After the stock market closed on Wednesday, there was a good deal of celebrating at r/WallStreetBets, the Reddit message board favored by small investors who have been bidding up the shares of GameStop, a video-game retailer that has been hit hard by the coronavirus pandemic. A couple of weeks ago, the stock was trading below twenty dollars. It’s been rising sharply since, and on Wednesday it shot up more than a hundred per cent, to close at $347.51 on news that a number of short sellers—Wall Street traders who bet on stock prices falling—had closed out their negative wagers and suffered big losses. “Tards this is bigger than all of us. Once we’re done with GME”—the stock symbol for GameStop—“we take down the whole fuxking Wallstreet! Get Fxked!,” one Reddit user wrote, employing a shorter version of the derogatory label that many Reddit contributors apply to themselves ironically. Another wrote, “Market is closed guys, get some fresh air and eat some veggies. We have a big day tomorrow.”
There are two stories here. The one that has drawn the attention of everyone from Elon Musk to Representative Alexandria Ocasio-Cortez is a David and Goliath yarn, in which the buyers of GameStop are viewed as underdogs battling the Wall Street giants. By banding together, the day-traders have recently managed to ramp up some beaten-down stocks, such as GameStop, Blackberry, and AMC Entertainment Holdings, besting some short sellers in the process. “Individual investors are winning big—at least for now—and relishing it,” the Wall Street Journal reported.
There are plenty of good reasons to be outraged at Wall Street. But what sort of victory was this? On Thursday morning, GameStop’s shares plunged fifty per cent after TD Ameritrade and Robinhood, the popular trading app, restricted investors’ ability to trade in certain stocks. The stock continued to trade on other platforms, and it subsequently rebounded—at noon it was trading above two hundred and fifty dollars. Still, some people who had bought in on Wednesday were sitting on significant losses, which could well get larger if they don’t sell out soon. (Prior to the past couple of weeks, GameStop’s all-time high was about sixty dollars.) One Reddit poster commented: “I’M OUT OF CASH, DOWN 50%, AND HOLDING TIGHT. THE LINE IS OURS BOYS!!”
The larger story is that the U.S. stock market is in the grip of what Charles Mackay, a nineteenth-century historian of financial manias, called “the madness of crowds.” The GameStop short squeeze didn’t happen in isolation. For almost a year now, investors have been bidding up shares in companies like Tesla, Shopify, and Snap to prices that bear little relation to the actual earnings prospects of the underlying companies. And it’s not just small investors who have been participating in this frenzy. Looking past the short sellers, who are relatively few in number, many professional investors have been playing the speculative game, even though they know that it’s likely to end badly.
Nearly twenty years ago, I published a book titled “Dot-Con: How America Lost Its Mind and Money in the Internet Era.” Between January, 1998, and March, 2000, hundreds of new Internet startups held initial public offerings of stock, and many of them saw their stock prices skyrocket. In the same period, the Nasdaq exchange, where many of these stocks were listed, rose by about two hundred and twenty per cent, and large numbers of ordinary Americans took up day trading as a way to make money. Things haven’t progressed as far this time. Make no mistake, though: we are pretty far along. Since the middle of this past March, when the first wave of the coronavirus was raging, the Nasdaq has risen by almost a hundred per cent, despite a deep recession. (On Thursday, the Commerce Department announced that the Gross Domestic Product declined by 3.5 per cent in 2020, the biggest fall since 1946.) During the past twelve months, there have been more I.P.O.s than in any period since 1999, and day trading has once again become popular. In the latter respect, the main difference this time is a technological one. Thanks to trading apps like Robinhood, and the abolition of commission fees for many online stock trades, people can speculate from minute-to-minute while sitting on their own couches, instead of using commercial trading facilities, which was the case in the late nineties.
Building on the work of the economist Hyman Minsky and the economic historian Charles Kindleberger, we can say that almost all speculative manias happen in four stages: displacement, boom, euphoria, and crash. A displacement happens when something changes people’s expectations about the future. In this case, the pandemic created the stay-at-home economy and prompted the Federal Reserve to slash short-term interest rates to near-zero and pour trillions of dollars into the financial markets through a policy known as quantitative easing. Since March, we’ve been in the boom period, with prices soaring, skepticism giving way to greed, and more and more people flocking to an inflated market.
Copycat behavior is at the heart of speculative bubbles. There is nothing like the sight of others making seemingly easy money to persuade people to take risks that they don’t fully comprehend. “At a late stage, speculation tends to detach itself from really valuable objects and turn to delusive ones,” Kindleberger wrote in his book, “Manias, Panics and Crashes,” from 1978. “A larger and larger group of people seeks to become rich without a real understanding of the processes involved.” Some of the people who have bought stock in GameStop exhibited a sophisticated grasp of the mechanics of a short squeeze. But all the publicity has also pulled in a lot of newbies. “Just bought 2 shares, my first investment ever and I feel sick but excited I need support,” one Reddit user wrote on Wednesday. Two others replied, “Hold and enjoy,” and “I’m here for you brother.” This type of hand-holding is one of the novel aspects produced by the current technology. But there is absolutely no reason to believe it will prevent this episode of speculation from most likely ending in a costly bust.
One of the lessons we learned in the dot-com era is that this reckoning can be delayed for longer than one might think. As that historic bubble inflated in the late nineties, some Wall Street analysts warned that stocks were overpriced, and some professional investors placed short bets. But as prices kept going up, many of the skeptics lost their jobs or fell silent. Eventually, many investors, including some big hedge funds, switched sides and also tried to surf the bubble. Something similar appears to be happening now—and I’m not referring merely to the hedge funds that have closed out their shorts in GameStop. For months now, many big institutional investors have been riding the remarkable rise of mega-cap tech stocks like Amazon, Apple, and Tesla—despite the obvious risks of concentrating their portfolios on a small number of winners.
Over the past fifty years, the average price-to-earnings ratio for stocks in the S. & P. 500 index has been about nineteen. At the market opening on Thursday morning, Amazon was valued at ninety-five times its trailing earnings; Apple was at thirty-eight times trailing earnings; and Tesla was at about thirteen-hundred-and-seventy times. Do all those handsomely paid fund managers really believe these are safe investments? Quite possibly not, but the momentum behind such stocks has been phenomenal. If you are in the game of trying to beat the market index on a quarterly or annual basis—as many professional investors are—it can be a career-ending move to avoid the high-flyers, regardless of how overpriced they may seem based on sounder conventional metrics. So you keep buying in the hope that you will be able to get out before everything goes to hell. This is the peculiar logic of collective action that I have called, in the past, “rational irrationality.”
The ringmaster of this circus is the Federal Reserve, which is primarily responsible for the monetary and regulatory environment in which investors—amateur and professional—operate. But today, as in the late nineties, the Fed is trying its best to look like a bystander. During a press conference, on Wednesday, following a meeting of the central bank’s policymaking committee, Jerome Powell, the Fed chair, refused to comment on GameStop specifically. Speaking more broadly, he said, “If you look at what’s really been driving asset prices, really in the last couple of months, it isn’t monetary policy.” Powell also said that the Fed wasn’t considering raising margin requirements, which limit the amount of money investors can borrow from brokerage firms, to quell speculation.
To be sure, Powell has persuasive-sounding reasons for adopting a hands-off policy. With the country still poleaxed by the virus, and many people out of work or otherwise suffering financially, he and his colleagues want to provide as much support as they possibly can for hiring and spending. If they were to say or do anything to tank the stock market, their actions could conceivably have a negative effect on the rest of the economy, at least in the short term.
Powell’s intentions may be honorable, but his claim that the Fed’s policies haven’t been feeding speculative activity isn’t credible—and it’s likely not sustainable either. As Powell’s predecessor Alan Greenspan discovered in the dot-com era, speculative bubbles tend to take on a life of their own. The longer they are allowed to inflate, the bigger the eventual bust, and the more negative fallout there is for the economy—and for Americans, as a whole. If the Fed chair doesn’t want to store up more trouble for all of us in the future, he would be well advised to pay more attention to Reddit.