In early 2021, retail traders made Wall Street’s finest look amateur. Retail investors – simply – are non-professional investors. These investors often do not have experience or professional knowledge of the stock market or the companies underlying it. Irrespective of their ability, the democratization of financial markets has ensured that they have power to cause material ructions in security pricing.
Over the course of history, the professional base has been responsible for the lion’s share of daily trading volume. However, as with countless other trends, the COVID pandemic disrupted the status-quo. Retail investor participation in the stock market increased dramatically. Over the last two years, retail investors accounted for as much volume as hedge funds and mutual funds combined. Retail share has declined recently but remains above trend.
The growth in retail investing can be attributed to a variety of factors. Many individuals found themselves with a large amount of free-time on their hands due to lockdowns and work-from-home policies. In addition, fiscal policy in developed nations facilitated stimulus payments to consumers, which together with a decline in discretionary spending, led to a sharp uptick in personal savings.
Seemingly this combination of high savings together with limited activity resulted in individuals seeking stimulation through trading stocks. Luckily for them, investing is now easier and cheaper than any other time in history. Online trading platforms such as Robinhood and FreeTrade have disintermediated stockbrokers due to compelling propositions – low fees, a catalogue of investment options, and ease of use.
As retail participation increased, social trading “clubs” began to emerge. These clubs were created through social media, online forums, and messaging groups. The most publicized group – the r/WallStreetBets forum on Reddit – comprised 9.4 million members at the end of 2021 – up fivefold since the start of 2021 and more than 10 times since the start of 2020.
This group gained media attention following its self-declared war with short sellers. WallStreetBets coined the term BANG stocks, its own version of the FAANG stocks. BANG is an acronym for Blackberry, AMC, Nokia and GameStop. This quartet of companies had a common characteristic – large short positions held by hedge funds. Many of the Reddit crowd view short selling as a rigged part of the investment profession. The view follows that the downfall of some should not be for the benefit of others.
WallStreetBets initiated a short squeeze by colluding to bid up the prices of the BANGs. From January 25th through January 29th 2021, many of these stocks gained more than most stocks do in a decade. A short squeeze causes share prices to shoot up sharply because of the payoff profile of a short position. Short sellers realize losses when share prices rise, thus, they are forced to purchase the stock to cover their positions – which again lifts prices higher.
It is important to note that professionals, on the other hand, are legally restricted from colluding and incur much higher brokerage costs.
It’s obvious that the gains in these stocks have nothing to do with the underlying economics of the businesses. GameStop is a video game retailer – a market in perpetual decline due to direct-to-consumer services. Similarly, AMC operates movie theatres, another industry that is struggling to cope with the digital economy.
Notwithstanding the disconnect between fundamental value and price, management of these two businesses were appreciative of WallStreetBets’ support and took advantage by issuing additional stock to the public. Both GameStop and AMC each completed two rights issues following the rally, raising a total of ~$1.5 billion and ~$1.2 billion, respectively. AMC sold shares to the public at an average price of $50.85/share, 7x its pre-pandemic level. GameStop sold its shares at an average price of $157.42/share, 31x its pre-pandemic level.
Amazingly, the traders on WallStreetBets celebrated each of the companies’ rights issues despite the massive dilution to their existing stakes in the businesses. The head scratching doesn’t end there…
AMC decided to use the proceeds from its lucrative rights issue to buy a stake in a developing gold and silver mine – Hycroft Mining. Matt Levine from Bloomberg adequately captures our thoughts on the purchase: “One reason for a company to diversify is something like: We are in a declining industry, we make good money now but in the long run we worry, so we’d better get into some new industries with a brighter future. A thesis like that for AMC might suggest buying a stake in, you know, a streaming service, or a chain of movie theaters in the metaverse. Use some of AMC’s entertainment-industry expertise to move into an adjacent but more futuristic bit of entertainment. But, nope, a gold mine.”
The emergence of WallStreetBets and their famous victory over short sellers is just one example of how a rise in the retail investing base can lead to irrational movements in the market. While we do not believe that all retail investors act in this care-free way, we do believe on balance, that lower participation by professional investors leads to less efficient markets.
The professors who developed the efficient market hypothesis (EMH) would struggle to defend it in today’s world. In the original theory, the EMH was built on three fundamental beliefs – Investors are rational, rational investors use arbitrage to remove pricing errors, and a collection of diverse opinions on average will set an efficient price.
The first two beliefs are easily debunked by the movements in AMC and GameStop. The traders buying the stock were not acting in a rational way, and arbitrage became too costly for the short sellers. The final belief fails to hold when the diversity in opinion declines. The diversity prediction theorem follows: collective error = average individual error – prediction diversity. Thus, when prediction diversity is low, collective error is high. Collusion is a perfect example of conforming to a common thought.
The volatility prescribed by the growth in uninformed market participants should warrant a cautious view of the market’s day-to-day movements. During the pandemic, the disconnect between price and fundamental value surfaced in many sectors of the market. It is our job as professional active managers to adhere to the warning signs and remain firmly grounded by the financials underlying the businesses we own.