It's still early in 2021, but there's a good candidate for stock story of the year.
Shares of GameStop (GME 0.08%), a stodgy video game retailer, have soared recently thanks to a band of traders on the Reddit group WallStreetBets. Though there's been no significant news out on the company this year, these traders have executed a massive short squeeze on a stock with a low float that was heavily bet against. As of the end of December, 260% of GameStop's float been sold short, meaning the average share had been borrowed 2.6 times. The overwhelming majority of investors were betting on the stock to go down, but the skyrocketing share price forced many of those traders to buy back the stock, helping to propel the rally.
GameStop stock has essentially doubled in each of the last two weeks and was off to a blistering start on Jan. 25 as well, pushing the share price as high as $159 before it pulled back. The ascent continued on Wednesday morning, as shares jumped to $250 in pre-market trading. Over the last six months, GameStop shares are now worth more than 50 times what they were as recently as August, when they were trading below $5 -- penny-stock range. While there's no telling how or when the stratospheric rally will end, there are some important lessons for investors to take away.
Image source: Getty Images.
1. Don't short stocks in this market
Shorting stocks, which means betting that stocks will go down rather than up, is always risky. Over the long term, stocks tend to go up rather than down, and shorting stocks exposes you to infinite risk. When you're long a stock, meaning you own shares, the worst that can happen is that lose all the you money you invested.
By contrast, when you short a stock, the best you can do is to double your money, though you can theoretically have infinite losses. If you short a stock at $5 and it goes up to $50, you could be forced to buy it back for 10 times more than what you paid for it. If your original investment cost $1,000, you would've lost $9,000.
Today's market has crushed the fortunes of more than a few short-sellers. In the case of GameStop, Citron Research's Andrew Left, a well-known short-seller, argued in a video, "This is a failing mall-based retailer. So the amount of people who are so passionate about putting GameStop higher not based on any fundamentals -- it just shows the natural state of the market right now."
Similarly, the chart below shows how Tesla short-sellers have had to close out their bets after getting burned over the past year.
2. The market is as frothy as ever
Not since at least the dot-com bubble have stocks been this divorced from fundamentals. Despite the rise in its share price, GameStop remains a fundamentally weak company. The stock spent the past five years on the decline, as its business model has been disrupted. Many video game systems no longer rely on cartridges, and e-commerce providers have supplanted much of what business GameStop would otherwise have gotten. In its recent holiday sales update, it reported declining sales in the November-December period, showing that its recent performance is no justification for the stock's sudden surge. Nonetheless, GameStop has gone from all-time lows to all-time highs.
But GameStop isn't the only example of the market's frothiness. Valuations are getting stretched across the market. The price-to-earnings ratio for the S&P 500 has gone from just over 20 at the end of 2019 to 39 even as the global economy is still reeling from the coronavirus pandemic. Traders have piled into bitcoin, among other cryptocurrencies, lifting its value from less than $10,000 last summer to more than $40,000 earlier this month. Initial public offerings (IPOs) have regularly doubled on opening day. Similarly, the special-purpose acquisition company (SPAC) boom has also delivered plenty of single-day stock pops.
Additionally, sectors like electric vehicles and renewable energy have also skyrocketed almost entirely on expectations that such technologies will go mainstream, even though that transition could take decades. Finally, call-option buying has surged to a new record in 2021, following a previous high in 2020.
3. Fundamentals don't matter until they do
GameStop's recent surge is reminiscent of earlier bubbles, including one in marijuana stocks. Shares of Tilray, a Canadian marijuana grower, soared in 2018 ahead of Canadian legalization, rising from an IPO price of $17 in July of that year to more than $300 in September 2018. But that boom was primarily due to a low share count as demand for Tilray shares exhausted supply ahead of Canadian legalization, and also combined with a short squeeze. Today, Tilray trades barely above its $17 IPO price.
Similarly, 3D-printing stocks captivated the market in early 2010s, much like investors currently seemed to be enthralled with electric and vehicle and renewable energy stocks. You can probably spot the bubble in 3D Systems and Stratasys below.
It's also noteworthy that these two stocks are suddenly soaring again even though the industry largely contracted last year during the pandemic.
GameStop's unprecedented rise makes it clear speculators are driving the movement in a number of corners of the market today, and many of these traders are buying stocks based on the greater fool theory -- namely, that someone else will come along and pay more. But history has shown that eventually stock valuations return to historic norms. Fundamentals prevail.
The party in GameStop shares could go on for a while longer, but for long-term investors, it's another reminder to be wary of any stock skyrocketing on little fundamental news.
