GameStop went loco


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February 2, 2021

The stock market was front and center in the news and on our social media feeds over the last week. Maybe you were confused by what was going on with GameStop, like some people who called me to ask for an explanation. I’ll break it down in simple terms.

 

Let’s lay some groundwork in order to explain what’s going on with GameStop. At the end of this, I believe you’ll have a pretty good understanding.

 

If you’d prefer to listen to an audio version of this newsletter where I talk through this scroll all the way to the bottom of this page to the audio player.

 

There’s a type of investment pool called a hedge fund. A money manager attempts to earn returns that are greater than the overall stock market or returns that not correlated to the overall market.

 

Usually, when we think in terms of investing, we think if the stock market went up, we may have done well if we were invested in the market. That’s not always the case with hedge funds. Their returns don’t always correlate with what’s going on in the stock market or economy.
High net worth individuals whose life would not be too impacted if they saw a big downward swing with the money invested may place a portion of their assets in a hedge fund. The investors are looking for greater returns than the market generally produces, or they may be looking for an alternative investment to what is traditionally offered.

 

How do hedge funds make money? One way is through the use of options. There are several types of options. Here’s a simple example of what an option is.

 

Let’s use Apple, the computer and smart phone maker. Apple’s stock is trading around $130 a share right now.

 

Let’s say you studied the company. You read news reports and maybe even looked at the fundamentals of the company. Maybe Apple was coming out with an innovative new phone and you became convinced that when that phone began selling in stores it was going to be a big seller.

 

Because of your research, you believed the sales of the new phone would cause Apple’s share prices to go from $130 today to $170 in six months from now. You may buy an option to profit off of this move. You would pay a premium (dollar amount) to buy an options contract. Let’s say the premium is $5,000 in this hypothetical example.

 

You may buy an option to buy 1,000 shares of Apple in six months for $130. If you were right and Apple was selling for $170, you would exercise the right to buy 1,000 shares of Apple for $130. Then you’d immediately sell the stock for $170 a share. You made $40,000 minus your options price, which was $5,000. So, you walk away with $35,000.

 

But what if Apple’s new phone was a bust? Let’s say it did not meet consumer expectations, and it did not sell well. The stock price may drop to $120 in six months. If that were to happen, you would not exercise your option and you’d lose your $5,000 premium.

 

This is only one type of option. There are others and they are sophisticated and complicated. For most people, options are not suitable as they are normally highly risky.

 

Options also can move the value of a stock a certain way if enough investors understand what the options that were bought are designed to do.

 

A hedge fund noticed that GameStop has been in decline for years and saw an opportunity to buy an option. The hedge fund was betting that GameStop would continue to struggle and they bought options accordingly.

 

Well, a website where people gather in an online community to discuss various topics has a forum where individuals share stock picking tips. They noticed what the hedge fund was doing and did not like it.

 

The forum participants decided to buy GameStop stock. This was incredibly risky for these individual buyers. Buying individual stocks can be risky under normal circumstances, but what happened with GameStop came with even greater risk.

 

The GameStop buyers wanted to drive the price up and cause the hedge fund to lose out. Somewhat miraculously these individual stock buyers were successful.

 

Here’s a glimpse of GameStop’s recent trading volatility.

  • On January 12th  $19.84
  • On January 22nd $65.01
  • On January 27th $347.51
  • On January 28th $193.60
  • On January 28th $325.00
  • On February 1st $225.00
  • On February 2nd $98.80

A hedge fund lost so much money they asked another hedge fund for emergency funding. Then many people were angered when several trading platforms began limiting trading of GameStop stock or not allowing it all. Congress began issuing statements on the issue. The political elite called for more regulations and even more taxes to remedy the situation.

Warren Buffett once said, “For investors as a whole, returns decrease as motion increases.” And that’s what we saw. The market experienced some minor gyrations that made some market participants nervous.

Mark Cuban

Another billionaire, Mark Cuban who owns an NBA basketball team was interviewed on CNBC last week and stated he is concerned with the potential for deflation in appreciated stocks.

 

In other words, Cuban thinks some stocks are overvalued and may return to a more accurate price. He adjusted his portfolio accordingly. Cuban said, “…there will be a deflation of some sort in those appreciable assets and it’s going to be scary when that happens.”

 

What could drive a market correction? The stock market likes when our legislative bodies are split. When one party controls everything that means laws are likely to be changed and the economy may not know how to price those changes beforehand.

 

Joe Biden has stated he’d like to raise the top tax bracket back up from 37% to 39.6%. He’s floated the idea of changing how capital gains are taxed, and he’s talked about changing how Social Security is taxed for higher income earners.

 

We’ve been warning that we are entering a rising tax rate environment for the simple reason that our government is spending more than it’s taking in. We’ve ran deficits for over twenty years and at some point, it won’t work anymore.

 

It may be appropriate for you to look for ways to lower your taxes in retirement. Many retirees have used tax-deferred accounts to save for retirement. There are strategies that you may be able to be implement to lessen the impact of taxation on your tax-deferred accounts.

 

If you have questions or would like to explore if tax reduction strategies are viable for your retirement accounts, please Click Here to schedule a quick call with me. Or if you have questions about anything I’ve covered here feel free to reach by calling 864.641.7955.

 

Until next week,

David C. Treece,

Financial Advisor

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