By Jonathan Katzenellenbogen -3 February, 2021
An army of small traders on the US stock market have shown immense power over the past week. Many of these retail investors are now emboldened and much of the public has enjoyed the perverse pleasure of seeing some Wall Street hedge funds badly hurt.
There is much that is new in this, but the mania sparked last week was just a 21st century adaptation of similar episodes of frenzy that have periodically emerged on markets.
Small, diverse investors can now be rapidly mobilized to act with common purpose. Seeing this as a class struggle on its own gives little insight. Ultimately there are no such things as social classes on a market. There are buyers and sellers, and winners and losers, and all is settled on price.
As for the claimed altruism of the army of small traders on Reddit, that is an unlikely motive on its own. Many, bored with lockdown, and in the absence of sports gambling outlets, have decided to bet on the market instead. We all like to give what are purely profit-making activities the semblance of a higher motive.
And another assumption may also be wrong. What may have begun as a movement of small traders may no longer be the case. The sheer scale of the buying over the past week may indicate that some big boys are also buying. The strategy of swarming short positions to induce a “short squeeze” has often been used by hedge funds as part of a strategy to push a stock price higher.
And then some investors with long experience simply wanted to take a bet.
Potential losses for some investors
The force of small investors acting rapidly through message board sites and trading apps is relatively new, but the pattern of last week’s events is anything but. It is all part of the early stages of the build-up to financial crises. While global financial markets were slightly unnerved by the events of last week, this is very unlikely to evolve into a more generalised financial crisis, like that in 2008.
The full cycle has yet to come, but many individual investors who have been part of the hysteria may still suffer great losses. The hedge funds have already been hit, but the small investors who bought late and sold late will be burnt. That is the nature of market mania and collapses.
That is laid out in Manias, Panics, and Crashes, A History of Financial Crises, Charles P. Kindleberger’s classic on the subject. It all comes down to a pattern of speculation fuelled by credit expansion and a key change such as war or a technological innovation. That’s followed by financial distress or crisis, and ends in panic and a crash. Sorting out the losses is always a big part of these sagas.
Individual investors as much as bankers and sophisticated financial investors have been subject to mania. In recent times bankers have repeatedly over-lent. In the early 1980s, when the large US and European banks were awash with oil producers’ surpluses, they recklessly lent to Latin American countries, who were then forced into austerity and debt rescheduling. The Great Financial Crisis of 2008 was fuelled by the reckless home loan lending and ended with threats of bank collapses and the need for bailouts.
In the mania of the past week, masses of small US retail investors were egged on by chatter on a sub-Reddit message board, r/wallstreetbets. The clear mania of this is indicated by GameStop’s outmoded business model and enormous losses for some time.
Through message boards and social media, disparate traders were rapidly persuaded to buy. This sort of swarming has happened often in politics, and its impact has spread to investing over the past few years. Combined with the new ease of trading online through apps, this has made for a new world. Arguably, groupthink and mania can be set off on a far larger scale than was previously possible.
Mania forced hands
The mania had its desired result in forcing the holders of short positions – those who had borrowed stock in the hope that they could deliver it back later at a lower price – to buy the stock to cover themselves. Forcing the “short squeeze” meant the stock of GameStop soared to 2 500 percent on its start of the year price, by the middle of last week.
After retail trading brokerage platforms restricted trading on the grounds that they required additional capital to remain compliant with the regulators, the price took a nearly 40 percent tumble. But yesterday the GameStop price was still up by about 1 000 percent on its level at the start of the year.
Those who bought early and exited early have made a good turn. But those who are late to exit, hoping for greater gains, could be enormous losers.
After targeting GameStop, the small traders widened their targets to other shorted stocks in the US and abroad, and early this week, their attention turned to silver.
What should the regulator do?
The US stock market regulator, the Securities and Exchange Commission, might find it difficult to identify market manipulation from a posting on a Reddit message board. Evidence of “pump and dump” activity might be hard to prove. After all, an individual can say, ‘At the time when the message was posted I was bullish on the stock, but then changed my mind and dumped’.
Hearings in the US Congress have been promised and the regulators across the world will be talking to each other.
There is the argument that the regulators should update regulations for the age of message boards and social media. Arguably, market crashes do add discipline for a while. Further, why should gamblers be protected from themselves? The market should not discourage them as they do add depth and liquidity to a market.
Walter Bagehot, the Victorian English journalist wrote that one thing is certain: “that at particular times a great deal of stupid people have a great deal of stupid money.”
A new era emerges
The age of the online small trader swaying markets has been long in emerging.
The big tech stocks like Facebook, Amazon, Netflix, and Google have been through rough rides due to the activities of the smaller investor, who often quickly sells on a downswing.
A force has been unleashed that will be used both to profit and potentially to take a stand on social justice issues. As Financial Times columnist Merryn Somerset-Webb pointed out over the weekend, a Reddit shareholder army could take on a company on issues such as CEO pay or many other issues.
The South African market is not as exposed to potential short squeezes as are larger markets, as these positions are far lower here. But the force can act globally, and local stocks or the currency could be exposed.
There is little that can be done, other than to adapt to potentially more short-term volatility