Short Term Madness Vs. Long Term Winners

“Making sense of market volatility.”  This was the subject of an email I found in my Inbox on Friday afternoon.  “What’s all this?” I wondered.   Schwab was sending out emails to investors in order to soothe fears stoked by the madness and volatility in heavily shorted stocks last week.

Last week was crazy-town.  A few select stocks rose or fell by over 100% in a single day!   The volatility was extreme, and trading volumes were through the roof.  Blood was in the water, and speculators were having a feeding frenzy!

Thankfully, most small investors were not involved in this madness.

The fact that prices were trading plus or minus 100% in a single day must have been a little stomach turning to regular Mom and Pop investors.  Most savers don’t want to believe their hard-earned retirement is in the hands of wild Reddit gamblers and sleezy hedge fund managers.

Yet, this is the disgusting reality on Wall Street.  Sometimes markets can be incredibly inefficient.  Share prices can become completely unhinged from any kind of rational valuation.  At times, the price of a stock has absolutely nothing to due with the actual underlying value of that stock.

Yep, market inefficiency at its finest.


There’s Nothing New Under The Sun

Last week’s excitement was the case of Melvin Capital vs. Reddit’s Wallstreetbets forum in a violent short squeeze.  Melvin Capital was recklessly short GameStop shares (reportedly more than 100% of shares were short), and a trader going by the name of Keith Gill noticed this anomaly.  He led the Reddit forum r/wallstreetbets to create a fantastic short squeeze.

Frankly, the stock market was working exactly like it should.  Melvin Capital made some incredibly stupid bets, and the r/wallstreetbets guys took advantage of it.  Good for them, I say!

Mr. Gill ended-up making millions from his GameStop trade.  At one point he was ‘up’ by $33 million dollars, and published this screenshot to the internet:

deep f value
(click for larger version)

Holy Cow! Assuming that’s real, it’s one amazing bet!  Unfortunately the news media decided to interpret this short squeeze in GameStop’s shares as something “new” and “unprecedented”.

In reality, short squeezes and large market swings have been going on for almost as long as the stock market has been around.

Take for example, one of the more notable examples from history — A short squeeze in shares of Northern Pacific Railway.  This happened back in 1901 when the railroads were a much bigger part of the U.S economy.  Reportedly, Northern Pacific shares popped from $150 to over $1000 over the course of three days, as speculators and wealthy investors (led by J.P. Morgan) fought over control of Northern Pacific Railway.

northern pacific
(click for larger version)

The price spiked to new highs and then plummeted to new lows during those three days.  The madness in Northern Pacific Railway shares was enough to spark the Panic of 1901.

Any of this sound familiar?  The names and dates may have changed, but wild speculation happening in the stock market should come as no surprise.  The times may have changed, but they really haven’t changed at all.

Instead of coffee houses where speculators used to meet, we now have Reddit forums where modern gamblers bet their pandemic stimulus money.  Instead of financiers like J.P. Morgan wrestling for control of a stock, we have billionaires shorting stocks through hedge funds.

The truth is, the news media likes to make these things sound exiting, but none of it is new.  It’s just Wall Street being Wall Street.

So… should we start joining the ranks of the Reddit traders and capture some of those sweet gains?  Should we be placing our hard-earned cash into Gamestop, AMC, or other heavily shorted stocks and “stick it to the man”?


Keep Calm, And Act Like An Owner

Several years back, I wrote an investing parable that might offer some guidance on how to think about situations like this.  It was called Farmers, Hunters, and Investing For Financial Independence.  It’s a great read, and remains just as relevant today as when I wrote it back in 2017.

In the post, I separated investors into two main categories — Farmers and Hunters.

Hunters, as you might expect, are always hunting for a good kill.  A quick score of ‘wild game’ to keep themselves fed.  In other words, Hunters are the short-sellers and day traders of the investing world.  These investors are looking for a quick score and are unlikely to own a stock for long.  Hunters are always on the move — always looking for the next big game.  If they don’t hunt, they don’t eat.  It’s that simple.

Farmers however, are a different class of investor.  They are the “buy and hold” investors of this world.  They hold assets for longer periods of time (years, or even decades) and harvest the gains from that ‘farm’ year after year.

In essence, a Farmer acts like a business owner.  They care about the businesses, they collect the dividends, and reap the rewards from being part of that growing business.  Year after year.

If you haven’t guessed, I view trading in shares of GameStop right now as pure speculation. In other words, gambling.  The trade worked-out for the WSB folks, but GameStop is NOT a business you want to own long term.

Fundamentally, GameStop (or any of the other heavily shorted stocks from last week) are distressed businesses.  They have too much debt, revenues are declining, and it’s unclear how long they’ll last in the face of rapidly changing technology (streaming and/or downloads).  Not to mention the incredible competition from Amazon.

Most investors should not touch stocks like GameStop with a 10-foot pole.

If you don’t want to own a stock like this for 5 years, you really shouldn’t own it for even a single day.  THIS is what it means to be an owner — Seek to tie your fortunes to the results of the business, not to the wild gyrations of the stock market.

Gains from stock market volatility should not be your primary wealth generator, the business should be.  Given enough time (assuming you hold long enough) your returns should roughly approximate the ROE (Return On Equity) from that business.


Final Thoughts

Although it may seem tempting to join well-publicized trades like this, lets be honest and call the GameStop fiasco what it is — Entertaining speculation.

Don’t let the reported gains of the WSB traders tempt you — Day trading is an extremely dangerous game.  It’s easy to lose money.

Most people should avoid the noise and stick to index investing.  It’s a game that works because it ties the fortunes of the small investor to the business results of our largest public businesses.  Over time, compounding will work its magic and you will win.

On the other hand, GameStop was in a declining business before all this started, and will still be a declining business after all is said and done.  At some point the business fundamentals will re-assert themselves and the stock will drop again.  Last week was just a temporary reprieve from reality.

How long until reality re-asserts itself?  I have no idea!  I left my crystal ball in my other pants, so you’ll get no predictions from me!

Good luck out there!


[Image Credit: Flickr]

12 thoughts on “Short Term Madness Vs. Long Term Winners

  • January 31, 2021 at 8:21 AM

    “Melvin Capital made some incredibly stupid bets, and the r/wallstreetbets guys took advantage of it. Good for them, I say!”

    Totally agree – that’s the way the market should work! It’s stupid though that a number of brokerages started shutting things down though.

    It’s not good that a lot of newbie investors started jumping in, but that’s the way the free market works. Most are going to lose a lot of money, but that’s a lesson learned. Good that they’re starting to invest – bad that they went that way. Maybe some of them will heed your advice and stick around and invest in index funds instead.

  • January 31, 2021 at 2:35 PM

    Thank you & a good message. Your advice on index investing is also good, especially for a beginner or one with a small account, but you personally allocate to individual companies rather than indexing. I would think that even large account holders are risking much more when investing in individual names, but you were able to generate higher returns with individual picks ..?

    • January 31, 2021 at 2:52 PM

      To be clear — A good chunk of our money is indexed, but we do pick a few individual stocks. Less than 13 at last count.

      I don’t consider this inherently riskier than mass diversification. The difference is that I do a great deal of research before (and after) I buy any individual names. They stand a very good chance of outperforming or I wouldn’t buy them.

      Yes, sometimes I’m wrong too, but the winners more than make up for my mistakes. 2020 was a perfect example of this. Some under-performed (due to the pandemic) and some outperformed (various reasons).

  • January 31, 2021 at 6:56 PM

    Thank you for clarifying.

  • January 31, 2021 at 11:25 PM

    Seems pretty crazy to me. I don’t have time or talent for that kind of speculative trading. As soon as I buy GME, it’ll drop.
    Luckily, I’m in Thailand and couldn’t care less right now. 🙂 I’ll stick with my buy and hold strategy. Slow and steady works better for me.

  • February 1, 2021 at 3:38 PM

    I don’t buy the narrative that the GME thing was led by David vs Goliath types. There were people posting tick by tick data from Bloomberg terminals. Average retail investors don’t have those at 45k for the machine and 15k/month for the data feed. Those retail investors got used by hedge funds that were even sleazier than Melvin.

  • February 2, 2021 at 7:33 AM

    Impressive that DFV has been able to get people to continue buying up the shares but he’s been steadily taking money off that table. At least $13m at last count – but the reddit followers seem to miss that. They just see that he is still invested.

    Interestingly, do you think this is his first major win? I suspect (from looking at older screenshots) that he has been trading in call options a long time. It seems that he has done very well for himself off his trading (prior to this massive gain). It almost makes you want to become a day trader again haha.

  • February 2, 2021 at 3:39 PM

    I love the story of the little guy winning vs the big guys. However, that was completely irrational, Gamewas was not worth $24B at all by any means and it was all going to crash down.

    I bought some puts when it was at $160 and was sweating when it hit $320. I am now breaking even now so whew, thank goodness for gravity.

  • February 2, 2021 at 7:18 PM

    It’s been fascinating to watch, but I don’t want any part of Reddit day trading. Great advice. I’ll go check out that Hunters and Farmers article you wrote. I’d say half of my coworkers who sit within earshot of me bought in on gamestop. I hope they didn’t lose too much… The recent volatility isn’t bothering me as I’m just dumping into my index funds and not withdrawing anytime soon. As long as it doesn’t take a nosedive, it’s been nice getting some buys when the market happens to lurch down.

  • February 7, 2021 at 2:42 PM


    Boy, it’s been kinda awful to watch this. Like a train wreck you can’t look away from kind of awful.

    You know what’s going to almost certainly happen—yet here we are, watching it occur in real-time unable to look away.

    And since you posted this, it’s only gotten worse.

    I know it’s easy to think—well, they shouldn’t have speculated//gambled like this, but I don’t know. I feel like, as with many bubbles, so much of it is driven by atypical investors. Novices. In the case of Reddit and WSB, I feel like a lot of it is going to be younger folks who are already struggling off a pandemic and crushed economy.

    And now they’re going to be even further behind. Even less likely to invest in the market for the long term.

    It’s going to hurt them. That’s the part that sucks and makes me sad. 🙁

    Sigh. I can hope it’ll be a good cautionary tale.


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