How to Keep Your Cool in the GameStop Market

Even during a calm stretch on Wall Street, the stock market contains pockets of madness. But these days have been anything but calm. One word captures it: GameStop.

It’s no longer just the name of a chain of video game stores at shopping malls. GameStop has become a stock market phenomenon — an eruption of irrational exuberance that, if only for a day or two, commanded center stage in the midst of a deadly pandemic, an economic downturn and a simmering political crisis.

GameStop shares rocketed so rapidly that the rise — more than 1,700 percent for the month through Wednesday — looks like a series of typos: $19.95 on Jan. 12, $76.79 on Jan. 25, $147.98 on Jan. 26 and $347.51 on Jan. 27. Then the price started falling, as retail platforms like Charles Schwab, TD Ameritrade, Robinhood and Interactive Brokers curbed trading in the stock. By the close on Thursday, GameStop was down to $193.60 but was climbing back on Friday morning. Where it will it be in the coming week is anybody’s guess.

The stock’s gains had nothing to do with its merits. The company is losing money, as you might expect when you look at its business model: Why, in a pandemic, would you drive to a mall to buy video games when you can download them at home on high-speed Wi-Fi? The company strikes me as having as much of a future as, say, Blockbuster Video, the bankrupt chain that was also swept up in the mania. Its current incarnation as a penny stock, BB Liquidating, surged more than 700 percent on Tuesday alone.

While there is a David versus Goliath element to the GameStop stock saga, it is likely to be a cautionary tale. The extreme volatility is reminiscent of the tulip mania in 17th-century Holland, another episode in which rollicking asset prices soared way beyond their intrinsic value. Tempting as it may be to join in the fun, at moments like these most long-term investors are usually better off if they stay sober and avoid the urge to make quick profits. A better option would be salting away money in dull, well-diversified stock and bond portfolios, these days preferably in low-cost index funds.

“Trading in stocks like GameStop is the last thing people should be doing,” said Richard Bernstein, a former chief investment strategist for Merrill Lynch who runs his own investment firm in Manhattan. He said some of the money being poured into the global economy by central banks and governments during the pandemic was “inflating the values of financial assets, and regulators need to be concerned.”

But the wild trading should not distract investors from the big picture, which he said is that despite the pandemic, the world is “shifting into a new, accelerating stage in the corporate profits cycle,” with opportunities in the stocks of sober, moneymaking companies in sectors like energy, materials and manufacturing. Buying shares of firms with weak or no earnings like GameStop, Mr. Bernstein said, is not the way to go.

Consider that, until it began making headlines, GameStop was notable as an investment chiefly for attracting negative bets — known as short interest — from big institutional traders like hedge funds, which saw little value in the stock.

What seems to have happened is that a group of individual traders, gathered on the WallStreetBets message board of the social media site Reddit, decided to make enough highly leveraged bets to thwart the short-sellers and drive GameStop’s price into the stratosphere. The hedge funds had to buy shares of the stock to cover their negative bets — creating what is known as a “short squeeze,” and adding to the upward momentum.

Day traders exulted that they had made a lot of money, riding GameStop and the stocks of other downtrodden companies as high as they could. In the sense that individual investors were gaining while hedge funds were losing, this was a case in which, for a while at least, the little guy won.

The short squeeze extended well beyond GameStop to a variety of troubled stocks that had attracted negative bets, largely from institutions like hedge funds, data from Bespoke Investment Group shows. The most heavily shorted 10 percent of stocks rose more than 38 percent for the year through Wednesday. By contrast, the 10 percent that were least heavily shorted declined 0.9 percent. In a whimsical note, Bespoke called the day traders’ assault on the hedge funds “the greatest squeeze on earth.”

The Securities and Exchange Commission said it was monitoring the trading closely. “Consistent with our mission to protect investors and maintain fair, orderly and efficient markets, we are working with our fellow regulators to assess the situation,” the agency said in a statement on Wednesday.

While speculative trading is fun when it’s profitable, it is dangerous — closer to gambling than to serious investing, most academics who have studied the subject say.

“For many people, this can only end badly,” Professor Ciamac Moallemi of Columbia Business School said in an interview.

He said he had no particular sympathy for hedge funds: “They are sophisticated investors, and they know, or should know, what they are getting into.” But people without much money are making wagers, using derivative instruments in which they could lose everything, he said.

Using social media to organize a stock trading campaign appears to be new, Professor Moallemi said, but in other respects, “we’ve seen this kind of behavior before, and it leads to people getting hurt.”

Given the magnitude of global financial markets, the wild rise and fall in prices of stocks like GameStop so far has been limited in scope, and there are few signs of broader disruption.

What could derail the stock market? Many things, of course, including the possibility of opaque, systemic connections between hedge funds that have lost money in the short squeeze and sensitive global financial institutions. The collapse of one money-losing hedge fund — Long Term Capital Management in Greenwich, Conn. — sent unexpected tremors through global markets back in 1998. But that is exactly the kind of thing that regulators will be looking for now.

There has been a flood of initial public offerings, particularly of entities known as SPACs, short for special purpose acquisition companies; my colleague Michael J. de la Merced has described them as “publicly traded shell companies created solely to merge with a privately held business.” Many such companies have traded without earnings or revenues, another indication that a deluge of easy money has led to speculative pockets in the stock market, which could lead to serious trouble.

In the meantime, the long overall rally continues. It began in March when the Federal Reserve and other central banks began a rescue operation, vastly increasing the global money supply and pledging to do whatever it took to maintain financial stability in the face of the economic downturn driven by the pandemic. Fiscal stimulus — big government spending programs — has made up for some of the income of millions of unemployed people and thousands of failing businesses. In the United States, if the Biden administration has its way, more government aid is on the way.

Thanks in no small part to the infusion of money, asset prices across the board have risen, and interest rates remain extraordinarily low. Big tech stocks like Apple, Microsoft and Facebook, which all reported earnings in the last several days, have fueled the rally, helping to make stocks expensive by historical measures. But if corporate earnings rise as expected — Mr. Bernstein anticipates a year-over-year increase that could be 40 percent or more, given the devastation wreaked by the pandemic in 2020 — the stock market may seem less outrageously priced.

Low interest rates make stocks attractive compared with alternatives like bonds, many strategists say, but that could change. Katie Nixon, chief investment officer of Northern Trust Wealth Management in Chicago, said that she expected the bull market to live on, but that if the yield on the benchmark 10-year Treasury note, now a little above 1 percent, reached 1.5 percent or even 1.75 percent, there could be a severe stock market reaction, much as there was in 2013 and again in 2016.

Such a rise is unlikely but possible, because government statistics are likely to show an apparent spike in inflation in coming months — in large part because the severe economic downturn of 2020 held prices down.

“There is a super-high probability of very high numbers,” Ms. Nixon said, but they are likely to be illusory, reflecting the economic recovery, not a fundamental increase in prices. “Our base case is that both the Fed and the market will understand that and see through those numbers.”

Truly long-term investors may not need to worry about such issues, however. The great temptation in a rising market like the recent one may be to buy soaring stocks, for fear of missing out on easy profits. The temptation during severe downturns, like the one a little more than a year ago, is to sell your holdings to avoid big losses.

Setting a steady course and sticking with it for many years is a better approach, Ms. Nixon said. Hold stocks and bonds in an allocation you can live with, she said, and ignore the GameStop madness.

“Tighten your seatbelts,” she said. “There will be a rocky ride ahead.”

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