The Market Is Not Broken

In the most recent episode of AWM Insights, Brandon, Erik, and Justin discuss Gamestop and the other stocks that appear to be making irrational moves. Short selling, short squeezes, hedge funds, meme stocks, Robinhood and Reddit are terms being thrown around all of financial media. I’ll do my best to give you a few things to take away from the situation.

Gamestop’s stock has plummeted over 80% from the recent highs and any buyer of the stock who bought anywhere close to the peak is either sitting on massive losses or has seen their gains evaporate before their eyes. I warned of this exact situation on my last podcast. Justin warned of it on this Insights podcast:

“Hopefully not many, but people are going to lose money. The hedge funds have lost money. I think some retail traders will lose money. Some retail traders have made a lot of money as well. Hopefully if they've sold. Some people might just be sitting on gains and not doing anything with it and expecting it to go further, but it's been a fascinating ride.”

Justin makes a great point about paper gains. You have to sell to notch the gain or you haven’t made any money. Many people that rode the stock up did not sell on some irrational idea that it would just go up forever and now will ride it all the way down to wherever it ends up settling in at.

Why Did Gamestop Spike So Quickly and Then Crash?

A short squeeze involves short sellers that do not currently own the stock becoming forced buyers because they must buy it back from someone else to close out the trade. Some of the hedge funds were forced to do this at the worst possible time. These market distortions can cause incredible short-term movements in share price but eventually the fundamentals of the company, which include the long term business prospects, win out in the end and share price returns closer to their intrinsic value. Brandon describes a core tenet of long term investing:

“And you mentioned fundamental analysis, and I think it's good for people to understand what your expectations should be when you go to buy a stock. They should be that when you're buying a stock, you are buying the earnings of that company. That's fundamentally what you're buying. And so those, then we look at, okay, well, how much are you willing to buy those earnings for? When you look at some companies that are, they're growing quicker, you're going to pay more for those earnings because you expect those earnings to accelerate at a greater pace. We're looking at an instance here with GameStop where, to my knowledge, I don't think they actually make money. So we're seeing the price that you're willing to pay for a company that doesn't make money. So those negative earnings you're willing to continue to pay more and more and more and more”. -Brandon

One of the best chapters ever written on market fluctuations is Chapter 8 in the revised edition of The Intelligent Investor by Benjamin Graham and the more up to date commentary by Jason Zweig who acutely describes why we advise a long-term investing mentality. During the COVID Crash I recommended to anyone that was panicking and wanting to sell out of the market to read that chapter on price swings and stock prices becoming detached from reality. The quote “the markets can remain irrational longer than you can remain solvent” by John Maynard Keynes perfectly applies to Melvin Capital’s forced buying of Gamestop stock. Similar events transpired during the COVID crash when margin requirements tightened and forced selling took place en masse. Leverage magnifies gains and losses so even the best professional investors must be cautious or face the consequences of unwinding positions at the worst possible time.

This Is Not New

Anyone that has studied market history has seen this story of euphoria and fear of missing out play out in different areas of the market throughout time. Gamestop is just the newest chapter in the same story of investor psychology.

• 1800s Tulip Mania

• The South Sea Company

• 1929 after the Roaring 20s

• 1980s Japan

• US Housing Market in 2005-2007 (watch: The Big Short with Christian Bale)

• Dot Com Bubble of the late 90s

Technology has increased the speed at which information can be disseminated across the world and the Reddit Forum r/wallstreetbets is a prime example of that. Communication is faster than ever and that is a trend likely to continue and will be a factor in the markets.

Are You an Investor or Speculator?

It is more exciting to gamble than be a long-term investor. Patience is rewarded in the market and the evidence of investing has shown this in the long-term data.  

“you need to recognize that you're wired to do everything wrong when it comes to money and investing. If your fear of missing out leads you to day trade on speculative stocks, you're taking an approach that typically results in failure over the long term. And I think that that's really important is our croc brain.” -Erik

For the traders at home that think they can win at trading, I recommend educating yourself about who you are competing against. You are not trading against other humans but machines the majority of the time. This includes high-frequency trading, algorithmic trading, and quantitative programs that exploit almost every opportunity in millisecond time frames. Trading scratches the gambling itch and that’s why Brad Portnoy of Barstool Sports turned to it when sports were shut down.

The Market Is Not Broken

“I want everybody to be clear about that. We're talking about a very small sliver of the market and what is happening right now. So if you're a long-term investor, the market is not broken, stay diligent, allocate to where you expect the returns to be, be it globally diversified over the long-term. This is a blip in the radar. It is not going to throw off your entire investment plan. So I know I've gotten a couple of questions on that, I'm sure you guys have. But I just want to reassure people that are doing the right thing, that this whole thing isn't going to implode your portfolio.” - Brandon

Will buying Gamestop or Dogecoin in large amounts give you a better chance of achieving your priorities? Even the most talented investors do not over-concentrate because there is always the chance the market becomes irrational or the market knows something you don’t. Diversification is the closest thing to a free lunch the market offers and all investors should be wise to heed that advice.

“The other core tenant, timeless truth is risk and return, they are always attached.” -Erik

When you have clarity on your priorities and allocate your assets to accomplish those priorities you can tune out the short-term noise. This is easier said than done but it continues to be proven over and over again throughout market history.

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