Gamestop. 1999 déjà vu all over again?

In case you haven't noticed, Gamestop and a few similar stocks are in a classic bubble. At least it was at 8 AM pacific when I read the print WSJ, possibly not at 9:30 AM as I write. What's going on?

It's not the only time. This sort of thing has happened over and over again through history, most recently in the late 1990s. It's too easy to just say "people are dumb," and move on. That can explain everything. Instead, we can and should as always look at a repeated phenomenon like this and try to understand how the rules of the game are producing a weird outcome, despite pretty smart players. 

The best and most prescient analysis I know are Owen Lamont's "Go Down Fighting: Short Sellers vs. Firms," (last working paper, ungated here) Owen's classic paper with Dick Thaler, Can the Market Add and Subtract? Mispricing in Tech Stock Carve‐outs and of course my "Stocks as money" which offered (I think) a different and more cohesive view of the Add and Subtract event, and extended it to other situations.

There are four essential characteristics of these events, along with a few corollaries spelled out in my paper:  

1. Securities are overpriced. 
2. Trading volume is enormous. There is a big demand for short-term trading. There is some fundamental news and a lot of talk about the stock.  
3. There are constraints on short sales, limiting the ability to take a long-term bet on the downside.
4. There are constraints on the supply of shares,  among them the same short sale constraints. 

The first is obvious. The second through fourth however sharply limit our view of what is going on. Simple irrationality, people get attached to a stock, can explain overpricing, but not mad turnover, why they would sell it a day later. 

Demand

The central feature is a high price together with a trading frenzy. 

This is the widespread and inevitable pattern. Palm price was high, but Palm trading  volume was astronomically higher than 3Com. And it extends to markets as a whole. One graph from Stocks as Money:

Left: Total market capitalization (price times shares). Right: dollar volume. Source: "Stocks as money"  

Stocks as money pursued an analogy. Well, money is overpriced relative to bonds. You don't get interest on money. So is it irrational to hold money? No, as nobody holds money for long periods of time. 

Nobody holds gamestop for long periods of time either. Yes, gamestop is overpriced. Yes, over the long run, which may be years, it will yield a low, almost certainly negative return. But suppose you think you read the reddit chat rooms, and you think it will go up 20% next week. That the stock is overpriced, and has a long run negative return, perhaps even -1% per week (50% a year, a huge negative return) Well, the 1% is just a small cost of doing business. High frequency traders do not care about overpricing! 

If you want to bet on gamestop, there is no substitute to buying gamestop shares. So there is a "demand for shares," independent of demand to receive a long stream of dividends. And the reason for this demand is to speculate, either on information or opinion, or information about what other people are likely to do in the future. This is a slightly negative sum game, which leads to an academic question about rationality, below. But the odds are better than in Vegas. For now, we know where demand comes from. 

Today, the price is falling due to brokerages restricting trading. That fact falls nicely in my story. If the price is just irrational valuation of a company, restricting trading should have no effect.  

Supply 

Now, a first rule of thinking like an economist is that there is always supply and demand. Even if there is a huge, irrational demand for shares, then there should be a supply of shares. For a price to surge, we need a limit on supply. 

Short selling is both a way to express a negative opinion, but it is also a way to supply shares to a market where more people want to hold gamestop than there are shares available. Here's how it works. A has gamestop shares. B, the short seller, borrows those shares from A, and sells them to C. Now both A and C can have long positions in the stock. We have doubled the supply of shares. 

Alas, this mechanism is imperfect. It only lasts a day. B must be ready to buy back the shares the next day and return them to A. If the market goes up, B loses money, and must post that cash. The market can be irrational longer than you can stay solvent. There are also all sorts of legal and regulatory restrictions on short selling. Here Lamont's go down fighting is superb. 

Now the fun can happen. A might buy the shares, and lend them again to B. It can happen that the shorts have borrowed more shares than are outstanding, and physically cannot buy enough to repay them the next day. The price skyrockets. Big railroad barons used to do this. This event has been described as democratization of short squeezes, via coordination on the internet. It all gets worse when the short sellers are hedge funds, who have borrowed money to play! 

Short selling is a crucial supply mechanism. A lot of regulation is devoted to propping up stock prices, and thus hobbling short selling. Lamont is great on this again. 

There are other supply mechanisms. One can create synthetic securities in the option market, so that mechanism must be imperfect. It was in the 3com palm case as Lamont and Thaler document and I review. 

If prices are way too high, why don't companies issue more shares? They would like to, but that takes time and faces legal barriers. 

As WSJ reports, 

it takes time [for companies] to prepare an equity sale, and businesses risk raising the ire of regulators if the share price crashes after a fundraising round.

Some already have tapped the opportunity. Power Plug Inc., a hydrogen fuel-cell company that saw a roughly eightfold rise in its stock price over the past six months, on Tuesday said it was planning to raise about $1.8 billion by selling stock, about $300 million more than initially planned. AMC Entertainment Holdings Inc. this week raised more than $300 million in an equity sale. On Wednesday, its share price more than tripled.

Some investors hold debt they can exchange for new equity. And the WSJ reports Silver lake converts debt to equity. Palm/3 com also fell as share supply came on line. 

In short, stocks as money put together the facts and theories in the following table. 

The larger market

Are these, as the saying goes, the tip of the iceberg? Or are they the whole iceberg? To what extent is the highly traded, growth, lots of news and speculation, tech end of the market deep into bubble, convenience yield, very low expected return, whatever you want to call it, but certainly not a great place for long-term buy-and-hold investors? Good question. 

Rationality and trading. 

So is this all based on folly? We know that speculating is a slightly negative sum game. We can't all make money betting up or down on gamestop. 

I'm not quite ready to say that all speculative trading is by se irrational. The major hole in the theory of finance is that we do not know how information makes its way to market prices. That seems to involve trading, a process where we each look at what others think and form a consensus, and shares trade hands along the way. But we can argue about that. 

It's not even obvious that gambling is irrational. You have to look hard at people's budget constraints to make that statement. Take an extreme example. Most people in the US with income under about $60,000 face a roughly 100% marginal tax rate, according to Casey Mulligan, as income and wealth limits to government programs take away a dollar or more for each one you earn. Add to that the informal marginal taxes. If you live in a poor neighborhood and make an extra $10,000, it will be hard to keep it from friends, relatives, and crime. 

Suppose you're in that situation. A marginal dollar is of no use. But if you could pay $1 for a one in 10 million chance of getting $1 million, it's worth it. 

The small chance of breaking out makes slightly negative expected value bets which give a small chance of a big payoff rational. More generally, if you really want to make the big time, $10 million say, for most people there are no regular investments, or startup opportunities to get there. Is it irrational to risk some beer money on a small chance to get there, even if the average return is slightly negative? 

That small retail investors are driving much of the frenzy seems relevant. In other cases, leveraged traders who can go bankrupt and not feel losses drive the frenzy. 

Last comments  

Readers will know I generally resist the bubble word, as an ill-defined synonym for "I wish  had sold yesterday but I'll pretend I'm smart anyway by saying how dumb everyone else is." For a fun read on this line, see my review of Peter Garber's "Famous First Bubbles." But this time there is a good limited definition of bubble and I think it fits well.  

I love to agree with people on the other side of the spectrum: 

Our regulatory system does a lot in the name of "protection" to keep people of low means away from the kinds of investments that wealthy people can access. Whether those are a good idea or not is not for us to say, if you believe as most wealthy investors do that these are good ideas, keeping people out does not seem very fair. 

Stopping the trading saves the hedge funds. AOC has a point. (Update; not so clear. I learned there are good reasons here that brokers stop people from trading in times of very high volatility. Here is a very good thread explaining the details. A lot of it has to do with securities regulations. Marginal Revolution explains as well, with good links.  I'll leave my hasty rush to opine up as penance for having done so.) 

A bottom line

These stories show a definite market pathology. The rules of the game produce what sure looks like an undesirable outcome. House prices zoom from artificial supply limits. Let us stop focusing on irrational "demand" and focus on why supply cannot fill it. We learned in 1914 the need for "elastic currency" to fill puzzling spikes in money demand. There are definitely institutional legal and regulatory roadblocks in the way of a flat supply of shares. We need ways to take long-term short positions more easily. Short sales constraints designed to prop up prices contribute to stock bubbles as zoning and construction codes contribute to house price bubbles. 

Update: Interview with Owen Lamont, who has a different perspective on many of these issues.