Revenge Of Retail As Melvin Capital Loses On Gamestop Squeeze!

Summary

• Retail Traders Inflict Pain on Hedge Funds.
• Congrats to small investors as it epitomizes investing.
• Structural issues will get examined by regulators.

‘Robin hood- Rob from the Rich Who Stole From the Poor to Give Back to the Poor'

It was truly a legendary week in the financial markets this week. The story on everybody’s mind is the remarkable rise of Gamestop and other highly shorted stocks. A massive group of retail traders led by the subgroup Wallstreetbets on Reddit enjoyed the fruits of buying Gamestop while Melvin Capital lost billions of dollars. Don’t worry about the hard working folks at Melvin as they went back to investors Citadel and Point72 Capital for an additional cash infusion. We will address Citadel in a moment because they are an integral part of this situation. There are many aspects to the Gamestop issue which are interesting and worth a discussion. From my perspective, the main point to digest is the whole situation took place because a couple of excellent small individual investors realized a long time ago there was much more value in Gamestop than the market price reflected. Persistently, they continued to buy the stock and over time, some positive developments took place and the stock began to rise. The real gasoline on the emerging fire was the issuing of a short report by noted short, Andrew Left of Citron Research. The WallStreetbets followers took umbrage at that report and in retribution, decided those who were short should pay. Pay they did, as in the history of short squeezes, this one may be the most dramatic. According to press reports, the largest clearing house required brokers to post more collateral for their customers. How much more collateral you ask? Uh, 7 billion. Yeah, that is with a b. It it highlights one of the structural issues investors have long had to deal with. Let’s take a look at it.

Brokers have customers who have different financial profiles. If you are a more conservative investor, you pay for your purchases with the existing cash you have deposited. Not all customers employ this method of buying securities. If you are more aggressive, you can buy larger volumes of securities by using margin, or borrowed money. In addition, another way of aggressively buying securities is through the options market. Like margin, option buying allows for an investor to potentially control more shares using less capital, for a specific and limited period of time, that is, the length of the option. Brokers extend the margin to investors, who ultimately are responsible for paying for those securities, one way or another. If the position goes against you and you use margin in some form, you can get a margin call requiring more funds. On the opposite side of this situation from the broker is a market maker, who pays the broker for order flow. A huge market maker is, ta da, Citadel Capital, who has relationships with large brokers like TD Ameritrade and, yes indeed, Robin hood. Citadel has huge profit margins and is incredibly profitable, so much so that the founder, Ken Griffin, is a multi billionaire. Mr. Griffin has capital in hedge funds and is quite a prolific and successful investor. Robin hood, the on line broker, has their brokerage house set up to allow investors to sign up for an account on line and immediately get access to margin in both stock trading and for option accounts. Robin hood has millions of users, so you can see how their influence can potentially have ramifications for a specific stock, especially if it is targeted by investors the Robin hood crowd agrees with. What is missed with this whole situation is the individuals who did the work and analyzed Gamestop when it was dirt cheap and continued to invest for a long time have reaped the rewards. It is what makes investing a wonderful activity. I am sure they are shocked at their out sized gains, much of which is the result of piling on by enthusiastic followers who want to stick it to the well heeled Wall Streeters. I’m pretty sure other hedge funds got wind of the trouble and piled into the trade as well. It brings up the issue of retribution for the 2008 bailout and the lingering anger at how it was handled. The Wallstreetbet crowd is correct in it’s criticism that those who caused much of the problems in 2008 were allowed to borrow billions of dollars and leverage their capital in a way that risked blowing up the entire financial system. Robinhood itself was under capitalized and had to go to JP Morgan and Goldman Sachs to get access to large credit lines to then extend to their customers. As a result of their lack of capital, Robin hood restricted trading in specific securities and highly shorted stocks, like, yup, Gamestop. So, like the legend of Robin hood, the firm did ‘rob from the rich and gave to the poor’, if you believe individual traders and investors are ‘the poor’. Naturally, the politicians noticed, so much so that Ted Cruz and AOC were in agreement that something needed to be done about Robin hood. Lord, help us.

Elsewhere in the markets, it was a big week of earnings as heavyweights Microsoft, Johnson & Johnson, Verizon, Visa, Mastercard, and Facebook all had nice results. Las Vegas Sands and Tesla missed slightly, while Comcast raised their dividend after reporting a solid number. Looking forward to next week, there will be another big week of earnings but all eyes remain glued on the Gamestop story, along with the other highly shorted stocks. One implication for investors is I suspect high profile short selling is now going to be very scarce. Why risk the wrath of the Reddit crowd if you don’t have to? Also, I am confident regulators are going to look at margin availability and short selling rules, along with the entire situation with Gamestop. Finally, other hedge funds who are suffering may have to liquidate winning positions to cover the losses in their shorts. Consequently, it should be an interesting few weeks in the investment world, but it always is.

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