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Reddit’s r / WallStreetBets just dropped a hedge fund. You will love what comes next.
As a member of r / WallStreetBets, a popular Reddit forum, let me tell you something: it wasn’t supposed to happen. Our happy group of rag-tag investors should use our little corner of the Internet to exchange risky stock investment ideas, not to topple one of America’s most prominent hedge funds. Source: Mehaniq / Shutterstock.com However, here we are. Last week, traders reading the WSB and other forums took GameStop (NYSE: GME) and a series of other highly sold stocks to impossibly high levels, bankrupting at least one hedge fund and causing multiple platforms to stop to negotiate. Wall Street’s response was so clumsy that longtime enemies of Congress, Ted Cruz and Alexandria Ocasio-Cortez, have even managed to coordinate a mess (Twitter tweet?) In the American financial system. But as Citadel picks up Melvin Capital’s pieces and Reddit users find their next short target, people are starting to ask themselves, “What’s next?” Try it Let me be clear: you won’t find my posts on r / WallStreetBets. As much as I read and enjoy the platform, my work and ethics prevent me from talking about any action I have. (Sorry, Elon Musk. I would like to be you.) Wall Street Bets has always been a matter of fun. Many of the posts are intentionally stupid – think of out-of-the-money calls to failed retailers – and there are many contributors showing screenshots of life savings reaching zero. Profitable or not, it was about finding the joys and absurdities of market speculation. In November, GameStop was among those fun little ventures. And everything seemed like a normal fare for the subreddit rated “4chan finding a Bloomberg terminal”. GameStop fans applauded buyers as they cursed Melvin Capital for short selling the shares. All in the hope of having America’s favorite pastime: making a lot of money with as little effort as possible. But then Citron Research changed everything. Citron Research? Meet r / WallStreetBets On January 19, respected short seller Andrew Left finally managed to choose the wrong target. As a longtime Wall Street outsider, Left made his name by exposing companies like Valeant Pharmaceuticals, whose executives were channeling and raising prices for life-saving drugs. He would have been a major contributor to the WSB had he been willing to tolerate the hate speech of 15-year-olds. But then something happened. The day before the presidential inauguration, Mr. Left announced that he would argue why GameStop’s shares were only worth $ 20. Perhaps Mr. Left was right to target GameStop, a declining company that still rewarded its executives with $ 20 million . Or he could be wrong – for $ 20, GameStop would still be worth less than half of Best Buy (NYSE: BBY) when adjusted for sales. But it didn’t matter at all. GameStop suddenly became more than a profitable venture for Redditors. It has become a way to fight Wall Street’s greed; now it was war. How did the WSB do this? In a financial system that values a stock based on its last trading price, even tiny trades at odd prices will reevaluate all of a hedge fund’s stake. In other words, some purchases at the right time can cause confusion, especially in stocks with few sellers. This is exactly what happened to GME. Until then, interest rates remained relatively stable. Market makers, mainstays of the United States’ financial system, were doing their job combining orders and sales. Everything changed on Wednesday, when prices jumped from $ 150 to $ 350. As market makers began to brake, markets started to go crazy. This represented problems for Robinhood. On Wednesday, Robinhood stopped trading for GameStop and almost a dozen other companies. “In order to protect our company and our customers,” said CEO Vlad Tenev later, to Andrew Ross Sorkin of CNBC, “we had to limit the purchase of these shares.” Can Robinhood go under? In the world of commerce, most conservatively managed platforms have no problem managing liquidity. As long as you maintain sufficient capital and maintain disciplined margin requirements, it is rare for your clearinghouse to force you to raise new capital. But when it comes to Wall Street, all financial companies seem to face the same problem – when your customers are making so much money, it’s hard to resist the temptation to join them. Financial regulators have long known these Wall Street antics. All banks, from Bear Stearns to Barings, went bankrupt when they tried to trade the client’s money as their own, leaving taxpayers and shareholders to pay the bill. Many others experienced minimal capitalization – only later to realize their disastrous mistakes. Thus, over the years, smart governments have occasionally found the willpower to ban such practices and impose strict margins and capital requirements. (Often, these rules would be broken by even smarter financial lobbyists.) Today, many platforms use a loophole to lease securities from clients to make a profit. And when GME shares can be leased at 25% interest rates to short sellers, there is a big temptation for these financial companies to dive twice. Did Robinhood do that? Possibly. Despite Robinhood’s claims that its closing deal was proactive, the company still reduced capital lines and banned users from buying more GameStop shares – a sign that Robinhood himself could be short on capital and shares. (As Robinhood is a private company, we may never know the truth.) But will Robinhood have regulatory problems? Almost certainly. The company banned a dozen shares from trading on Wednesday during peak investment demand – presumably because the company needed time to raise new capital. So, while retail investors watched from behind the scenes, hedge funds profited from lower prices. In a very real sense, Robinhood probably saved billions of dollars to institutions at the expense of investors. Should we be afraid? As Wall Street picks up the remnants of Melvin Capital and the aftermath of the GME, two things become clear. 1) “Dumb money” is not that stupid, after all, and 2) “smart money” is being taken to the woodshed. First, let’s consider what Wall Street has long called “dumb money”, the retail investor. Most of these people are like you and me – investing most of their savings in long-term retirement stocks, while playing with a small part for fun. And the cheerful absurdity of r / WallStreetBets aside, most retail investors tend to know what they are buying (even if they sometimes get it wrong in reviews). Robinhood’s top 100 stocks represent a broad sample of consumer-related companies that have grown in popularity in the real world, as well as in stock-related fame. Second, the GME fiasco revealed “smart money” for the absurd bets they sometimes make. While a long-short hedge fund can help investors smooth their gains, they are usually just as bad as what they call “dumb money” in closing losses. Melvin Capital, for example, lost 30% of its net worth in the first three weeks of January. But it took another six days (after the shares gained another 250%) for the hedge fund to finally give up its gigantic position. Since then, other hedge funds have emerged to replace Melvin in this high-risk “hot potato” game, as if trying to prove the r / WallStreetBets point that hedge funds will always try to make more money from regular investors if they believe that the chances are certain. GameStop also exposed the revolving door behind hedge funds and market makers. When Ken Griffin’s Citadel LLC, a $ 35 billion fund, bailed out Melvin Capital, Twitter users quickly pointed out that Citadel also has a market-making operation that serves none other than Robinhood. Where to go from here? Investors looking to absorb the financial system would do well to buy index funds and stay in them forever. You may not have the joy of watching a hedge fund explode, but companies like Citadel, which depend on retail money, will see revenues run dry. But for those looking to invest wisely, consider this. With the newly discovered power of retail investors, you can expect short sellers to think twice before selling a company. Andrew Left of Citron Research has vowed never to publish short sales reports again. Other hedge funds are nervously watching. This means that bullish stocks will move faster than ever. As Reddit users learned this week, it doesn’t take much to influence stock prices when only marginal trading counts. And, with no one willing to short-sell shares in front of an angry mob, price increases will become more and more common. You can expect many winners and losers. After all, the stock market is basically a fixed-sum game. But for long-term investors, the same truth is still true: the path to consistent wealth has always been to buy a group of high-quality investments bought at a reasonable price. Practice this discipline with your main portfolio and you will have a lot of fun with me in reading about the trials and tribulations of others on r / WallStreetBets. As of the date of publication, Tom Yeung had (directly or indirectly) no positions in the securities mentioned in this article. Tom Yeung, CFA, is a registered investment consultant with a mission to bring simplicity to the investment world. More from InvestorPlace Why everyone is investing in 5G Everything wrong The stock picker reveals his next 1,000% winner No matter if you saved $ 500 or $ 5 million. Do it now. 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