Did the Short Squeeze Game “Stop”?

To put it lightly, the stock market this week was unforgettable. The “short interest” revolt traced back to the wallstreetbets thread on Reddit caused companies like GameStop, Nokia, AMC Entertainment, Naked Brands, and Blackberry shares to rise steeply. Retail investors flooded the market through Robinhood and other brokerage accounts. As explained in my blog last week on Behavioral Economics: The Psychological Shifts Driving the Current Financial Ecosystem, Robinhood investors’ “fad investing” continued well beyond predictable measures. This trend, potentially propelled by a lethal cocktail of greed and boredom (determined to teach Wall Street a lesson) amid “get rich quick” publicity littering social platforms, likely caused retail investors to over purchase shares in “out-of-favor” stocks, artificially inflating prices.

However, to really understand the dynamics of this past week’s historical trading environment, we must define what this dynamic is technically called: a short squeeze. A short squeeze is a rapid increase in stock price (usually a reaction to technical indicators in the market) not regarding any underlying fundamentals. Sometimes a short squeeze occurs when there is a lack of supply, and an excess of demand as short sellers cover their positions. The latter proved true, in the current “Retail Revolution,” as retail investors banded together to purchase shares of stocks with high short interest (inflating demand), compounding the effects of a traditional short squeeze. The massive influx of retail purchasers caused volume for some of the higher-profile names to skyrocket past normal levels, causing share prices to go parabolic. Furthermore, if the stock rises, the more the short seller is exposed to infinite losses (hedge funds). Therefore, if short sellers want to exit their trades, they must purchase the shares to cover their spread, intensifying the price appreciation. In essence, it causes a perfect storm of counterintuitive events leading to exuberate short-term gains.

Volatile Reddit Stocks’ Weekly Chart

Now rationalizing this is hard as these extreme occurrences almost directly combat Eugene Fama’s “efficient market hypothesis” focusing on the notion that “capital markets channel investor’s money to its most efficient uses.” It can be coined that these occurrences are the growing pains to return to pre-COVID norms. Excuse maintenance remains unhinged as economic uncertainty and social eagerness fuel “nudge” methods (including defaults, social proof heuristics, and increasing the salience of the desired option). The retail investing rebellion is just another occurrence challenging neoclassical economic theory. Even though this investing behavior is the closest thing to pure irrational decisions, it also raises the question that if everyone is doing something irrational, does that make it rational by the masses? The hard to govern social platforms of Reddit and Twitter enable retail investors to take unified stances against short sellers as these centralized platforms remain the ideal place for ideas to congregate and the “hivemind” to reap havoc on institutions. Without mathematically testing this theory, it is hard not to think this way whether you are an institutional investor or a retail investor. The stock market, like neoclassical economics, is driven by supply and demand. However, the stock market is also driven by consumer’s transaction cost economics rooted in bounded rationality and opportunistic behaviors. The notion that “financial systems are efficient until they are not” is the best (or the only) way to summarize this week’s unprecedented trading activity.

With four intense trading days behind us, brokers have struck back by restricting trading activity in select names (GameStop, Nokia, AMC, Naked, Blackberry, etc.). This is likely due to the history of assigning blame during periods of market bubbles, as seen during the dot-com bubble in the late 1990s and the housing and credit bubbles of 2008. These debated actions seem to fuel the beginning of the end of the epic short squeeze, likely decreasing market volatility (evidenced by the VIX initially rising to 37 on January 27^th, and then falling to 28 mid-day January 28^th). However, with short interest still high (in the likes of GameStop) and the VIX creeping up early on January 29^th, a short squeeze has the potential to resurface (though likely not to the nuclear assent experienced earlier this week). Regardless of the market volatility and retail investor’s market influence, one aspect that has the potential to linger among institutional investors is their expression of bearish views on a company or stock. Company’s publishing short interest reports may have second thoughts, drastically changing the institutional dynamic and transparency.

Instances like these are important to remember and to use as learning lessons when deciphering market trends, conditions, or uncertainties. Additionally, it is also important asset managers remain aware of these market bubbles or dislocation and position their portfolios (equity or fixed income) swiftly and efficiently to decrease or eliminate any volatility risks associated with unpredictability. However, based on the new brokerage restrictions and prospect theory’s risk aversion actions amid gains, it appears that the 2021 short squeeze game has stopped (for now).