Stock Market Bubbles
In a nutshell, as with any stock or asset, people are allowed to overpay if they want to. Wall Street does not like this when it is affecting them.
Ok, to try and write as simply about this as possible for the novice investors. GameStop is a business that buys and sells video games.
GameStop is listed on the stock market, this means that any of us can go and buy shares in GameStop and the price is determined by economic forces. If someone is willing to buy the stock for $10 and someone else is prepared to sell their stock for $10 then a trade will be made.
When the pandemic hit, a lot of investors thought GameStop was going to lose lots of its business and ultimately not make as much profit in the future.
The future profits and losses of a company determine its value. If a company is expected to make it a profit of £100 million this year. Then it will be worth more than if it is going to make £20 million. This links back to the share price as if we think it will make lots of profits the share price will go higher.
Now for the rest of the blog, we are going to describe BIG investors as the banks/mutual funds, think of Wall Street, and SMALL investors as the traders on Reddit (more of this later).
The BIG investors bet on GameStop to fall in value. This is called short selling.
In share investing, a short is a prediction that the value of the asset (the share) will fall at a point in the future. This can generate massive profits if you are able to predict well, however, the investor can also lose big if the share goes in the wrong direction.
To keep the numbers simple, let’s say the GameStop share price is $10, then if you “short sell”, you sell at $10 with the obligation to buy back at a future point in time.
So the BIG investors thought this is an easy trade. We will sell at $10, and the value of GameStop will fall lower, let’s say to $2. So now the BIG investors make $8 per share when it drops to $2. They sell at $10 and buy at $2.
Now, this type of bet (short selling) is mostly exclusive to big banks.
Now a collective group of Reddit traders (subreddit called wall street bets), started to buy the stock and make its share price go higher and higher. This is what we call in finance a bubble. The value of GameStop may have been only $2 per share. But the Reddit traders bought and bought, so the price kept on rising and rising.
Think about any product. If someone keeps buying and buying the price will get higher and higher.
Now, the SMALL investors collectively have raised the price so high, that the BIG investors are going to lose on their bets.
Now let us say the share price of GameStop has risen to $300, this is disastrous for the BIG investors, remember that bet they made, they promised to buy at a future point in time. So now they have sold at $10 and they have to buy at $300, making a loss of $290 per share.
Now the price of GameStop keeps going up and up because these investors need to keep buying the share in order to offset some of the losses.
Note that the values have been made up for any easy explanation.
If you want to read what the Securities and Exchange Commission says about Shorting shares, find the link here.
So should we all buy GameStop?
Buying an asset above its fundamental value is a sure way to the poor house, whether the share price will last 5 hours, 5 days or 5 months is yet to be seen. But sooner or later, the price will fall as we see with all bubbles.
As of writing this article we are already seeing the price come back towards its fundamental value, although this event has not fully played out yet.
We will update this article once GameStop has returned to its true value.