Something strange has been happening in the US stock market in recent weeks. The share prices of struggling companies have rocketed. The explanation for this phenomenon is a ‘short squeeze’, which is something of an historical relic.
Over the past few weeks, shares in struggling US companies whose business has been hurt by the pandemic have soared in value, alongside unprecedented price volatility and trading volumes. Chief among these companies is GameStop, an American high street shop that sells consoles and games. The price of shares in GameStop increased from about $20 on 12 January to $347 by 27 January.
Other struggling companies have experienced similar increases in value. For example, the cinema group AMC Entertainment saw its share price rise from $2 per share to nearly $20 in the space of a few days, while BlackBerry and Nokia have seen their share prices suddenly double.
This has happened because small investors have been attempting to identify companies in which big institutional investors like hedge funds have large ‘short positions’. A short position is essentially a bet that a company’s share price will fall.
The small investors then act on this information by buying up shares in these companies, driving up the price in order to force the hedge funds to overpay and lose money on their bets. According to data analytics firm S3, this has cost short-sellers more than $5 billion in the past week. This strategy is known as a ‘short squeeze’, and it has a long history in financial markets.
Figure 1: GameStop share price over the past year
Source: Yahoo Finance
What is a short squeeze?
The typical stock market investor earns a return from dividends, and if they eventually sell their shares for more than they bought them, they make a capital gain. Investors can also earn a high return from falling share prices by selling shares in the hope of buying them back later for a lower price. If the investor does not own the share, they can go ‘short’: borrowing shares, selling them, buying them back later for a lower price, then returning them to the lender. The short-seller is hoping that the share price will fall in the intervening period so that they can make a profit from the trade.
In practice, however, short-selling is often much more difficult and risky than simply buying a share. When an investor buys a share, the potential losses are limited, but the potential gains are unlimited; when an investor short-sells a share, the opposite is true. Short-selling even the most clearly overvalued share could completely ruin an investor if its price continues to rise.
A short squeeze occurs when shareholders, often large shareholders and the company’s directors, collude to buy up shares and ‘corner’ the market. This makes it very costly for a short-seller to buy back the shares that they need in order to return them to the shareholder from whom they have borrowed them. If the colluding parties successfully take control of the entire supply of outstanding shares, this is described as a corner. Corners can have devastating consequences for short-sellers.
Have short squeezes happened in the past?
Short squeezes and corners are nothing new. They seem to have been prevalent in financial markets in the 19th and early 20th century (Allen et al, 2006).
One of the most famous examples in the United States was the corner in shares of Piggly Wiggly, the first self-service grocery store, in 1923. Clarence Saunders, the founder of the company engineered a buying campaign of his company’s shares to counteract the short-sellers who were driving down the share price. Saunders managed to gain control over a large proportion of the shares, the price of which had increased substantially. But the New York Stock Exchange suspended trading in Piggly Wiggly shares, causing their price to fall and bankrupt Saunders, who had borrowed heavily to finance his plan.
One of the best-known examples of a short squeeze in the UK was the cornering of three bicycle company shares during the ‘bicycle mania’ of the mid-1890s. During this financial market ‘bubble’, directors, promoters and market manipulators found that they could exploit short-sellers by buying up a controlling stake in a company that was sold short. Since short-sellers had entered into a contract to sell the shares, the engineers of the corner could then name their price. The losses they imposed on short-sellers were substantial.
During the Bagot Tyre corner, for example, one investor was forced to pay 21 times the face value of Bagot shares and subsequently faced a loss of £2,318 (about £270,000 in today’s money). The short-selling strategy he was attempting to execute would have returned only £26. Having initially refused to reimburse his brokers, he was taken to court, where the consensus of the judge and jury was that short-sellers who lost money in a corner were getting what they deserved – a view shared by many of those following the current round of short squeezes (Quinn, 2019).
Historical corners have caused dramatic and large price jumps and volatility around the date of the corner, which suggests problematic disruptions to orderly markets (Allen et al, 2006). Although corners may be limited to the shares of one company, they can introduce mispricing in other shares by alerting would-be short-sellers to cornering risk. This was the case during the bicycle mania, where shares with greater cornering risk experienced greater mispricing (Quinn, 2019).
There have been some attempts at engineering corners in the more recent past. These include a failed attempt to corner the silver market in 1980 by the Hunt brothers (Williams, 1995), a corner by Salomon Brothers in a 1991 Treasury note auction (Jegadeesh, 1993; Jordan and Jordan, 1996) and a squeeze in the London bond futures market in 1998 (Merrick et al, 2005).
Corners in stock markets were much less common after the 1920s due to regulatory developments that punished attempts at cornering, increased transparency and made disclosure of beneficial ownership by large shareholders a requirement (Allen et al, 2006).
What is different about the current short squeeze?
Historical US corners typically involved directors of the companies involved, large shareholders, robber barons and plutocrats (Allen et al, 2006). With the short squeezes in the shares of GameStop, AMC Entertainment, Nokia and BlackBerry, this is not the case.
Instead, more than four million amateur day-traders, using commission-free trading platforms such as Robinhood, have coordinated a short squeeze through Reddit’s wallstreetbets discussion forum. These companies were chosen because they had all been heavily sold short by major hedge funds.
Another difference is that this episode is also a ‘gamma squeeze’. This occurs when a rising share price legally forces a market-maker to buy more of that share in order to hedge their position with respect to options traders. This buying pressure further accelerates the price increase while the squeeze is taking place. But market-makers are also legally required to sell those shares when the price is falling. As a result, this short squeeze has been much more volatile than those of the past.
Should policy-makers be concerned?
Regulators will be concerned about the effect of these episodes on the integrity of stock markets. Short-selling is widely considered to help with ‘price discovery’, ensuring a more efficient allocation of capital. Limits on arbitrage and constraints on short-sellers, including cornering risk, can make this process less effective.
Short-selling may also prevent mispricing from turning into a fully-fledged bubble; some parts of the stock market, particularly shares in companies producing electric vehicles, appear to be in a bubble right now. The growth in the number of day-traders during the past year suggests that one of the main conditions for a bubble to form – a large number of novice speculators – is in place. The economic effects of financial bubbles vary, but they can lead to substantial economic downturns (Quinn and Turner, 2020).
On the other hand, short-selling is not always as benign in practice as financial theory suggests. Short-selling can also be used to liquidate margin traders or bankrupt firms that have used their shares as collateral.
An extreme example of the dark side of short-selling occurred in 2017, when the Borussia Dortmund football team was bombed by a terrorist hoping to profit from a fall in Dortmund’s share price following the attack. While such severe cases are rare, the creation of a significant body of capital with a vested interest in economic failure may have underappreciated ‘second order’ effects.
Furthermore, economically efficient does not mean socially optimal. The most overpriced shares during a bubble are often highly innovative growth companies with world-changing potential.
The effect of apparent mispricing in the current stock market is that firms manufacturing electric vehicles find it much easier to raise capital than, for example, firms manufacturing fizzy drinks. The recent move towards ethical investment suggests that investors are increasingly concerned about the environmental and social effects of the projects they are funding, and these considerations would be undermined by a maximally efficient market. Short-selling has both positive and negative effects, and its real overall impact is therefore somewhat ambiguous.
In the short term, intervening may do more harm than good to the integrity of the stock market. The policy response to the global financial crisis of 2007-09 has created a perception, which is not entirely unfair, that governments will step in to prevent powerful financial institutions from losing out, while turning a blind eye to the suffering of ordinary people.
Government action that is seen to benefit large hedge funds at the expense of retail investors would further reinforce the narrative that the current economic system is rigged in favour of the wealthy. This can already be seen in the outrage on social media at the decision by Robinhood to ban purchases of GameStop shares on their app, while still allowing sales.
In the longer term, governments may need to consider the issues that this episode has highlighted. The purported economic role of the stock market is to allocate capital efficiently to businesses, and its use as a casino has the potential to cause serious economic harm. Regulators and central banks ought to examine the distortive effects of quantitative easing, the business models of zero-commission apps and the apparent ubiquity of market manipulation. Short squeezes and corners by activist investors were not an adequate substitute for effective regulation in the 19th century – and nor are they today.
Where can I find out more?
- Understanding the pandemic stock market: Economics Nobel laureate Robert Shiller looks at the role of crowd psychology, the virality of ideas and dynamics of narratives in the explaining the bounce of the stock market.
- A podcast on the bicycle mania: William Quinn discusses the UK bicycle mania of the 1890s and corners in cycle shares.
- The Piggly crisis: Bryan Taylor examines the shorting of Piggly Wiggly shares in 1923.
- Northern Pacific – The most famous stock corner in history: Bryan Taylor looks at the corner in Northern Pacific Railroad shares in 1901.
- Are Bitcoin and other digital currencies the future of money? William Quinn explores the economics behind Bitcoin and other cryptocurrencies.
- Why has the stock market bounced back when the economy seems so bad? William Quinn and John Turner explore the possibility that there is a bubble in the stock market.