How Redditors and Retail investors could pop the stock market bubble

Disclosure: All opinions presented here are purely my own and do not represent my firm or anyone associated with it.

Following my post last week on the Gamestop situation (here), I couldn’t help but think about the potential broader repercussions of what’s happening right now.

I posted a Twitter thread on it yesterday (here) but I’ll add it here

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What’s happening now with Reddit and retail investors being heavily involved in the stock market could be the collapse of the bubble where we see huge drops in stock prices across the board.

Here’s my thinking…

If Redditors and retail investors continue to hold big positions in heavily shorted stocks, like Gamestop, AMC and Nokia, the hedge funds are going to have to pay back their short shares eventually.

This usually takes a few days, which is why some of the names have been trending downwards in aftermarket hours. Hedge funds are changing positions outside of market hours to force retailers to sell their position because it looks like the stock is going down.

But as we saw with Gamestop at the end of last week, the price pre-market (can’t remember which day) went down to ~$100 dollars, but the stock closed on Friday, Jan 29th at $324/share.

Why?

Because retail was still buying and holding, forcing hedge funds to cover their positions.

What’s interesting about these other names (Nokia, AMC, etc.) is there are big short positions on them as well.

I can’t verify all the information personally, but if it’s true then hedge funds are going to have to start buying shares at much higher prices in order to cover their short positions. All of this is dependent on retail investors continuing to hold their shares and not selling on the dips.

This is how retail wins. They squeeze them out of their shorts.

So what are hedge funds going to do?

They might have to start liquidating from some of their other winners. Companies that have done well since the pandemic started like Amazon, Apple, Zoom, etc. are going to see big sell orders.

Hedge funds are going to need cash to cover.

This could be the demise of many hedge funds, but also the broader market because of the massive selling.

There’s a concept in behavioural economics and psychology pioneered by Amos Tversky & Daniel Kahneman called loss aversion where there is a tendency to avoid losses more than acquiring the equivalent gains. Basically, the person who loses $100 dollars is more upset than the person who made $100.

This may start to come into play because if you start seeing red in growth stocks for a couple of days/weeks, institutions, pension funds and other retail investors may start selling to reap their profits.

Eventually, and who knows for how long (could be days/months/years), these big-name stocks that have done so well are going to trend downwards.

This could create a negative feedback loop.

“Stocks that did well are going down -> I (pension fund, retail investor, etc.) made money on this stock so I should sell to convert some profits -> keep seeing stocks go down -> keep seeing people trying to sell to make a profit.”

It could spiral out of control.

It’s likely we’ll continue to see brokerages have stoppages on these names (AMC, Nokia, Gamestop, etc.) because this could spiral quickly if hedge funds and institutions start to lose billions of dollars quickly.

But retail wins. They effectively beat them at their own game.

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So where do we end up?

The whole market could collapse if this continues where retail wins and big money (hedge funds, institutions, etc.) lose and lose lots of money.

Lots of rich people will not be happy but you can sense people are tired of rich people always winning.

The inequality gap in America and around the world has continued to widen, particularly in the last year.

Look at this:

3.9 TRILLION DOLLARS!

For context:

One million seconds is equivalent to 11.5 days, one billion seconds is 31.25 years and one trillion seconds is 31,710 years. Read that sentence again. That’s how much money the richest people in the world made as a collective last year.

Meanwhile, the Oxfam report quoted in the article estimated between 200 to 500 million people may have fallen into poverty in 2020.

The average person in America, and around the world, has struggled. They can’t afford food, they can’t afford healthcare, they don’t know how they’re going to pay for rent, they don’t know if they’ll have a job and they’re isolated with their mental health deteriorating every day.

This is how most people have handled the pandemic. It feels like all the voices I see in the tech and innovation economy are talking about how great their tech companies and the broader tech industry is doing.

But the average person is struggling and no one is coming to help them.

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I’m sure the average person is happy to see rich people fall.

But a market collapse is going to have so many broader consequences that will affect all of us down the line.

I don’t know what the second, third and fourth-order consequences are right now, but they don’t look good in the short term.

Or I could be totally wrong and this was a fun thought experiment :)

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Since I wrote that, there are a few thoughts I’ve had

1. This is all dependent on retail investors buying into stocks and holding their positions, potentially for weeks, months and years. If they can do that and not sell when CNBC or other mainstream media outlets tell them to sell, then hedge funds will fall.
2. Hedge funds and market makers are going to do everything they can to not allow retail to win. Expect to see a few questionable decisions in the markets over the next few weeks, months and years because as we’ve seen recently, hedge funds play by a different set of rules and rig the game in their favour
3. This decoupling and decline in the market isn’t going to happen instantaneously. For example, if you look at the previous stock market crash that many people think happened in 2008, the bottom of the market didn’t occur until 2009. So these things could happen over years
4. This upcoming stimulus bill is going to have a major impact on what happens. Pay attention to where the money goes. Does it go more to individuals or institutions?

No matter what, the next few weeks are going to be interesting to watch.

This moment in the markets feels like something that will be discussed for decades to come.

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Keep going, you're doing great

-AK

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