Why I Want to See the Meme Stock Game Stop

Many new investors are purchasing stocks. Generally, this would be a good thing, but these new investors appear to misunderstand what a stock is. They are not really investors, in the true sense of the word, but speculators. Rather than approaching the purchase as an investor buying a business, they seem to be acting as speculators purchasing a speculative vehicle for the purpose of selling it to someone else for more, or even in some cases, simply for the purpose of trying to manipulate the price further. This has always been a part of the stock market. What is troubling now is the scale of the speculation, the coordination of the speculators on seemingly arbitrary targets, and the way they are using a calculated approach to maximize their manipulative impact.[1] Stocks targeted by these investors are called “meme stocks” because they are promoted through online discussion boards and video sites, such as Reddit and TikTok. Promotors are trying to make certain stocks “go viral.” Based on comments I have read in online message boards, these speculators see this as a game, and their opponents are the short-sellers and those who dare to discuss the underlying economics of the stock. It is like betting on one’s favorite sports team, with the key difference that the bettors can (at least temporarily) affect the outcome if enough others join their side. Fans of a stock purchase shares and recruit others to do the same, pushing up the price. The goal seems to be to create a short squeeze by driving up the price of heavily shorted stocks to the point where the short-sellers are forced to cover, driving the price up further still. It seems some of these stock price manipulators believe they have found a way to create wealth out of nothing, while others are on some sort of moral crusade to rid the world of short-sellers whom they believe to be harming businesses. (By the same logic, we could solve death by getting rid of morticians.) I see three major problems with the Meme Stock Game, which I expect to inflict harm on participants and on the market in general.

Two obvious examples stand out.[2] GameStop Corp. is a physical video game retailer. As gaming moves to the freemium model or gets sold online, physical retailers suffer. In the two fiscal years prior to COVID (FYE Jan ’19 and Jan ’20) revenue dropped by 10% and 22%, while gross margin contracted 3.5% from 33% to 29.5%. Earnings per share (EPS) went from a meager $.34 to a loss of $5.38. Asset impairment is listed as a special charge, which it usually would be, but GME takes this charge every year as the assets (stores) keep dropping in value. The first year of COVID saw another 21% drop in revenue, and five percentage points of gross margin loss. The operating loss grew about 1700%. Over the last three years, GME has lost over $15 per share, and about $2 more in the first six months of this fiscal year. Could new management find a successful strategy to move the company out of its death spiral and make it profitable again? Maybe. But to what level? I posit the $15 Billion market cap and roughly 3000% price appreciation in the stock is based not on a discounted cash flow analysis by sharp-eyed analysts, but by the so-called “apes” who see equity investing as a game. The second meme stock poster child is AMC Entertainment Holdings (AMC). AMC has been trying unsuccessfully to buck the trend of movie theater declines. Streaming services, online videos, gaming, and big screen TVs present formidable challenges to the silver screen. The theater chain took on so much debt for acquisition and theater remodeling that it has had a negative tangible book value for years, while only earning about a 4% operating margin. This was an untenable business before COVID. COVID was a devastating blow to a dying company, driving the net loss to common stockholders from $149 million in 2019 to $4,589 million in 2020. The first two quarters of 2021 have seen over $900 million more in losses. Despite issuing over $2 billion of stock to the meme stock buyers, tangible book value has plunged to negative $5.6 billion. In other words, the company is insolvent, and still burning cash at a rate of $1 billion/year. You would never know this by looking at the stock, however. Despite about five times as many shares outstanding against the same assets (which ostensibly are much less valuable than before the pandemic accelerated the already deleterious trends), and roughly the same level of debt, AMC shares are up 744% in a year, and sport a valuation of over $25 billion, representing about $40 for every dollar of revenue last year. If there is an underlying case for why AMC is worth 35 times what it was worth before COVID took it from a death spiral to six feet under, I am unaware of it. It will likely continue to issue shares to subsidize losses, rather than restructuring and adjusting capacity to demand.

The Law of Supply and Demand is one of the most basic principles of economics. Students learn in their basic macroeconomics class that the price of a commodity is set at the intersection of the downward sloping demand curve and the upward sloping supply curve. This makes sense and we see it play out in the market. Some think the price of stocks are determined in the same way. By encouraging more people to buy a stock, the stock can become more valuable. Should stocks be priced on supply and demand? Yes, and no. In the short-term, stock prices do move around based on the balance between would-be buyers and prospective sellers. Longer term, however, prices should trend to intrinsic value.[3]

Why are stocks different from commodities, produced goods, or services? The difference comes in where utility is derived and how supply is created. A barrel of oil is valuable because it can be refined into gasoline or diesel, used to create electricity, or used as a chemical feedstock to produce all sorts of products that are useful to people. Supply is increased through the risky process of acquiring rights, drilling exploratory wells, drilling, pumping and transporting the oil. This will only be undertaken if the prospective rewards are high enough. Furthermore, there is a limited supply of oil in the ground to be found and extracted. Stocks are different. A stock generally has no utility other than the claim on future earnings of a company.[4] Demand then is based on an expectation of future cash flows in the underlying business. A share of stock has no other value. Supply is also easily increased, but by issuing more shares, corporations are diluting their existing shareholders.

Under normal circumstances, stock prices are set by rational investors assessing the future prospects of a company and then discounting those future cash flows at a rate based on the risk relative to other opportunities. While no analyst is perfect, prediction errors will theoretically average out. This means stock prices should trend toward intrinsic value – the point at which all stocks yield roughly the same risk-adjusted return. While the theory never plays out perfectly, the system works reasonably well. The companies with the best opportunities can raise capital to pursue those opportunities, while those with poor expansionary prospects find their best opportunity to be repurchasing their own stock, shrinking their pool of outstanding shares. This system functions to direct capital to where it can be best employed and remove or harvest capital from companies and industries that have less efficient uses for it.

For the system of crowd-expectation-based price setting to work, potential buyers and sellers must be uninhibited. This requires short-sellers. Short-sellers, or “shorts” are investors who borrow shares from a shareowner and then sell the borrowed shares with the expectation of repurchasing them later.[5] Short-selling is important for price discovery, because it allows everyone to take a position on the true value of a stock. Without shorting, the only decision available is to buy or not buy a stock. As long as enough people want to hold a stock regardless of price, its value can be driven up to unreasonable levels. Allowing non-holders to also express their view through shorting helps to establish a consensus view of the value. I do not posit that no short-sellers ever engage in dishonest activity to push a stock price lower. However, to suggest that this is a regular part of shorting is naïve. I believe in general, investors buy stocks because they think they are going higher in price, and sell or short stocks because they believe they are going lower, at least relative to other opportunities. Short sellers have uncovered frauds when regulators were unable or unwilling to do so. Professional investors who short stocks would have little incentive to manipulate their positions if they expect to be going concerns, for a few reasons. First, without a huge amount of money or a large group of collaborators, it is not easy to manipulate a stock price. Even if you can successfully move the price with buying or selling actions, you still need to close your position. Second, stock manipulation, whether through coordinated transactions or spreading misinformation is illegal. It would be much less risky to simply try to find stocks that are grossly overvalued or have a fatal flaw that is widely unrecognized, than to invent something whole cloth, over and over as a business model. Third, institutional short-sellers have more scrutiny than long investors, as many people have a vested interest in seeing the short-sellers fail. Finally, those with the greatest incentive for misinformation are corporate insiders who stand to collect incentive compensation based on the stock price, and who often have large, concentrated bets on their own company. If a short seller makes a successful pick, he makes a return and needs to find another stock. Company insiders riding a soaring stock price for a few years can become fabulously wealthy. Individual investors would do better to trust the warnings of short-sellers than the promises of stock promoters.

I see three major problems with this meme stock game, which I expect to end very poorly for those participating in the manipulation scheme, and to cause significant collateral damage.

First, stock price manipulation, like any other sort of bubble, results in the misalignment of capital by undermining the price-discovery mechanism. Money that could flow to creative, productive enterprises is instead diverted for non-economic reasons to poorly performing, dying, or already insolvent operations, extending their life and raising their paper value, but not necessarily changing their reality.

Some may argue that the meme stock cash infusion has saved companies, preserving jobs and creating wealth. Sadly, this is not the case. Instead, billions of dollars have been invested in dying businesses, which could have been used for wealth creating ventures. The companies will use the capital to stay in operation longer, but if they had a realistic chance of survival, they would have been able to raise capital through other means. The problem is not COVID, but that long-term trends have changed. A higher AMC price will not draw more people to the movies, or improve the return on investment in individual theaters. A higher GME price may excite some new shareholders who will want to buy at GameStop, but it will not prevent the game developers from continuing the successful direct to consumer model. Artificially inflating asset prices and sustaining unproductive companies and jobs can only work temporarily.

It may be helpful to use a hypothetical example to illustrate. Imagine a large group of people decide to drive up home values in one town. Let’s call it Any Municipal Community, or AMC for short. They borrow as much money as they can and buy every house for sale in that town. As new listings appear, they snap them up at well above asking price to drive up the comparables, which raises the appraised value on the homes they already own. They use the appreciated value in their houses to borrow more to buy more houses for above asking, keeping the game going. The good residents of AMC, seeing the “value” of their homes surging will be tempted to sell and move somewhere else. Many will, but the “investors” will just keep buying those houses, sustaining or increasing apparent value. The colluding “investors” will make staggering sums on paper. Other residents will borrow against their paper gains to improve their homes, seeing the new debt as manageable relative to the appraised home value. Some will even want in on the game and leverage their house to buy the house next door, envisioning massive, easy wealth. Eventually, builders will see the opportunity and start building more homes, which the colluders will need to also purchase. The problem for the new real estate owners is that no actual wealth has been created. AMC has no more new jobs, other than the transitory construction jobs, and the economy does not support the housing prices. Homeowners can’t earn a return by renting out their properties at a high enough price to cover their investment. New homes (misallocated capital) are merely speculative vehicles. Nobody can afford to live in them. Ultimately, the prices collapse as overleveraged speculators can neither rent the homes nor find anyone to pay the outlandish prices. If instead, the people pooled their money to build a factory, or to develop a tourism industry, they could have grown the real economy.[6]

Second, the speculators will ultimately lose. As in the real estate example, when people pay a price for something that is not supported by the economics, they can only profit as long as someone else comes along to pay a higher price. This is called the greater fool theory. At some point, the greatest fool has bought in and there is nobody left to sell to. This reverses the cycle and the price falls back to what is warranted by the economics. This cycle happens repeatedly, with each new generation of speculators thinking they’ve found a way to make money out of nothing. Much wealth is destroyed, with the rest being transferred from the hopeful to the wise.

Third, speculative frenzies that ignore reality and focus on perception undermine the system for those who want to play by the normal rules. Short-sellers are harmed when their thesis is right but a well-organized manipulation attack on some of their positions causes them to lose money. Index investors are harmed when they buy a passive index, unwittingly taking large positions in stocks with inflated prices devoid of any connection to reality. Market makers are harmed when the options they sell are manipulated. Eventually, nearly everyone will be harmed by the crash that inevitably follows a bubble. Bubbles and busts undermine faith in the system and harm investors in all cases, but especially when prices are intentionally manipulated. This is why there are laws against stock price collusion. To entice investors to risk their money in the system, the game needs to be fair.

This has been an interesting chapter in history, and the ending promises to be even more interesting. There are precedents in the stock market bubble of the 1920’s, the tech bubble of the 1990’s and the real estate bubble of the early 2000’s. Each of those preceded great loss of capital and brought on recessions. When speculators are dominating prices and people are using the markets as a get rich quick scheme rather than an ownership in productive businesses and assets, the good times end in tears. This is why I want to see the meme stock game stop.

[1] Specifically, the Reddit crowd has bought short-term, deep out of the money call options, giving them exposure to stock for pennies on a dollar, but exposure that would expire with a complete loss of their premium within weeks unless the stock made a massive short-term move. The purchase of the options causes the market-makers who are selling the options to buy some shares to hedge their exposure. This purchase pushes the stock price up a little. As more options are purchased, the stock price is pushed higher, which causes the market makers to buy more shares to stay hedged on the already sold options contracts. This is a rather clever means of stock price manipulation. Part of the strategy is generally to push the price high enough to cause those who are short the stock to need to cover some or all of their short position, further driving up the price. This is known as a “short squeeze.”

[2] For well written articles on meme stocks, check out Doomberg’s “Super Stonk” series: www.doomberg.substack.com

[3] A better way to think about supply and demand vis a vis stock is by stock type. If there is more demand for a certain type of stock, such as disruptive growth stocks, investors will accept a lower expected return to invest in these stocks.

[4] Some stocks are held by some people as a matter of sentiment, and not for the potential cash flows. Shares of the Green Bay Packers are a good example. Others may be held by some people for both economic and sentimental reasons. Disney comes to mind.

[5] Generally, selling a borrowed item would be unscrupulous. If I borrowed your car and then sold it, expecting to buy you a new one for less than I received, you would be understandably upset. In commodities and other fungible financial securities, however, short-selling is legal, common and accepted. A share of stock or a bushel of corn are the same whether it is the specific one borrowed or not. Further, shareholders often receive a payment for lending their shares. There is a theory that large players conspire to manipulate stock prices through the illegal practice of “naked short selling” which is shorting stock without borrowing shares. I believe this comes from a misunderstanding of the short interest data.

[6] A version of this actually happened in the 2004-2006 housing bubble, but without the deliberate manipulation and without focusing on just one community.