In the last week of January, the price of stock in GameStop—an ailing brick-and-mortar video-game retailer—soared 323% for the week and 1,700% for the month. Nothing happened within the company to drive the increase; its fundamentals remain unchanged. It was a speculative bubble—but with a twist.
With any bubble, investors who get in and out at the right moment make a lot of money, while those who get in too late or stay too long suffer large losses. Participating in a speculative bubble is thus like playing roulette in a casino, with the financial-services companies (like Charles Schwab) and retail-investment platforms (like Robinhood) acting as the “house.”
But the GameStop bubble is unusual, because it challenges both of the most common interpretations of financial markets. The first interpretation is that financial markets efficiently allocate capital to enterprises that have strong economic fundamentals and away from those that do not. The second is that big Wall Street traders speculate in ways that destabilize markets, making unseemly profits at the expense of the little guy.
The investors who purchased all those GameStop shares—often young, mostly amateur traders coordinating on message boards such as Reddit’s WallStreetBets—seem to subscribe to the latter interpretation. In their view, by conspiring to drive up struggling companies’ stock prices, the little guy was beating Wall Street at its own game. And, indeed, the hedge funds that had been short-selling GameStop have swallowed massive losses.
But this David-versus-Goliath narrative has serious flaws. In fact, there are no clear-cut heroes or villains in the GameStop story. For starters, both sides used the same tool: options trading. The hedge funds bought put options (“selling short”), betting the stock would fall. The small traders then bought call options (“going long”), betting it would rise. They did the same with other struggling companies, such as the movie-theater chain AMC Entertainment and the mobile-device manufacturer BlackBerry.
Short-sellers tend to generate more hostility than those who go long, but there is nothing inherently nefarious in their approach. On the contrary, they often fulfill a useful economic function. By betting against what they view as an overvalued stock, hedge funds drive the price closer to what a company’s fundamentals warrant. This practice can help to slow down the growth of price bubbles, whose implosion can be devastating—as the 2008 global financial crisis showed. Short-sellers also brought attention to dubious sales schemes in the nutritional-supplements industry in 2015 and dishonest accounting practices at the German company Wirecard last year.
The small GameStop investors are not villains, either. True, no one claims to believe that GameStop is actually worth $325 per share. Their motive for continuing to buy appears to be either to ride the speculative wave—much as casino habitués gamble for fun—or to inflict pain on the hedge funds as a sort of populist political message. They are within their rights to do both.
To be sure, had a few big hedge funds colluded in the way the Reddit traders did, they could well have faced prosecution for illegal market manipulation. But this doesn’t apply to the GameStop investors, who were small, numerous, and open about what they were trying to do.
Moreover, at a time of extreme wealth inequality, the GameStop investors are far more sympathetic figures, with everyone from US Representative Alexandria Ocasio-Cortez of New York (on the left) to US Senator Ted Cruz of Texas (on the right) taking their side. Despite incurring huge losses, the hedge funds remain wealthy.