Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared at Project Syndicate.
Whether one thinks that the overall equity market is currently valued properly or not, something very unusual happened in the last week of January to assets such as stock in the company GameStop. Its price rose 323 percent for the week, and 1,700 per cent for the month (that is, an 18-fold increase). This is a speculative bubble. That is, the price departed from fundamentals.
Some investors who got in early and got out early have made a lot of money. Just as many people, who get in too late or have stayed in too long, are losing a lot of money, as valuations come back to earth.
We focus on GameStop, an ailing bricks-and-mortar retailer of video games and consoles, for concreteness. But a similar phenomenon has affected prices of a number of other assets.
It will be dollar loss per dollar gain, or slightly worse. In this respect, participating in a speculative bubble is like playing roulette in a casino. The role of “the house” in this casino is played by brokers like retail-investment platform Robinhood or financial-services company Charles Schwab.
So far, not so unusual. Speculative bubbles happen from time to time.
What does this bubble say about finance?
The GameStop episode is interesting in that it cuts against both of the two common interpretations of financial markets. On one side, the “establishment” view, in favor of financial-markets, is that they competitively and efficiently allocate capital, via the signal of the stock price. The claim is that they direct capital to enterprises that have a bright future in terms of their economic fundamentals, and directing capital away from those firms that don’t. On the other side, the “populist” view is that big Wall Street traders speculate in ways that destabilize the markets, in order to make unseemly profits at the expense of the little guy. In the most sinister view, they are even suspected of conspiring with each other to destabilize the market.
Let me say right away that I think there is some truth to both views. This column is not going to identify a hero or a villain.
With GameStop, you have on one side the little guys (mostly amateur traders, mostly young, stuck at home), who in this case are the ones conspiring to create the speculative bubble, by coordinating on message boards such as Reddit’s forum WallStreetBets. On the other side you have hedge funds who are doing what they are supposed to do: identify a stock that they figure is priced out of line with fundamentals (in this case, priced too high), and place bets against it — “going short” — which works to drive the price down.
Remarkably, the little guys dominated, at least for awhile. Perhaps, at the beginning, they evaluated GameStop as genuinely worth a bit more than the price it was trading at. But then they kept going. They succeeded in creating a speculative bubble, even with the hedge funds pushing the other direction.
More often, it is the latter that prevail. In this case, the hedge funds appear to have swallowed their losses and to have refrained from further short sales.
Analogous run-ups in the stock prices of American Airlines and AMC Entertainment have encouraged these two companies to issue more stock. One would have thought that their business prospects have been adversely hit by the pandemic. One could argue that the price signal coming out of the stock market is guiding the allocation of capital in wrong directions.
One need not understand the fine details of options or other derivatives to understand the basic bets that the players made. In this case, options were used both by the hedge funds, who bought put options to bet against GameStop, and the small traders, who bought call options to bet that the stock price would rise. There is nothing inherently nefarious in such contracts.
In the classic film, East of Eden, Cal – played by James Dean – “goes long” in beans, reasoning that the US will enter World War I and the army will need beans. He is right, and the price of beans goes sky-high. But his moralistic father, to whom Cal tries to give his winnings, disapproves of making money out of misfortune. He doesn’t realize that when Cal’s bet on beans helped raise the futures price, it sent the socially desirable signal to incentivize farmers to plant more beans for when they would be needed.
Traders who sell short (buying put options) tend to generate more anger and moral disapproval than those who go long (buying call options). It is understandable if an entrepreneur like Elon Musk hates short-sellers (the way Captain Hook hates the crocodile who took his hand in Peter Pan): Musk takes it personally that they tried to take down his beloved company.
But short-sellers often fulfill a useful social function. In the film The Big Short, the heroes are iconoclasts who realized that the US housing market in 2005-06 was in a speculative bubble and that mortgage-backed securities were too highly priced. By selling short they slowed down the market, helping to reduce the magnitude of the bubble. In other words, the 2008 market crash would have been even worse without them.
Who should be more tightly regulated?
So, who are the good guys and who the bad guys, in the GameStop bubble? There is no need to feel sorry for the hedge funds. Their business is risk. They are aware of the wisdom in the dictum, often attributed to Keynes, “The market can stay irrational longer than you can stay solvent.” Even after taking their losses, these institutional investors remain plenty wealthy.
But the hedge funds in this case are not bad guys. They were doing what they were supposed to do: pushing the price of GameStop toward a level more consistent with economic fundamentals and thereby sending a useful signal for the allocation of capital.
The small investors who pushed the price up are not bad guys either. True, the boosters are not heard even claiming to believe that GameStop is truly worth $325 a share, its price on January 29. Their motives for buying appear, instead, to be either to ride the speculative bubble – much as casino habitués gamble for fun – or to inflict pain on the hedge funds, as a sort of populist political message. But they are within their rights to do either.
The collusion by these Reddit traders, if it had been undertaken by a few big hedge funds, could well have been prosecuted as illegal market manipulation. After all, some of the traders are on the record as essentially saying “come on, guys; let’s push up the price.” They seem to meet the criterion of an intent to effectuate a market price that is artificial when judged against the true economic value of the company.
But the Reddit traders are probably not liable to prosecution, because they were small, numerous, and open about what they were trying to do. Moreover, these traders have the sympathies of populist politicians, ranging from New York Representative Alexandria Ocasio-Cortez, on the left, to Texas Senator Ted Cruz, on the right. They probably have the sympathies of the typical American bystander as well.
There will be some traders for whom one should feel sorry. Those are novices who jumped on the GameStop bandwagon, buying after the price had already begun rising, and determinedly staying in even as the price goes down. (They call it “holding on with diamond hands.”) As a consequence of playing the Reddit game, they will probably end up losing most of the money that they invested – losses that some of them will be ill able to afford. One duty of financial regulation is to protect people who may not know what they are getting into.
The regulator, the Securities and Exchange Commission, rather than investigating either the roulette players who bet on red or those who bet on black, is investigating the casino “house.” Already in December, the SEC made Robinhood pay a fine for not being honest with its customers about how it makes its money. (The trades are supposedly free, even for very small transactions, which is what has made it so popular.)
Robinhood’s customers were not very upset about that. They are very upset that the company on Friday, January 29, put restrictions on trading in 50 companies (like limiting purchases to one single share or 10 options contracts). Besides GameStop, the companies include also American Airlines, AMC Entertainment, and Blackberry. (The list was subsequently narrowed to eight.)
Why the restrictions? Robinhood was operating with too thin a margin. It encountered both regulatory constraints (in the form of capital requirements) and demands from its clearing house (that it put up more deposits to back its trading). In the worst case, the casino would have had insufficient funds to pay off punters who had won their gambles.
Robinhood will come through this episode. (It was able to raise more capital.) But it will probably be reined in. A capable regulator like Gary Gensler, if he is confirmed as the new Chair of the SEC, may find a need to tighten, not loosen, the regulations that led the broker to restrict trading in the 50 companies. Capital requirements could be raised, for example.
The customers will probably complain bitterly. They have already angrily concluded that Robinhood stands revealed as a wolf in sheep’s clothing, that is, a member of the financial establishment who had only been masquerading as a bold innovator who would democratize finance. They still believe in message boards such as Reddit’s WallStreetBets, however.
In this respect, these irate traders remind me a bit of some victims of history’s Ponzi schemes. I am thinking of the victims who, despite suffering devastating losses, retain their faith in the persuasive confidence-man behind the scheme, and instead blame their woes on the law enforcement authorities who shut it down.
This post written by Jeffrey Frankel.