What Wall Street’s ‘short squeeze’ means for investors and regulators

Wharton experts discuss the sharp surge in the stock prices of online video game retailer GameStop, and what comes next in the stock market.

Equity stock investors of all sizes woke up this past week to a powerful new market force—individual investors congregating on social media and acting on their own, but with a common motive. They grouped together on Reddit, Discord, Facebook, Twitter and other platforms to drive sharp surges in the stock prices of chiefly online video game retailer GameStop and movie theater operator AMC Entertainment. The market capitalization of GameStop briefly soared to $26.5 billion on Wednesday, Jan. 27, surpassing that of Delta Air Lines; by the next day, it had plunged 44%.

Outside entrance of a GameStop storefront in daylight.

In the latest rally, the collective purchasing power of retail investors singed big hedge funds and other short sellers who were forced to buy those stocks to meet margin requirements or delivery commitments. Gleeful individual investors saw that “short squeeze” (Wall Street parlance for pressure on short sellers) as comeuppance for hedge funds and professional money managers, whose market heft and perceived predatorial behavior they have long resented.

“The hedge funds that were engaging in short-selling activity are certainly the ones feeling the most acute pain right now,” explains Wharton finance professor Sasha Indarte.

The consternation over the stock price surges at GameStop and AMC is rooted in their disconnect with their financial performance—both companies are losing money, made worse by the pandemic lockdowns.

The other shoe is yet to drop for those who bid up the share price of GameStop, according to Indarte. “I think we’re going to see more pain felt potentially by the retail investors that are in effect bidding up the price of GameStop,” she predicts. “It’s hard to justify the prices that we’ve been seeing for the company, based on the company’s fundamentals.”

Regulators don’t have easy or ready solutions to prevent the speculation in stock prices that can occur on social media, and the harm it can cause unsuspecting or relatively less-savvy investors. At the same time, social media can also be a good and desirable actor in price discovery with information dissemination.

“The complication for regulators is that actual information that is supposed to be incorporated in prices can also be diffused through social media,” says Wharton finance professor Jules H. van Binsbergen. “This can still lead to sizeable price changes, but those price changes make financial markets more informative, which is beneficial to the real economy.”

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