“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.
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:
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.
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.
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]