GameStop’s Record Run: A Reminder of What Determines Stock Prices

Over the couple of weeks, GameStop Corp. (NYSE:GME), which wasn’t typically on the radars of most investors beforehand, has become the single most-discussed stock in the news.

Starting around Jan. 21, the price of this old-school video game retailer began a record-shattering bull charge, increasing more than 700% at one point before beginning to settle down somewhat as Robinhood and other brokers imposed buying restrictions on the stock.

This unusual situation led to many people learning about the stock market for the first time as investors scrambled to figure out what was going on – and then to tell as many people as they could about how a wave of day traders led by a subreddit figured out a guaranteed way to dramatically increase the price of a stock that had enough short-sellers.

The great short squeeze

GameStop was, until recently, the most-shorted stock on the markets with more than 100% of its shares sold short. With the brick-and-mortar video game retailer seemingly on a permanent decline due to the rise of e-commerce, increasing console storage space and digital downloads of games, the majority of smart money considered being short GameStop to be – well, easy money. There was no way a significant number of investors would ever turn in favor of a dying company.

Unfortunately for the shorts, they never expected that a subreddit called /r/WallStreetBets, known for being a place where day traders intentionally made dumb or funny investments, would figure out that if enough people bought shares of GameStop all at once, it would actually be very easy to cause a short squeeze.

For those who aren’t familiar with a short squeeze, this market movement can happen any time the price of a heavily-shorted stock rises rapidly enough. Short sellers “borrow” shares in order to sell them at the market price, intending to buy the borrowed shares back once the price drops and return them to the lender to pocket the difference between the buying price and the selling price. When the price of a heavily-shorted stock rises rapidly, it forces the short sellers to “cover” their positions by buying the stock back at the higher price in order to avoid further losses. This adds fuel to the fire, causing the price to rise faster and forcing even more short sellers to cover their positions.

An estimated 400% of GameStop’s recent run is attributed to the short squeeze, which significantly hurt the returns of a few hedge funds that had large short positions in the stock. Most notably, Melvin Capital, a $13 billion hedge fund, lost 30% in January courtesy of its GameStop short, nearly going bankrupt before prominent hedge funds Citadel and Point72 Asset Management extended it a $2.75 billion financial lifeline.

So why did so many people decide to work together to cause a short squeeze in GameStop? There’s no single answer. Some wanted to cause a short squeeze knowing they would later be able to sell at a much higher price, while some wanted to prove a point to Wall Street and others bought the stock because it had become a fad at that point, not caring whether they would gain or lose money on the trade.

However, one thing that all of the recent buyers of GameStop stock have had in common is this: they wanted to buy the stock. It’s that simple. As always, the most important factor in determining whether the price of a stock will rise or fall is investor sentiment, which can be manipulated but cannot always be predicted.

Mr. Market and information arbitrage

One of the earliest works detailing the importance of investor sentiment in the stock market was Benjamin Graham’s “The Intelligent Investor.” In this classic value investing work, Graham introduces the iconic character of Mr. Market:

“One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers to either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings.”

Mr. Market is a personification of the shifting nature of investor sentiment that remains relevant to this day, even though Graham’s investing strategy, which relied on information arbitrage, has become less successful due to the sheer amount of information available these days.

In Graham’s time, buying undervalued stocks could bring in a heftier profit once more people discovered how successful the companies behind them were, thereby increasing demand for their stock. This can still happen in the present day, but it is far more common for the investing public to have already identified the best companies and traded them up to sky-high prices.

Hopping on the hype train

Of course, as /r/WallStreetBets has recently highlighted, the attractiveness of a company’s profits are far from the only reason why investors buy stocks.

Another avenue for increasing the demand for stocks has come to the world via the rise of the internet and social media. With the internet at their fingertips, people can easily research information about companies that was simply not accessible in prior decades.

The difference here is that, unlike decades ago when investors had to read stock manuals to find investments and were more concerned about a company generating profits, the constant flood of information has resulted in a higher number of investors favoring the stocks of companies that make the best story, or the ones that are believed to have the highest potential for growth (even if that growth is not expected until the distant future).

The media simply gives more attention to the biggest and flashiest companies, putting them constantly in front of investors’ eyes and thus increasing the likelihood that they will want to buy and bid up the price even more.

Some company executives even take advantage of this hype factor and deliberately take action to psyche up investors and increase share prices. A famous example of this is Elon Musk’s efforts to keep up Tesla’s (NASDAQ:TSLA) share price through social media posts and promises of what the company could deliver someday.

Conclusion

GameStop’s sudden dramatic upswing may seem ridiculous and nonsensical on a surface level, but, in fact, it is no less sensical than the stock market as a whole. When demand increases, regardless of the reason, the stock price increases. When demand decreases, regardless of the reason, the stock price decreases. Market manipulation is also far from a new thing – the U.S. Federal Reserve has been doing it all throughout the Covid-19 pandemic through various quantitative easing policies, even going so far as to invest in corporate bond exchange-traded funds.

Are enough people ever going to like the stock enough to buy it en masse? If it is a small company, can it grow enough to enter the public eye? Has it been involved in any scandals that may impact it far into the future? If the bargain seems too good to be true, there may be a lodestone that you have overlooked, and if investor sentiment is too high, volatility might be a real danger in the case of bad news. For these reasons and many more, one should always conduct a thorough analysis of investor sentiment when deciding whether to buy or sell a stock.

Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.

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