Commentary on Political Economy

Thursday, 28 January 2021

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The Reddit Wolves of Wall Street

A social-media stock bubble is a new version of an old phenomenon.

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The GameStop stock mania has captivated market speculators, spectators, politicians and even morning TV. It’s certainly high financial drama to see armies of retail investors on Reddit hunting the so-called wolves of Wall Street. This may be a new example of the power of social media, but it isn’t a crisis of capitalism or the stock market.

There are two broad theories of how equity markets work. One is to focus on fundamentals like the growth path of the U.S. economy and the prospects and earnings of companies. You buy and hold a stock, or you invest in a fund that tracks an index like the S&P 500 or Russell 2000. This is what most people do.

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Yet we market fundamentalists have to admit that more than a few people have become very rich betting on the famous phrase “popular delusions and the madness of crowds.” Stock manias are common—and wonderful until they become panics. This is where we seem to be this week as investors used online brokerage platforms like Robinhood Markets to bid up shares in companies hyped on social media that may or may not deserve their soaring market capitalization.

The drama was heightened as the Reddit pack pumped up stocks like GameStop and the movie-theater company AMC that were shorted by hedge funds. Most are hoping to make a quick buck by riding the roller-coaster up and selling before shares crash, though some also want to squeeze the hedgies.

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Short sellers have to deliver real shares when their short contracts expire, which means buying shares and raising the price even more. The losses can be high. Some in the Reddit pack triumphed this week when Citadel LLC and Point72 Asset Management had to rescue Melvin Capital Management from its short bet against GameStop. Hedge funds are sophisticated investors and know the risks.

As for the Reddit investors, many may soon learn Herbert Stein’s Law that if something can’t continue, it won’t. If GameStop’s future earnings don’t warrant a valuation of $28 billion, which it reached this week, it will eventually fall back down to earth.

That process has already begun as Robinhood and other online trading platforms first raised margin requirements for investors and then put restrictions on buying shares like GameStop and AMC. GameStop shares fell 44% Thursday. Many Robinhood customers are angry, and so are politicians who want to speak up for small investors.

New York Rep. Alexandria Ocasio-Cortez and Texas Sen. Ted Cruz lambasted Robinhood’s restrictions. “Gotta admit it’s really something to see Wall Streeters with a long history of treating our economy as a casino complain about a message board of posters also treating the market as a casino,” AOC tweeted. “Tax the Rich.” Naturally.

Politicians are calling on financial regulators to investigate the GameStop rally. But investor platforms and brokerage firms have every right to police their own sites with borrowing limits or other rules to protect customers. Robinhood hopes to go public this year and doesn’t need an investor bloodbath.

The focus of regulators should be fraud or those who might be coordinating a pump-and-dump scheme. It’s possible someone nefarious is driving the mania in one or more stocks. But the Occam’s razor explanation is the madness of crowds rather than market manipulation.

The government body that should come in for more introspection is the Federal Reserve. The central bank may be feeding the asset frenzy as it holds interest rates near zero and crushes the long bond yield curve so it doesn’t send accurate price signals. As investors search for yield, they have moved into commodities, real estate, junk bonds, foreign currencies—and stocks.

We don’t profess to know if stock prices are overvalued, and perhaps investors are right that Tesla deserves its price-earnings ratio of 1,600 based on future sales of its electric cars. But in the Federal Reserve’s current world of negative real interest rates, there is also plenty of speculative money chasing higher returns.

Many young people can’t go to Las Vegas or even a bar, so they are playing roulette on Robinhood. Asked about the craze, White House press secretary Jen Psaki said Wednesday that Treasury Secretary Janet Yellen was “monitoring the situation” and “it’s a good reminder, though, that the stock market isn’t the only measure of the health of our economy.”

How about reminding people that investments carry risk, that stocks fall and rise, and that the GameStop losers won’t be bailed out?

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Appeared in the January 29, 2021, print edition.

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