opened these markets to more participants. Markets are always improved when information is more freely available and there are more participants. It is also important to note that markets and prices are not about being right and wrong over any time horizon. They simply tell us about preferences of buyers and sellers at any point in time.

From my perspective this activity does not mean that we should ignore fundamental analysis of companies and macroeconomic data, but we also need to pay significant heed to market supply and demand dynamics. Between 50 and 70 percent of equity trading in the U.S. is initiated by algorithms and not people. Understanding what drives those algorithms and the psychology of other market participants has become AT LEAST as important as fundamental financial analysis.

Professor Jared Sheffield

So, who’s at fault for the past couple of weeks in the financial markets? The narrative being circulated throughout financial media networks such as CNBC, Fox Business, and Bloomberg has placed blame on the shoulders of naïve retail traders who got bored playing video games during COVID-19 lockdowns and moved on to Robinhood to day trade penny stocks. These traders are easy scapegoats. To more squarely place blame where it’s actually due, we need to look under the hood of the chaos and begin to reverse engineer the situation. In doing so, institutional establishments, and the unforeseen consequences associated with their need to develop new profit centers, begin to creep into the spotlight.

In the 1980s, Charles Schwab and E-trade began to court a small group of curious investors. They created platforms that allowed these investors access to new markets and tools so that they could be engaged with their money in a way that previously was only accessible to the professionals. The brokerage fees were incredibly profitable causing others to take notice and want their cut of the action.

Over the past 40 years, new platforms have been developed, each offering new bells and whistles, to lure new traders to their software. Initially, robust databases with company financials and complex charting packages were enough to satisfy the avid retail trader, but as the burgeoning fintech space grew, the trading platform’s capabilities exponentially increased.

Lower brokerage fees, faster fill times, online tutorials, and more intuitive user interfaces drew more everyday people into financial markets. Despite the increases in expenses, brokerages remained extremely profitable. Profit margins were no longer the driver but instead, user volume. Brokerage platforms continued to add features to their platforms to differentiate themselves from their rivals and were able to negotiate higher prices for their order flows.

Fast forward to the year of COVID-19. Lockdowns are forcing people in front of their screens more than ever before, and online communities became more important to those looking for some form of interaction. They are learning how to bake bread, build a deck in their backyard, and yes, trade stocks. Trade stocks--not invest.

The classic long-term investor is different from the new mid-to-short-term active trader or the aggressive day trader. The modern retail trader doesn’t model their investing styles after Warren Buffett or Peter Lynch but instead learn about alternative styles from Jack Schwager or Scott Patterson books.

With the addition of all the educational resources provided by the brokerage platforms, the finance industry has created an intelligent retail trader. The analysis reports and videos that are uploaded to various internet platforms, such as Reddit or YouTube, are well organized, thorough, free, and almost indistinguishable in quality compared to those found on SumZero and Seeking Alpha. The quality is because of the robust research and charting tools on retail trading platforms.

Institutional investors and brokerages have always praised the idea of creating an active and knowledgeable retail trader. They would provide more liquidity to markets, a higher level of financial literacy for the public and, of course, more transaction fees. But, as in most cases, there are unforeseen consequences to actions.

There is now a new variable in the equation. Herd momentum was not a quantifiable variable within the Black-Scholes model, but now it is something that institutional investors and risk departments must take into account. These traders can identify discrepancies in the market, and they know how to exploit them.

Enter the GameStop play and the retail traders who “started” it. Retail traders recognized a trade opportunity that could be exploited. Every day, professional traders sit down at their Bloomberg or Eikon terminals and look for similar opportunities. Whether it’s an underpriced equity, a merger arbitrage spread or a technical chart pattern, the professionals are praised and heavily compensated for identifying optimal trading positions.

If we look back in history, there were plenty of other examples of short squeezes that were executed by institutional firms. In the 1920s there was Piggly Wiggly, and in the 1930s Volkswagen was placed on the block. Even in recent years, Herbalife, Snapple, and Tesla were heavily shorted, which caused the price to run up.

The GameStop trade was a great trade. It was a horrible investment. Those who got into it at the beginning looked at it from that angle. When it reached $400/share, few thought the glorified pawn shop was worth as much as the combined worth of the NBA and NFL, let alone had a higher market cap than American Airlines.

The speculation that the price could reach $600 to $1000 per share was based on modeling the potential run of the short squeeze, not the enterprise value of the company. But the narrative focused on the “dumb money” believing in the value of the company. Sure, there were those that piled into the trade late in the cycle that believed that storyline, but they weren’t those involved in the early setup.

In addition, despite what business networks implore their viewers to believe, it’s not just the "Reddit crowd” that fueled the fire. Keep in mind that the GameStop trade opportunity arose from institutional short positions. Not only that, but hedge funds piled heavily into the trade for the ride up, exacerbating the situation, and are now enjoying the ride down.

Unfortunately, with these kinds of plays, there will be broken bodies left on the trading floor and you can be assured that the media and politicians will be highlighting the stories of the naive retail traders who have experienced substantial losses because they were overwhelmed by a FOMO mentality. I’ve read a number of these accounts over the past week. Most of the people who lost in the GameStop trade were those who took on additional debt to get into a trade, five days too late, and did not understand the risk they were taking on. It is a sad side effect of financial illiteracy.

Good will come from this experience. Free markets will rebalance, and new and more wiser participants will be engaged in markets going forward. Professor Jared Sheffield

To paraphrase, Tom Sosnoff, a founder of Thinkorswim and Tastyworks, said in a recent podcast that 99 percent of the difficulty in creating an educated investor is getting individuals to sign up for an account and that once they are engaged, they will continue to learn. We need to look at the financial losers, as new engaged market participants. As long as someone learns from a loss or a mistake, it is an investment. This is true in life, not just in finance.

As a whole, the brokerage platforms have accomplished their initial goals and helped increase financial education to the masses. Active traders and investors now understand how to create wealth and manage debt. They know how interest rates affect their mortgage and student loans. Most know the difference between trading and investing. Financial literacy is one of the most important ways we can curb the wealth gap. The more people that are engaged in the markets, the more economic potential for the lower end of the socioeconomic spectrum.

Accessible brokerage platforms are a piece of this puzzle, but we must understand that the retail trader is not just “dumb money.” And we cannot blow up an effective system because of an anomaly that was exploited by someone other than another institutional player or because those less knowledgeable in a space made a bad decision. Trading is a zero-sum game. There are winners and losers. If someone plays a game and doesn’t know the rules, they are naturally at a disadvantage. The finance industry should focus on teaching the rules, providing more transparency and accessibility and everyone will be better for it.

The scariest part may still come as legislatures begin to debate new regulation, even before SEC regulators know the specifics of what happened. Of course, these are the same politicians that enable state lotteries to market hope to a lower socioeconomic population in their home districts. But maybe they know best, and maybe predatory practices are only meant for those at the top.

Regardless, while trading may be a zero-sum game, the narrative of blame in the GameStop scenario is not so clearcut. Everyone needs to take a step back and recognize the unintended consequences the platforms had, but they also need to educate themselves before calling for change. Good will come from this experience. Free markets will rebalance, and new and more wiser participants will be engaged in markets going forward.

Nyhsere Woodson ’21

The GameStop stock controversy can be viewed as David taking on Goliath in a financial setting. A large sum of retail investors empowered by the internet had the opportunity to identify a fault in Melvin Capital’s aggressive short position. Retail investors were able to squeeze Melvin Capital’s position by increasing the stock by purchasing shares and then performing long calls on the stock as well. In this combined effort they were able to force Melvin Capital to close on their positions which caused them to lose over $3 trillion.

I believe this event shows how the internet impacts the world of trading and investing. Information can be spread at market speeds and it can equalize the world of Wall Street. Resources online empower retail investors to create complex trading strategies that have never been seen before. Internet chatrooms can mimic the strategies of Wall Street’s finest boardrooms. With online disclosures of positions, retail traders can follow in the tracks of industry titans. Robinhood is cutting edge and disruptive because of their democratized approach to trading securities and by allowing unsophisticated traders to trade sophisticated options and other derivatives.

The GameStop stock situation did not occur due to the public’s faith in the underlying value of the company, but it was a chance to exploit an overexposed short position of Melvin Capital. It exposed the difference between momentum trading and value investing.

With GameStop’s outdated model and weak financials, the company was doomed for failure, but market sentiment provided short term funding. Keith Gill, a well-known trader on Reddit Forum WallStreetBets began this trade because of his mentor who is a chartered financial analyst (CFA). Gill’s mentor is described as “rouge” from Wall Street and provided Gill with the knowledge of GameStop and Melvin Capital’s overexposure.

Retail Investors saw this as an opportunity to engage in class warfare with Wall Street, they wanted to increase the price to force Melvin Capital out of its position and to lose billions of dollars. The internet was a catalyst because he was able to relay this information to his forum and the stock skyrocketed.

This trade birthed a new type of trading called “Meme Stock Trading.” This type of trading thrives on the internet and exploits the market because trades are disclosed on forums and by influential CEOs’ Twitter accounts. Traders are following each other’s tracks because demand of a stock will increase its price in the short term. It is essentially controlled momentum trading that has altered the world of day trading. The “Meme Culture” has reached Wall Street, and influencers are taking this opportunity to equal the playing field.