Sold short: why Reddit speculators will lose out in the GameStop gamble
While some may enjoy the discomfort caused for hedge funds, unusual market inflation never ends well.
Executives who have experienced the discomfort of short sellers predicting the demise of their businesses would need a heart of stone not to laugh at the punishment meted out to their foes by members of the Reddit tribe r/wallstreetbets.
The phenomenon, which started with stocks in US retailer GameStop, unfortunately only demonstrates precisely why the investment tactic will continue to prosper.
Short selling works by predicting that a business is overvalued and betting on a reduction in share price. In its purest form it’s a case of transacting to borrow the necessary shares and waiting to see if the bet plays out. In more contentious cases, research notes are published and efforts are made to illustrate the inevitability of the prophecy coming true, often drawing accusations from the business shorted of market manipulation.
It’s this latter category that tends to vex executives the most, and often finds leaders who should be focussed on the underlying performance of their business distracted trying to calm investor nerves by rebutting challenges to the business’ reputation as a sound investment.
But short selling prospers precisely because some businesses are overvalued or - in the most extraordinary circumstances - barely valuable at all. Irrespective of all those amused by hedge funds’ suffering as GameStop and others have seen their share prices surge, none of that sentiment reflects any change in the underlying value of the business (save perhaps from the benefit of short term free publicity).
Short selling is far from the most loveable investment tactic to defend. For all that an efficient markets argument can be raised for creating incentives to spot weaknesses that regulators may not be similarly motivated to proactively look for, it is still a form of investment too prone to cynicism and unwarranted activism that runs counter to most corporate cultures. It does though serve as an economic check on bubbles.
Stock markets - like all markets - have always been susceptible to manipulation. The pump and dump model of encouraging others to buy a share only to inflate the price of your own stock - best exemplified in popular culture by the antics of Jordan Belfort told in the film Wolf of Wall Street - showed not only the gains to be made by this tactic, but also the regulatory consequences that followed from being caught doing it.
Belfort himself has in recent days compared the antics of the Redditors to a modified pump and dump: in reality the only modification is the question as to what the motive truly is. What is billed as campaigning behaviour to give the shorts a bloody nose takes on a very different complexion when the question arises of exactly who the anonymous posters promoting assets are and what they stand to gain from rises. What can be certain is that there will be victims: no amount of hyping alters the true value of the businesses being invested in and eventually there will be retail shareholders nursing losses.
That almost certainly will attract attention of regulators and litigators alike. With no little irony, it also creates an optimal environment to make gains from a short position if you have nerves of steel and cast iron liquidity.
Alas for businesses subject to the grey world of short positions taken in them, the long term route out of the pressure they face is not to be found in an investment sub-Reddit. It does though reiterate how murky the regulatory and reputation impacts become when unusual market behaviour is encouraged.