In the last week of January, a small company stock shot up 500%.
The retail store, GameStop, which sells video games and consoles, was caught up in a collective frenzy from an online community that led to billion dollar hedge funds needing emergency capital and Congressional hearings and probes.
It’s definitely been no small thing, but thankfully has allowed us to reflect on an important aspect of markets without the catastrophic consequences of widespread market recessions.
We’ll look briefly at what happened and most importantly what this teaches us about market bubbles. Turns out it’s a lot.
In January, an online trading community on reddit.com called WallStreetBets led amateur individual traders to buy stocks that professional money managers and hedge funds were betting would go down.
The forum has been a place where traders from their computers at home share screen shots of large bets they’ve made in the markets and the subsequent results – some resulting in hundreds of thousands of dollars.
You know those beautiful vacation pictures that your friend shares on Facebook and your subsequent feelings of jealousy? It’s the same environment on WallStreetBets. Traders post screenshots of their investment accounts showing off how much money they made for risky bets they took.
Over the years, markets have become democratized. What used to have to go through a broker at a hefty fee can now be done for free from your smartphone. “WallStreetBets is the ultimate stage of this evolution. Thousands of people can amass small trades into giant pools of capital and whip each other into a collective frenzy,” said investment writer Jason Zweig.
The WallStreet Bets mantra can be summed up as this: “No more do we have to bow to the strong powers of large Wall Street banks and institutional traders. We, the people, have a say in things, too.”
Couple this with “the desire to get rich without labor” as written by Horace White in 1909 and we got ourselves a wild end to January for certain company stocks.
Before you rush to check to see how this has affected your own investment accounts. Take a breath.
According to Matarin Capital Management, an investment firm in New York. These stocks – GameStop, among others – only made up 0.13% of the S&P 500 and only 4% to 5% of leading indexes of small stocks. That means all of these events lightly breezed over your portfolio value – if of course you are globally diversified, like all Birchwood clientele are.
Explaining Market Bubbles
Here’s a look at GameStop’s stock price year-to-date through February 18th. It’s been quite the ride.
We can see the sudden rise of price in late January to a high of almost $350, a volatile jerk down and up, and then the subsequent crash.
Many people now ask:
- “If a group of traders can disrupt the system, are we all at risk?”
- “Is this the end of efficient markets?” and
- “How can we control these things so they don’t happen and cause disruption in my portfolio?”
In other words, how do we protect ourselves from the irrationality of market participants?
The truth is these traders were acting very rationally. In fact, ALL market bubbles are made up of rational investors. And recessions and market bubbles are going to be part of our market future for the rest of time.
Hyman Minsky was an economist at Washington University in St. Louis. His most important work was called the “Financial Instability Hypothesis.”
It goes something like this:
- When an economy is stable, people prosper
- When people prosper, financial risks don’t seem risky
- When they take more and more financial risk, the economy becomes unstable
Minsky wrote, “Over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.”
Big idea: Stability is destabilizing.
Timothy Keller says something similar about this cycle: “Without awe and wonder, success can and usually does lead to a sense of superiority and hubris. Then the spiral begins. Pride moves you toward foolishness, such as overconfidence in your intuition, which ultimately results in bad decisions and downfall.”
When short-term momentum begins feeding on itself – creating the potential for great returns – what do you expect people to do? Sit nicely on their hands? Ha!
The principle of long-term investing and being patient and letting compound work over time, suddenly goes out the door because it’s irrelevant to the new game being played.
People have different goals than you or I do. A day trader making buys and sells on GameStop is playing a different game than Aunt Betty who is putting money in her 401(k) each month. But they’re both playing on the same field.
Morgan Housel writes this in his great work, The Reasonable Formation of Unreasonable Things:
“If you view the plunge in asset prices that marks the end of bubbles as an indication that everything you thought you knew about long-term investing is wrong, you end up using the end of someone else’s game as an excuse to never again play your own. Like a passenger who questions whether it’s safe to get on a plane because he sees hundreds of people eagerly getting off the previous flight. It is the most devastating trick investors play on themselves.
Realizing that the rise and fall of bubbles does not negate the effectiveness of diversified long-term investing is one of the most powerful understandings an investor can have. And one of the hardest things an investor can do is maintain conviction on a long-term strategy when there’s a changing of the guard between one game and the next.”
As an investor you must do the work of separating the games people are playing around you from your own. Don’t be a participant in games other than the one you intended to play. It would be like sitting down for Russian roulette when you wanted to play Uno.
The solution cannot be some imaginary withdrawal from the markets (selling everything and getting out). We must learn to do something new – to engage critically, not surrendering to any reigning ideology, so we can be “salt and light” in a market rather than part of its decay.
Knowing why GameStop hit the newsstand and why future bubbles have occurred (and will occur) can be the best defense for maintaining thoughtfulness and grace through the inevitable and upcoming turmoil of financial markets.