Assessing Whether Quants And High-Frequency Trading Are The Real Cause Of GameStop Frenzy
Summary
- A report by the US Securities and Exchange Commission (SEC), released in mid-October 2021, sheds new light on the manic "meme stock" trading activity seen over the past year.
- We take a look at what the report had to say regarding GameStop and its broader implications.
- It appears that institutional investors played a much bigger role in meme stock trading activity than was first reported with an eye towards quant, trend, and momentum funds.
FinkAvenue/iStock Editorial via Getty Images
By Valuentum Analysts
Third-quarter 2021 earnings season was thrust upon a marketplace that had been preoccupied with talk over supply chain disruptions, increasing inflation expectations, unfortunate distractions from trading activity by key officials at the Fed, and Chinese regulatory unease. We think these items had largely been the key reasons for the pullback in the markets in recent weeks.
However, with news that President Biden re-appointed Jerome Powell as Fed Chief, despite his more hawkish tone of late, and the SEC easing off a bit on cryptocurrency pressures - having allowed the trading of the first futures-based Bitcoin ETF (BITO) - and chatter from the regulatory crackdown in China slowing (a bit), markets are looking like they might break out. Even one of our favorites, Facebook (FB), which has caught the ire of almost every skeptic, has caught a bid of late as investors start to again focus on what matters: fundamentals and earnings.
The media is having a field day covering COVID-19, but we're not reading much into the Omicron variant, and a more hawkish Jerome Powell isn't much to worry about, in our view. Benchmark 10-year Treasury rates are ~1.4%-1.6%, which is ultra low and below the highs of even this year, while inflationary pressures, in our view, will result in pricing power by many, pushing nominal earnings higher. All things considered, higher earnings and lower discount rates are a positive for equity values, even if the Fed starts tapering bond purchases a bit earlier than expected, a move that may be inconsequential.
What gives us confidence that this bull market still has legs, and the area of large cap growth, in particular, is that large cap growth (made up of the largest companies in the market) is full of moaty, competitively-advantaged companies with tremendous balance sheets (with huge net cash positions) and fantastic free cash flow generation (net cash from operations less all capital spending) that are tied to long-term secular growth trends, "Large Cap Growth Has More Room to Run." Facebook and Alphabet (GOOG) (GOOGL) are severely underpriced, while Apple (AAPL) and Microsoft (MSFT) couldn't be healthier. The stock prices of these entities may have run significantly, but just because their price advances have been great doesn't mean that they still aren't underpriced.
The secret to market success the past decade has been rather simple, and the discounted cash flow model and enterprise valuation have explained most all of it. Those entities with substantial cash-based sources of intrinsic value - net cash on the books and tremendous free cash flow generation (in excess of dividends, where applicable) - or more appropriately labeled large cap growth have trounced the opposite, those with net debt positions and free cash flow that barely covers cash dividends paid or doesn't, as in MLPs and REITs (and arguably the consumer staples and utilities sectors). Please view the image below for context.
Image source: Seeking Alpha, retrieved November 28. Our call to overweight areas of large cap growth and underweight overleveraged areas such as MLPs have served members quite well the past 5 years. Chinese equities and bonds have also languished relative to more attractive large cap growth in recent years.
The "GameStop Report"
On October 18, the Securities and Exchange Commission (SEC) released its "GameStop (NYSE:GME) Report," a staff analysis of what drove the widespread volatility in so-called meme stocks earlier this year. The SEC noted that there was a surge in the number of individual investors during the meme stock frenzy (the number of unique accounts trading GME increased to nearly 900,000 from 10,000, for example), but the report also noted that the median account balance at Robinhood Markets (HOOD) stood at just ~$240. We find it very difficult to believe, as others have, that individual investors acting in concert were the major driver behind the meme-stock trading frenzy earlier this year.
Image Shown: The cause of the GameStop trading frenzy remains largely unclassified as it appears to us that quant and high-frequency trading played a much bigger role in the market disruption than what is being reported.
From our perspective, the "GameStop Report" seemed to center more on dismissing "short covering" and "gamma squeezes" as the causes for the GME trading volatility and highlighting concerns related to the "gamification" of investing regarding the controversial practice of payment for order flow ("PFOF") than getting to the heart of the issue that is challenging market integrity and structure. As we outlined in the book Value Trap, our thesis has always been that the widespread volatility that shook equity markets during the meme-stock frenzy was largely driven by the price-agnostic trading, including retail traders but mainly from quant hedge funds - trend, momentum or algorithmic, high-frequency, or some combination of all four.
The narratives of some glorified individual investor revolt against Wall Street remain, but the "GameStop Report" clearly states on page 21 that: "In addition to individual investor activity, there was significant participation by institutional investors, including several hedge funds that purchased GME. Some of those purchases may have been used, at least in part, to cover short positions." We believe "significant" to be material, especially when we do the math. For example, assuming 900,000 accounts at ~$240 an account, that's only $216 million, or about 1.5% of GameStop's existing market capitalization of ~$14.2 billion, which is much lower than it was during the height of the meme-stock frenzy.
The SEC also noted that "more than 100 stocks experienced large price moves or increased trading volume that significantly exceeded broader market movements," with many of the stocks revealing high short interest as a percentage of float. We find it very difficult to believe that retail traders with small average account balances were whipsawing more than 100 stocks, all at once, some with market capitalizations in the tens of billions, when the math simply doesn't add up. For example, on January 22, 2021, alone, GME traded 197.2 million shares with the stock increasing from $43 to $72. That is $8.48-$14.2 billion in trading value on just one day on one meme stock.
Serious money was moving these stocks -not likely a meaningful percentage of which came from Robinhood customers or from accounts belonging to investors with an average age of 19, the latter representing a large portion of the surge in new brokerage accounts opened in 2020. The SEC report does not clearly disclose how many more institutional accounts - those with account values of $50 million or more - started to more actively trade in GameStop during the frenzy, but we estimate by eyeballing the graphical representation provided that perhaps there was a 5-10 fold increase from mid-January to late-January (and a huge increase from the beginning of the month). The SEC said as much in the report that "quantitative and high-frequency hedge funds, joined the market rally (in GameStop)," meaning that there is much more to the GameStop story than what appears at face value.
The Threat of Price-Agnostic Trading
Image Shown: Excerpt from the book Value Trap: Theory of Universal Valuation.
According to some estimates, fundamental traders, or those trading on firm-specific fundamentals, account for just 10% of trading on the exchanges today. Passive and quantitative investing, or price-agnostic trading, accounts for 6 times as much. Prices are set on the marginal trade, not on the amount of assets under management, and if most market participants aren't trading on underlying business value, this in turn can cause widespread dislocations in prices versus reasonably estimated intrinsic values (dislocations that may never fully be reconciled even over long periods of time). In such a scenario, the capital-raising function of markets could become significantly less attractive. What CEO would want the company's stock price to be driven by quantitative algorithmic trading mechanisms and correlations with unrelated assets instead of on its company's fundamental long-term business outlook, earnings and free cash flow stream?
In recent decades, finance seems to have only pursued more sophisticated methods of data mining to build a seemingly endless supply of new products to sell to investors. There are now more than 70 times as many stock indexes as there are stocks, themselves, and according to research, there are now more than 7,000 ETFs globally, with over 2,500 in the US alone. Though this sounds like a large number of diverse investing options, less than 1% of US ETFs, for example, receive more than half of fund flows.
What's worse, the core of what equity ETFs are made of is surprisingly shrinking. More than half of all publicly-traded companies have vanished in just the past 20 years. As speculative instruments that are based on targeting price movements in theme-based orientation proliferate (as in the case of many ETFs), the future may simply look nothing at all like the past. How could it? The decline in the number of investable stocks has reduced the variety of reasonable investable options for many savers and retirees that need better choices, not more. But fewer listed stocks and more thematic-trading vehicles isn't so bad, right?
Well, without enough buying and selling based on firm-specific intrinsic value calculations, or value-conscious trading, market prices may simply take on a life of their own (think GameStop, for example), beyond the grasp of even the most advanced computer models that try to forecast them (perhaps the problem is exacerbated by them). That means we could experience even bigger bubbles and even bigger bursts, and they could become even more frequent. There have always been periods of panic in the stock market, of course, but for many decades now, they have always been passing, transient events. What will happen if most market participants are no longer acting on estimates of value, or on expectations of the market's estimate of value? How will prices behave then?
Indexers and quantitative investors rely on value-conscious active management to set the "correct" prices. Vanguard founder Jack Bogle has said that "if everybody indexed, the only word you could use is chaos, catastrophe." The chances of everybody indexing may be zero, but what are the chances of both indexers and quantitative investing, or all price-agnostic trading, completely overwhelming fundamental value-conscious traders that calculate intrinsic value estimates, causing levels of market volatility we've never seen before? What are the chances that the arbitrage mechanism of the market in setting reasonable prices breaks down? That is a non-zero probability that can have widespread implications, impacting each and every one of our lives.
Concluding Thoughts
We think the SEC staff put out a fantastic "GameStop Report" with some excellent information. However, the report did not get to the crux of the matter, failing to disclose what actually caused the extreme market volatility in meme stocks, while glossing over the substantial increase in institutional accounts, likely belonging to quant/trend/momentum funds, that contributed to the trading frenzy this year.
We think investors and market participants deserve to know more about what caused this threat to market integrity and structure as the continued proliferation of which (price-agnostic trading) may only grow larger and larger in the coming decades. If it was quant trading, then we encourage the SEC to take steps to ensure that such trading is curbed effectively as it is clear that such price-agnostic activity is not contributing to market efficiency.
This article was written by
Analystโs Disclosure: I/we have a beneficial long position in the shares of BITO either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Valuentum owns shares in the DIA, VOO, SCHG, SPY, and QQQ. Brian Nelson currently owns shares in SPY, SCHG, DIA, QQQ, VOT, BITO, and IWM. This article is for informational purposes only and should not be considered a solicitation to buy or sell any security. Securities mentioned in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (39)
www.youtube.com/...I already saw this a while back:
www.youtube.com/...The interviewee, Patrick Boyle, also has his own Youtube channel, which I recommend in general. To me, Boyle is knowledgeable, disinterested, and also very witty. Watching his videos is like taking finance classes that are both entertaining (through his dry and sly wit) and very informative. He'd be a good instructor for the Great Courses videos that cover finance, and he does teach at King's College in London.I think it's very telling that none of the bulls commenting here will say what it is that Gamestop will be selling in sufficiently large quantities to grow into its stratospheric share price. Used games? Collectibles? Cryptocurrency? NFT's? Sex robots? Something new?
To me, it's very telling that the bears on Gamestop always are scornful/refuse to do some DD on Reddit while we know this site is full of members that are younger than most of us on Seeking Alpha.We are talking about a company that is involved in the gaming market.I grew up playing with Atari, Commodore, but have not been involved in gaming that much for the last couples of decades.
I am pretty sure there are plenty of the so-called smart money hedgies around who could learn a thing or two about gaming from the younger ones, no matter if Kenny downloaded a digital game ๐คฅYou talk about intrinsic value...What is the intrinsic value of those paintings that costs millions of dollars that the hedgies seem to like?
The paint, a brush, and a velvet. That's it, if it weren't for demand/supply.What we are dealing with in this particular situation is a totally distorted market of shares of Gamestop.
Because if you create a market where shares short sold don't have to be bought back, and you create an infinite supply of those shares, how could we find any true value, anyway? All hail to Queen Kong, Suzanne Trimbath.i.redd.it/...People call this the people's stock.
I agree, after all, the public is the majority shareholdersimplywall.st/...So, in my opinion, the best thing that 'the people' can do is get their shares registered in their own name.
Why? Because the shares will have to be recalled, thus bought back, among other obvious reasons.The only ones i trust to lend their shares are the current insiders.
They want what's best for the company AND their shareholders, and i'm pretty sure they don't like hedgies as well. The actions that have been taken (like buying the shares from ex-employees) are telling.
Sometimes it really is that simple.On top of that, it gives more evidence of the fuckery that continues to happen with this stock.Gamestop is the first (for me, the only) memestonk, so let it be the first one that has their retail shareholders registering the float, too.
And let's have some fun doing it, too.We will get what we deserve.
You see, i can be one too, but never in the way the mayo gang is.www.youtube.com/...If it's up to me, it literally will be no cell/no sell.
Best Seasons Greetings, hedgiesgiphy.com/...
The "smart" money surely knows better, right?
Do i need to remember you how dumb some of that smart money can be?
Perhaps you need to watch the Madoff documentary...www.youtube.com/...Red flags all over the place, they were ignored, many looked away for the obvious reasons, and not that many went to jail.
At the age of 6, i probably would have been suspicious about it.tenor.com/...
They didn't buy to close, his nose is now bigger than the George Washington bridge.www.reddit.com/...
In this case, it's the Gamestop management.
Basically most involved in this saga have been lying about the short interest from January. When they altered the numbers and the SI was "supposed" to be way down, the Gamestop management made it clear in the March SEC filings that this wasn't the case.=>A โshort squeezeโ due to a sudden increase in ๐๐๐ข๐๐ฃ๐ ๐๐ค๐ง ๐จ๐๐๐ง๐๐จ of our Class A Common Stock ๐ฉ๐๐๐ฉ ๐ก๐๐ง๐๐๐ก๐ฎ ๐๐ญ๐๐๐๐๐จ ๐จ๐ช๐ฅ๐ฅ๐ก๐ฎhas led to, and may continue to lead to, extreme price volatility in shares of our Class A Common Stock.And this is from September.i.imgflip.com/...I believe RC gave us even more reasons to not believe a word the sell-side/short cabal was claiming on the proxy vote results.news.gamestop.com/...Seven of the elections show a vote total of 55,541,279.
The Larry Cheng election, however, shows a vote total of 55,541,280.Now you know why RC Ventures/Ryan Cohen owns 9.000.001 shares ๐งโโ๏ธ
Ryan Cohen, as the manager, may be deemed to beneficially own the shares of RC Ventures, according to the SEC filings.So what does it mean (most likely)?
RC was pointing out that the 55.541.280 M shares were not in any way reflecting (not by a long shot) the real amount of "shares" that have been created.Even if it were so, according to Ortex (who has proven to be under-reporting/not trustworthy as well) there were 13,247,404 M shares on loan on the record date of the proxy vote.i.imgflip.com/...And there were 11,110,000 "officially" reported shares short to FINRA.i.imgflip.com/...source : Marketbeat.comThese 2 combined are 24,357,404 M shares.
Add the 55.541.280 M shares from the proxy vote and you have already
79.898.684 M shares.That's already 9 Million shares above the shares outstanding at the time.i.imgflip.com/...source : ProxymonitorAnd you can bet your ass very little institutional shares were voted, and surely not every retail investor submitted their vote.
On average, 28% of retail investors submit their vote the last couple of years according to Proxy Pulse.We see one glitch after another.upsidechronicles.com/...Just a couple of days ago 71,196,206 M shares were reported short by Refinitiv, pbs.twimg.com/...Thomson Onei.imgflip.com/...Finvizpbs.twimg.com/...And then they act like it never happened...pbs.twimg.com/...The short cabal drops the price 10% while Fidelity buy/sell ratio is 90%. charts.stocktwits.com/...So, it's all debunked from the start, but now, after all this time and after the theft in broad daylight, it seems that some of the media wants to talk to apes? It sure won't be me, i just love the stonk of stonks #GMEc.tenor.com/...And why, because individual retail investors are simply using their legal right to claim ownership of what they paid for with their hard earned money by registering their shares??Thanks, but no thanks, they don't deserve my trust/time.
Gamestop, an American icon by now, and their management, workers do deserve my time/support/trust, so i'll just do that.BUY/HODL/DRS/BUCKLE UP.
Feel free to share all you want, too.c.tenor.com/...No financial advice.PS. Did you read?The Omicron variant has been detected in at least 38 countries but no deaths have yet been reported.www.youtube.com/...
Some very basic flaws as the foundation for your argument.Sure there has also been significant institutional trading of GME, but none of that explains why it is still trading near $200.(and has been since March)Thereโs been a lot of effort to dismiss retail traders, but the underlying reality is hard to ignore.Do better next nextโฆ
www.valuentum.com
Do i need to remind you of the congressional hearing?
It was called...
Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors CollideDo i need to remind you of the volume/dollar amounts involved at the time, the rise in Wall Street Bets members, the "idiosyncratic" event (DTCC), the planes flying with banners, the tweet from Elon, DFV, etc...So no, it's silly to act like it was just one of perhaps hundreds wildly volatile stocks at the time.=>meme stocks are retaining a significant price-to-fair value disconnect.That's obviously your opinion, again.
In June, Morningstar had fair value at $315 already.gmetimeline.com/...Also back in June, Jefferies had a price target of $190gmetimeline.com/...