Ten or 20 years ago, the small retail investor was supposed to be afraid of hedge funds.
To put it another way: In the old market ecosystem, hedge funds were the predators and retail investors were the prey.
And the bigger the hedge fund — as measured by billions of dollars in assets under management — the more of a predator it was considered to be. The biggest funds were the apex predators, and retail investors were lunch.
Not anymore. The relationship has flipped. In the new market ecosystem, giant hedge funds are the prey — and an army of retail investors has banded together to systematically hunt them down.
If that sounds hyperbolic, consider the case of Melvin Capital, a $12.5 billion hedge fund that was almost destroyed in the past few days.
Melvin Capital was heavily short GameStop (GME), a brick-and-mortar retailer with a bleak outlook.
Via WallStreetBets, a popular message board on Reddit, a swarm of retail investors — they behave like a “retail investor army” — decided to buy GameStop shares en masse, putting a squeeze on the hedge funds that were short.
The idea behind a short squeeze is that, with enough aggressive buying, anyone who is “short” a stock (betting that the stock will go down) can be forced to cover their position.
We first wrote about the GME squeeze on Jan. 15, in “Scenes from an Epic Market Mania.”
This is something of a follow-up to that piece — to report that the retail army won. They squeezed GameStop hard enough to send its shares into the stratosphere, while nearly destroying the fund they were going up against.
After our first reporting on GME, the shares went from a close of $43.03 to an intraday high above $159 per share — a 269% gain — in just two days.
Melvin Capital, the aforementioned $12.5 billion hedge fund known to be short GME, was delivered a death blow — and likely would have faced shutdown if not for an emergency bailout.
The fund, which had an excellent track record heading into 2021, was reportedly down 30% as a result of the GME short squeeze (which was, once again, organized by a bunch of retail investors on a message board).
To counter the 30% drawdown — and likely to provide capital for defending the position — Melvin Capital received an emergency $2.75 billion cash injection from two other giant hedge fund operators, SAC Capital and Citadel.
And by the way, we doubt SAC Capital and Citadel ponied up that $2.75 billion out of the goodness of their hearts. It is more likely that they, too, had positional exposure in short names that the retail army was raiding — because this whole phenomenon goes well beyond GameStop.
The biggest hunters are now the hunted.
So, to recap:
- An army of retail investors on a message board decided to do a bull raid.
- They deliberately picked GameStop (GME) because of its heavy short float.
- They openly declared war on a $12.5 billion fund that was heavily short GME.
- They “squeezed” GME so hard the fund was down 30% almost instantly
- And the fund had to take a $2.75 billion capital infusion to survive.
Nor is this just about GameStop, or a single bull raid targeting a single large hedge fund.
Rather this retail investor army — as organized on WallStreetBets and elsewhere, equipped with zero-commission trading apps like Robinhood — has made “squeezing the shorts” a repeatable market tactic.
The basic strategy looks like this:
- Find a company that appears left for dead, with little hope for survival, that also has a large percentage of its shares sold short by bearish hedge funds.
- Coordinate plans for a bull raid on WallStreetBets, or some other message board or chat apparatus (these raiders are also active on Twitter and TikTok), and then point a virtual aircraft carrier railgun of money (thousands of small investors buying all at once) at the stock in question, in order to aggressively bid up the shares.
- Or, for an even more aggressive version of the bull raid, have the retail army pour money into short-dated call option buys, which in turn forces the market makers who sold the options to buy a concentrated level of shares in the open market as a form of hedging.
- Through this brute-force buying activity — which can be spread across unknown numbers of buyers, as WallStreetBets has 2.3 million members — raiders push the stock higher with such force that shorts are forced to cover at any price.
Another company that recently went through this process is AMC Entertainment Holdings Inc. (AMC), the movie theater chain.
As one can imagine, movie theaters aren’t very popular in the midst of a raging pandemic. As a result, AMC was on the ropes and headed for bankruptcy, its heavily shorted stock falling to $2 per share.
But then the retail army stepped in — running their squeeze play — and AMC’s stock price rose 250% in a matter of days on massive volume.
Not only that, but the heavy incoming volume from the retail army bull raid allowed AMC to raise $917 million in funding — which would have otherwise been impossible — which in turn means an outcome in the real world was changed. A company that was headed for bankruptcy (because of the pandemic) was given life by a squeeze play.
The ultimate prize for the retail army, which they talk about openly, would be to engineer an “infinity squeeze.”
The term “infinity squeeze” was invented to describe what happened with one of the biggest short squeezes of all time, which happened with Volkswagen in 2008.
The short version of the Volkswagen story is that Volkswagen, like many other auto companies, appeared headed straight for bankruptcy as a result of the global financial crisis back in 2008.
Because the company’s prospects were dire, hedge funds were heavily short Volkswagen shares, seeing bankruptcy as almost a lock.
But then, on Oct. 26, 2008, a surprise announcement was made by Porsche, another German auto company that had secretly acquired 74% of Volkswagen’s share float.
After the Porsche announcement, it suddenly became clear: The hedge funds with Volkswagen shorts were now completely caught out. If Porsche refused to sell, they would have to “buy back” their short positions at almost any price.
It was dubbed an “infinity squeeze” because, with no way to buy back shares, the shorts are at the total mercy of the longs, which means the price of a heavily shorted stock can go almost anywhere — and with Volkswagen, it did.
For a brief window of time, the VW infinity squeeze turned Volkswagen from a near-death bankruptcy candidate into the most valuable company in the world. The hedge funds that were short lost an estimated $30 billion, and Porsche made eight times more money on trading that year than it did from selling cars.
If the retail army succeeds in pulling off an infinity squeeze in GME (they are still trying as of this writing) or some other stock, it wouldn’t just mean a $5 stock going to $40, or a $20 stock going to $200.
It would be more like a $10 stock going to $1,000 or beyond, with a random beaten-down short name (they are always beaten down, that is why they are shorted) gaining a temporary market cap on par with Amazon or Apple.
It is hard to see how this can go on. The new bull raid, as perfected by this zero-commission retail army, has utterly destroyed the appeal of short-selling anything. Various compilations of the most heavily shorted stocks show that, in 2021, those are the stocks that have risen the most.
Now, very few investors will shed a tear for short sellers. But it isn’t great for markets when valuations cease to mean anything at all, and when share prices can be openly and aggressively manipulated not just for a few percentage points, but gains of hundreds of percent (or even thousands of percent).
The broader investor danger here comes when the GameStops of the world start falling back to earth. It may be that everyone is happy (apart from blown-out hedge funders) when cheap stocks get squeezed to astronomical levels.
But when the game of musical chairs comes to an end, we could start seeing popular stock names falling 50 to 90% in a matter of weeks or even days, collapsing as quickly as they inflated. That would wreak havoc on average confidence levels in the market.
One would think the Securities and Exchange Commission (SEC) has an open-and-shut case to put a stop to this stuff as textbook market manipulation. But it isn’t that simple. Who will they go after?
There aren’t any billionaires or famous hedge funders doing this work. It is a merry band of small investors now. And if they try to shut down one venue, like the WallStreetBets message board, there is no reason a bull raid community can’t spring up in some other venue. (And as mentioned, we are already seeing this phenomenon on Twitter and TikTok.)
So, it may be that the retail army will be eating the lunch of giant hedge funds for a while yet — or at least until either the current market mania burns itself out, or the incoming Securities and Exchange Commission Chairman, Gary Gensler, figures out what to do.
As one last observation, there is another possible side effect to all of this short-squeeze craziness. It could make the grand finale of the current market mania even more spectacular and awe-inspiring.
Chances are good we have not seen “the end” of the mania yet. Think about the grand finale of a July 4th fireworks display. In the final minute, the pyrotechnics become even more bright, more booming and dazzling, than all that came before.
Manias tend to work the same way: The grand finale is more of a spectacular blow-out than a whimper.
And now, thanks to the bull raiders, hedge funds will be too scared to death to short anything, for fear that the retail army will wade in and destroy them. (This is why current levels of shorting activity are low; the retail army is scaring the shorts out of business.)
And at the same time, hedge funds looking to make a buck will piggyback off the raiders when they can, adding buying power to positions where it looks like the retail army is at work. (Nor can we blame them; we are doing something similar in the TradeSmith Decoder portfolio.)
What this means is that, all other things being equal, we can take the forecast for a market mania grand finale and throw in an oil drum of nitroglycerine and a truckload of dynamite just for fun.
While the moves have been absolutely wild thus far, our suspicion is that the real insanity — and the mind-blowing moves that could mark the ultimate mania top — still await.