The Madness of Crowds[1]

Social media is the most wonderful delusion invention of the 21st Century.  From a friend:

“I was shopping at the mall just before Christmas and walked past this videogame store called GameStop.  It was selling games that you can easily download from a home computer.  My reaction was, like, why?  I mean, why go to the mall?  It was archaic!  And during a pandemic? So I thought to myself, ‘How does this place stay in business?’  There was, like, only one guy in the store … and he looked to be in his 50s.  It was so weird.  So I decided to check out the company when I got home.  It had to be a front for something, right?  But what?  Like no!  This GameStop is, like, a real company with 5,000 stores, all of which must be just like the one I had walked past – totally empty.  The company hadn’t made a profit in, like, years, and from what I could see, nobody had any reason to believe it would ever again see a profit.  So I wondered, like, what was going on.  And that’s when things got interesting.  You see, this guy, Ryan Cohen – he’s the former CEO of Chewy Inc., a really successful online pet supply company –, had started buying GameStop stock in August and he’d built a 13% ownership stake.  I thought to myself, ‘this guy must know something.’  In November, he’d sent a letter to GameStop’s Board of Directors saying that ‘GameStop has the flexibility to evolve into a technology-driven sector leader.’  ‘Wow,’ I thought, ‘this could be a great turnaround story.’  So I used my Robinhood app to buy 5,000 shares and posted on r/WallStreetBets.  Boy, was that a good idea!  I didn’t have to wait for any turnaround!  I made a cool $2 million a few weeks later when I sold my shares for $420/share, less than the high of $483, but who cares?”

There were any number of similar stories, all dealing with retail investors like my friend successfully squeezing the big hedge fund guys – the bourgeoisie –, right?  Well, not exactly.  Ahhh, the madness of crowds!

GameStop was a modestly-profitable retail business until it began to face online competition.  As recently as 2016, it had revenue of $9.35 billion.  That run ended in 2019.  For the 12 months ending Q3 2020, GameStop had a loss of $275 million on revenue of only $5.2 billion and its share price was dragging at around $4.  That’s when Ryan Cohen purchased his shares and the stock’s price quickly doubled … to $8.  One analyst observed that retail investors apparently believed “that [Cohen] can implement omnichannel initiatives that will materially grow earnings.”  It wasn’t until January 11th, however, that GameStop became a social media darling.  That’s when Cohen and two colleagues joined the Board and GameStop announced that “Their substantial e-commerce and technology expertise will help us accelerate our transformation plans and fully capture the significant growth opportunities ahead for GameStop.”  Several hedge funds were unimpressed.  They didn’t believe that GameStop could successfully compete online  It was late to the game and lacked the necessary growth  fundamentals, so they opened short positions, betting the stock price would fall back to its 2020 lows.  But a group of Reddit r/WallStreetBets users decided to band together and squeeze the shorts.  They bought shares, which propelled the price higher.  Professional investors quickly joined in the fun the mob the short squeeze.

Shorting is a bet that, instead of the value of a stock increasing, it will decrease.  Someone who believes a stock is overpriced can borrow a share when its price is, say, $100, and immediately sell the share in the market.  If the value of the-share thereafter declines to $80, as he hopes, he can buy the share back at the market price of $80, deliver it to the lender, and pocket the $20 (minus the interest cost).  Shorting is viewed by some as nasty unsavory.  The reality is that it’s risky …, very risky.  Although stocks can decline by only 100%, stock prices can go up by virtually unlimited percentages … and that’s precisely what happened with GameStop.  It soared by ~1,700%.  If a buyer makes a mistake buying a stock, the most he can lose is his entire investment.  That’s bad.  But if he makes a mistake shorting a stock, he can lose everything he has!  Even if his analysis is right – as so many have learned to their great sorrow –, a stock can go way up before it goes down, forcing a short seller out of his position.

That’s what happened to a number of hedge funds that shorted GameStop.

An interesting twist on the GameStop short squeeze is that both the extremist right and the extremist left found themselves aligned … and aligned with the Reddit crowd.  Tucker Carlson showed his support while simultaneously vilifying the short sellers:  “Short selling hurts companies, their investors, and their employees.  Ultimately, it hurts our country itself….  What’s happening on Wall Street is so clearly awful and so obviously destructive….  A group of independent investors in a Reddit group called Wall Street Bets learned that hedge funds planned to short the stock of a failing retail company called GameStop.  So they began buying shares of GameStop, and GameStop surged in value, ultimately by more than 1,000%.”  His comments are consistent with those of the extremist left:  openly anti-capitalist and anti-free markets.  His labeling of GameStop as “a failing retail company” means that, if so, the capital that flowed into GameStop should have been deployed elsewhere for the benefit of viable companies, their investors and employees.  Contrary to his assertion that shorting hurts “our country itself,” efficient capital allocation makes the American economy stronger.  Although he was spot-on in saying that “Short selling exists for the purpose of enriching the people who do it,” isn’t that how American capitalism is supposed to work?  Those who invest necessarily do so for the purpose of enriching themselves which, as capitalism has taught, benefits the greatest number (see TLR‘s “The Capitalist Manifesto” and “The Convergence of Communism and Capitalism“).

From the left came a similar outcry:  “Observers see the GameStop short squeeze as a populist attack on unscrupulous Wall Street types….  The GameStop story reinforced the growing sense that the system has been rigged for the wealthy.  People from across the political spectrum are demanding more thorough regulation of the stock market, a dramatic cultural change….  Leon Cooperman, a hedge fund trader worth $2.5 billion, took to CNBC to vent his fury.  ‘The reason the market is doing what it’s doing is, people are sitting at home, getting their checks from the government, basically trading for no commissions and no interest rates,’ he said, referring to relief for people thrown out of work by the pandemic.  With calls for unity in the air, Cooperman offered his own definition.  Democrats’ suggestion that the rich should pay their ‘fair share’ of taxes is ‘bullshit,’ he said. ‘It’s just a way of attacking wealthy people….’”

The extremist right and the extremist left therefore are united in their class war struggle against … exactly what?  Capitalism?  Efficient markets?  Fundamental value?  They favor … more regulation?  Both decry the profit-making motives of the wealthy investors, and especially those who pursue short selling …, even though selling short is simply the obverse of buying — “going long.”  There are, after all, always two sides to a trade:  a buyer who believes that a stock is a bargain and a seller who believes that the stock may be overpriced.  Isn’t betting that a stock’s price will go down as legitimate as betting that it will go up?  A well-functioning market of buyers and sellers enables price discovery, a necessity in any successful market.  It drives capital to where it is best utilized.  That’s not “betting against America.”  Quite the contrary.  It lubricates America’s businesses, favoring the better-run businesses and ensuring the relative success of America’s capitalist system.

The media storyline is that substantially all of the GameStop buying came from retail investors on Robinhood who bought early and at a low price and that the GameStop story therefore is a demonstration of the power of small retail investors beating up on billionaire hedge funds.  Retail investors on Reddit undoubtedly started the GameStop rally, but the facts show that the majority of gains were realized by market professionals.  Big-money Wall Streeters quickly climbed aboard the short squeeze engine and made more money from GameStop than their squeezed Wall Street brethren lost.  Similarly, those retail investors who bought GameStop after it peaked were the losers …, and a number of retail investors lost big.  The tragedy is that little guys invariably get run over by such Ponzi and pump-and-dump campaigns, which for many is what GameStop turned out to be.  The last buyers were left holding the bag …, and Wall Streeters are never the last buyers.

Short selling isn’t about right- or left-wing politics.  It also isn’t about the little guy vs. the big guy – or, as Karl Marx labeled them, the proletariat and the bourgeoisie (see TLR‘s “The Rise of Populism and the Agonizing Death of Compromise“).  It’s about accurately pricing companies in America’s market-based economy – price discovery working at its best and most efficient.  Yet, like so much in 2021, GameStop became a media trope, politicized by the extremists … and for essentially the same anti-establishment reasons.  Media reported that a number of retail investors said of their GameStop positions, “We’re not interested so much in the financial rewards we would get personally, but what we hope is that the rest of the world sees what we’ve done and that the hedge funds have been punished for what they’ve been doing.”  That’s class warfare.  It’s extremist.  It’s not capitalism.  It’s bad for America.  And it sends a frightening message about the Madness of Mobs that should be clear to both those on the right and those on the left.

For financial markets to function properly, they need to be driven by financial reality.  GameStop was never worth $483/share.  Today, economists would agree that it’s not worth even $48.30/share.  Yet it briefly traded at $483/share because of an irrational belief based on the madness of a crowd.  That’s also how the value of Bitcoin has been determined, another favorite of those on both the right and the left.  Bitcoin itself is not backed by earnings … or assets … or any fundamental or economic value.  Its value, precisely as GameStop’s value as well as the value of tulip bulbs, is based on faith, the belief of a like-minded mob crowd.  For many in the Reddit-GameStop mob crowd, value was driven by rage, rage against the inaccurately-perceived unfairness of America’s economic system.  In far too many instances, the extremist mob crowd reaches conclusions based not on fact, but on hype … a mob psychology that’s also permeated American politics.

Extremists on the right and the left not surprisingly share some of the same fantasies conspiratorial beliefs.  Many extremists believe that the value of GameStop is divorced from economics, mathematics, and fundamentals … and that it is based solely and simply on their common belief in a value of $1,000/share, the target urged by posters on WallStreetBets.  Their faith in such an outcome has been endorsed by Elon Musk and Mark Cuban … which would lead an observer to wonder how, if GameStop represents an assault by the proletariat against the bourgeoisie, billionaires like Musk and Cuban fit in … and what their game is.  Extremists historically have gained their greatest traction – and inflicted their greatest damage – when encouraged by “visionaries” … which both Musk and Cuban most certainly are.  Nevertheless, the answer that history teaches is that unsupported beliefs can flaunt reality for only so long.  As Philip K. Dick famously said, “Reality is that which, when you stop believing in it, doesn’t go away.”  So shall it be with GameStop and Bitcoin? And Tesla? And …?

Wishful thinking not only has linked the extremist right and the extremist left when it comes to questioning the rational foundations of free-market capitalism.  As TLR noted in “They’re All Keynesians Now,” despite the evidence of history that there is no such thing as a free lunch, both Republicans and Democrats are enamored of Modern Monetary Theory.  Moreover, despite the entrenched American values of individualism and self-sufficiency, both Republicans and Democrats have adopted a Statist policy that has rapidly devolved power to an all-knowing centralized government.  The GameStop phenomenon is not an outlier.  It’s an unfortunate sign of today’s mob-driven times the Madness of Crowds.

Finally (from a good friend)

[1] An endorsement of Charles MacKay’s 1841 classic, “Extraordinary Popular Delusions and the Madness of Crowds.”

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