Finance & Accounting Jan 29, 2021
Does GameStop Signal the End of Short Selling as We Know It?
A conversation with a prominent short seller about the possible consequences of a wild week on Wall Street.
Depending on your view, this week’s dramatic GameStop short squeeze is either comeuppance for giant Wall Street hedge funds, which finally find themselves on the losing end of the risky bets that have made them a fortune over the years, or evidence of a dangerously frothy market, one that must be tamed—perhaps by regulation—before too many people get hurt.
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The surprising decision by investing app Robinhood to restrict retail investors’ ability to purchase stock in GameStop and other volatile companies—and the vocal backlash to that move—has further thrown the market into chaos.
One thing is certain: short selling, always risky, is downright treacherous at the moment. And at least according to one prominent short seller, its risks could be untenable for the foreseeable future, changing how large institutional investors manage large endowment and pension funds.
Scott Fearon is the president at Crown Advisors Management, a Kellogg alumnus, a member of Kellogg’s Asset Management Practicum advisory council, and the author of Dead Companies Walking: How a Hedge Fund Manager Finds Opportunity in Unexpected Places. Last year, Fearon sat down with Bob Korajczyk, a professor of finance at Kellogg, to discuss his unique investment strategy, which sometimes involves shorting stock—that is, borrowing shares and immediately selling them with the goal of later repurchasing them at a lower price.
As the GameStop drama unfolded this week, Korajczyk spoke with Fearon again.
This conversation has been edited for length and clarity.
Bob Korajczyk: First, I have to ask … Are you short GameStop?
Scott Fearon: No, no. We’re not.
Korajczyk: I’ve heard rumors that the crowd is looking at other heavily shorted stocks.
Fearon: Oh, sure they are. The poster child this morning is a company up in Milwaukee called Koss. If you believe that markets are always efficient, today is proof that they are not. There’s no way GameStop is worth $347 a share. There’s just no way.
Korajczyk: I think you’re right. The problem is, it’s so risky to bet against the bubble right now.
Fearon: Oh, I wouldn’t! I’ve talked to a lot of hedge funds this morning who are just itching to short a few of these things, and they’re scared at the same time. They’re like, “If you could just short them and wake up a year from now, you’re going to make so much money you can’t see straight.” There’s no way that Koss is a $55 stock a year from now. But Koss could go to $100 tomorrow morning.
Korajczyk: So in your view, is this posing an existential threat to short selling—or at least the long/short strategy popular with hedge funds, where you go long on stock you think is undervalued and short on stock that’s overvalued?
Fearon: Oh god yes. This is bad. It used to be you’d short a stock, and you’d buy a different stock, and you’d wait for the quarterly earnings. The people who had better insight or better information—or just were more adroit at identifying the long-term winners and shorting stocks where the revenues and earnings will disappoint—would collect all the money after 6 months or 12 months or 18 months. Today, can you risk staying short on GameStop? Honestly, I don’t think you can.
The people getting destroyed are these big, billion-dollar-plus long/short funds. Their investors are not all wealthy individuals; they’re pensions and endowments. The pensions and endowment managers like to invest with large institutional long/short funds.
Korajczyk: Right. The press likes to play this up as the little guy sticking it to the billionaire. The hedge-fund managers are hurt only to the extent that they have some money in the fund and that their compensation is tied to the performance of the funds. The bulk of the hedge-fund losses may be going to the retirement funds of firefighters and police, teachers’ pension plans, and foundations that support charitable causes. So the bulk of the losses is being inflicted on non-billionaires.
Fearon: A lot of these funds are leveraged up 2:1, 3:1, 4:1. Down a lot. Very hard to come back from that.
“Somebody’s got to hold the bag when this comes unglued. It might come unglued tomorrow, and it might come unglued in 2022, but it will come unglued.”
— Scott Fearon
Korajczyk: Unless they can ride this out. And it’s not clear that they can, right?
Fearon: Or unless this ends abruptly. Most people would agree that the ’98, ’99 bubble ended with that article in Barron’s on March 20, 2000, with the title “Burning Up.” The market had already sold off a few percent going into that weekend, and then it was just a free-for-all. These things just collapsed over the next two years.
What’s happening now isn’t good for America, though. The Feds should react, I believe, by immediately raising the margin requirement to 100 percent—meaning, essentially, that a long investor can only lose what they invest. The current law in America is that you have to have at least 25 percent of the price. Most firms put this at 50 percent. But the government has the ability to move that margin requirement around for everybody.
Korajczyk: You could argue that the whole market’s overpriced now. But the market’s not as crazy as GameStop is. So if it’s just a few heavily shorted stocks, I’m not sure you want to make policy on the basis of that.
Fearon: Well, you’re right. During Powell’s press conference, he was asked just that question, “Would you raise the margin requirement?” And he said, “We’re not even looking at that. That’s not even a topic we’ve discussed.” His argument might be that this is such a small percent of our capital markets being impacted, so who cares.
My argument, though, is consider a worst-case scenario. Something weird happens overnight, and GameStop opens up at $22 a share the next morning. I promise you a lot of people buying the stock are buying it with margin account. This thing opens at $22, those guys owe more in margin calls than they have, and then it’s going to be the broker dealers in trouble. If a broker dealer were to fail because GameStop opens at $22 dollars a share tomorrow morning, I suspect the American citizenry would say, “Yeah you’ve got to bail us out. I got an account there, and I can’t lose half my principal.”
When crazy bubbles like this happen, it’s to the advantage of the American taxpayers to pop or stop that bubble from growing further. Because when it does burst, as we learned in ’08, the taxpayers are forced to bail out the system. Somebody’s got to hold the bag when this comes unglued. It might come unglued tomorrow, and it might come unglued in 2022, but it will come unglued.
Still, Robinhood should not have blocked investors from buying GameStop stock. The proper regulatory action would have been to raise margin requirement to 100 percent.
Korajczyk: There are two notions of leverage at work here. You have the longs that are buying on margin, and then you have the shorts that are borrowing shares and shorting them. Anytime you have this kind of leverage, it turbo charges everyone’s portfolio, so the longs are going to make a lot of money as long as things go up, and they’re going to lose a lot of money when things go down, and vice versa.
I think your idea of changing the margin requirements makes sense. If it was done by the Fed, it would have applied to all investors equally, as opposed to just hitting traders in specific apps. (And I agree with you about Robinhood’s decision seeming to be too draconian.)
You could also raise interest rates. That would be one way to tame the market. That’s not going to fix GameStop, but if they’re concerned that the market is overpriced, then they should be raising rates. People are putting money in the stocks because they’re not making any money in fixed income.
Fearon: You know, what’s happening is going to make a mockery of the whole idea of indexing money. The S&P can say no to including GameStop because they don’t have four quarters of profitability. But these other indexes that are profitability blind, like the Schwab 1000? They’ve got to put GameStop into the Schwab 1000. Well, what’s going to happen if these indexes have to put GameStop in the index, and then three months from now GameStop’s a $12 stock?
Korajczyk: Well, if you’re a broad index like the Vanguard total stock market: they’ve got over 5,000 stocks, I believe, in that fund. They had GameStop when it was small.
Fearon: Right. So in a sense they benefit from this. That’s a great point.
I also honestly believe that this week is the death of the entire efficient market hypothesis that says that all stocks reflect all public information at all periods of time. That clearly is not true anymore.
Korajczyk: Maybe. I think we both agree the current price is wrong, but it is not riskless nor costless to bet against the price. The price volatility is extremely high, and the fees to borrow the stock to short are currently very high—over 31 percent per year. Some might call this “efficiently inefficient.”
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