One of the biggest financial stories of the year was the recent price changes in GameStop stock (GME). Just this week we saw everyone involved testify in front of congress including the CEO of the trading platform Robinhood, the CEOs of hedge funds Citadel and Melvin Capital, and the Reddit user who started promoting GameStop stock. I wanted to share my thoughts on what happened, because I think this situation shows some important concepts about financial markets. WATCH NOW
Let me start by saying that we do not know exactly what happened yet. The SEC is still investigating and there are a lot of facts that are unclear, and we need to wait until they come out. The only thing we know for certain is that GameStop stock skyrocketed and then crashed.
Let us start with some key concepts that you need to keep in mind when we talk about GameStop.
- Financial markets are important. Financial markets are the backbone of our economy. They provide money for businesses which then create jobs which create the products and services we all use every day. It is incredibly important that we maintain a strong, reliable, and transparent stock market, because it impacts your every day life. What has happened with GameStop has raised concerns on whether the market is fair. If investors think the system is rigged against them, they are going to stop investing. So one of the main job of regulators at the SEC is to ensure that people have confidence in the market. Which brings us to our next point…
- Market manipulation is illegal. Market manipulation is when someone tries to artificially impact stock price in order to make money. So if you put out false statements about a company, in combination with a large coordinated effort to swing market prices so you can benefit from the impact on the market, that is illegal. The reason it is illegal, is because it is not fair to other investors, who have money at stake and get hurt by manipulation. It is not fair to ordinary citizens who get hurt when there is no longer confidence in the market. It is not fair to the companies who lose access to markets when no one wants to buy their stock again. So market manipulation is when you have one person who makes a lot of money by swinging market prices, by making a lot of other people lose money. That is a crime and the SEC will put you in jail.
There are two famous types of market manipulation. One is called pump and dump. This is when you hype up a stock with a lot of promotion. When the stock price rises, the instigators will dump their shares, making a lot of money. The stock price will crash back down, and everyone who had bought in during the rise, will have lost their money. Another scheme is called poop and scoop. This is the opposite of pump and dump. Poop and scoop is when you put out negative promotion about a company, buy when the market dips from people selling their shares, and then make money when the market rebounds.
Let us imagine a hypothetical scenario. How would you pull off a pump and dump scheme? Imagine you had an email list of unsophisticated retail investors. You identify a stock that has liquidity issues, meaning that a sudden increase in buying would spike the stock price. You send out mass emails telling everyone this is a great opportunity and they need to buy this stock. The price shoots up and you sell. Once the buying frenzy dies down, the stock price drops back to normal. In this scenario, you made money by scamming people into losing their savings.
Now of course there are people who make a living legitimately by recommending stock tips. But if that is your job, you need to be very careful you do not violate laws against market manipulation. That is exactly the reason why I do not give stock tips on this YouTube channel. If you go on social media and tell people to buy a stock, you have a responsibility to ensure you are not making money off market manipulation. You can look at an example like Jim Cramer on CNBC. Jim Cramer gives buy and sell recommendations on TV, but you will see there are tons of disclaimers on the show, and he is very careful he safeguards against being accused of manipulation. What these professionals often do, is give their personal investing to an independent third party. That other person is making investment decisions. That way, the person giving stock tips is not even trading on the recommendations they give to the public.
The GameStock situation is really a question about market manipulation. Did people manipulate the market here? Should people go to jail? People on reddit are accusing hedge funds of poop and scoop. People in the hedge funds are accusing the people on reddit of pump and dump. Again, we do not know the facts yet in this case. But the SEC will likely be looking at a few key questions:
- Did the hedge funds coordinate with Robinhood to stop the purchase of shares on the platform to the hedge fund’s own benefit?
- Did the Robinhood management actions hurt retail investors at the benefit of hedge funds?
- Did investors on Reddit try to inflate the stock price in order to sell?
If any of these people intentionally tried to manipulate the market in order to make money, they can go to jail for a long time.
Let us look at a chart of GameStop stock from the last month. You can see that at the end of January, the stock price started to go up, and then it crashed a short time later. Anyone who was holding short positions, like the hedge funds, lost a lot of money on the way up. Anyone who bought shares on the way up, lost a lot of money on the way down. All together, a lot of people lost a lot of money.
If I were to look at this chart, and knew nothing about this situation, this chart looks like a classic pump and dump scheme. You have a skyrocketing stock price and crash all within a week. You can see that any investors that bought into GameStop after Jan 27, lost a lot of money.
I want to be clear that I am not accusing the investors on Reddit. The investor who testified this week claims there are legitimate reasons to invest in GameStop, and there was no ill intent here. The question is whether he or anyone else on Reddit were hyping up the stock? Were there safeguards in place to ensure they were not making money off manipulating the market?
There are also plenty of facts that have come out about the management of Robinhood and the hedge funds that seem pretty shady. Did Robinhood change the terms of service to ensure their users lost money to benefit the hedge funds? Did Robinhood mismanage their company, causing disruptions that caused investors to lose money? Did the hedge funds take any action with Robinhood to cause retail investors to lose money at the benefit of the hedge fund? Did the hedge funds take any action to restrict or manipulate the stock market from freely pricing GameStop stock?
From what we know, it seems like there is a lot of blame to go around for everyone. The only thing we know for sure right now is that this was not normal market behavior and a lot of people lost money because of it. So the SEC will look into everyone, and if someone is at fault, they will go to jail.
If you are watching this all happen, the lesson you need to learn is that market manipulation is illegal. When you buy a stock, you should be buying it for a legitimate purpose. You should have done research about the company that identifies a new product or revenue opportunity is not currently captured in the stock price, so if you invest you expect to make money. In fact, every time you make a stock investment, you should be writing down notes of the reasons why you are making that purchase. If the reason for the purchase is because you are participating in a scheme where other people are buying to inflate the price, you are participating in market manipulation and that is illegal.
I want to end with two more key concepts that will help you make better investments.
- Financial markets are complex. One thing I really dislike about how the GameStop story has been covered, is everyone is talking about it in terms of class warfare. People are saying this is about the rich hedge funds against the poor people on reddit, and the poor people are rising up. That is not an accurate description. Financial markets are more complex than that. Everyone should be on the same side on protecting against market manipulation. It is true that billionaires have money in hedge funds, but so do every day Americans. Here is how financial markets work. If you look at a typical worker in America, like a janitor or a technician, a portion of their check every month goes into a pension fund or 401k account. Those accounts get managed by large investment firms, and a portion of that money goes into high yield hedge funds. So if a hedge fund goes down, it is not just the billionaires that get hurt, it is ordinary Americans that will lose their money for retirement. Not only that, the people on Reddit may not be who you think they are. The problem with Reddit is that we do not actually know who these people are. The people making those posts could actually be hedge fund people trying to manipulate the market, and you would never know. I do not think that class warfare is a helpful or accurate way talk about this situation.
- Be careful when you invest. If you are getting into investing, please be careful. Something you need to learn from this situation is that there are scams going on. There are a lot of people in the market who are working hard to take your money. Please be cautious. This should not scare you or keep you from investing. You just need to be smart about it. We live in such an amazing time, when an ordinary person has access to invest in financial markets. You should be taking advantage of that. But do it carefully and thoughtfully. Invest in good, long-term investments that make sense for your situation, and I always recommend that you talk with a financial professional.
Leave a comment down below letting me know what you think!
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Neither Zach De Gregorio or Wolves and Finance shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.