The network effect on stocks, cryptocurrencies and commodities
The discussion App Reddit has been making waves in the investment community for some time. It’s true power however has only just been revealed to the outside world in the last few weeks since a bricks and mortar games retailer called GameStop saw its stock rise from around $4 to a peak of $483 giving it a market cap of $22B. That is a pretty racy valuation for a company that will lose over $300m in 2020. But these are not sane times.
This article examines the phenomenon of the crowd and how it is affecting asset prices. It isn’t just stocks that have been impacted by the ‘Reddit factor’, cryptocurrencies and commodities are also receiving plenty of attention.
Reddit — A Background
Reddit is the killer platform for the small investor. It hosts various communities where users post news and opinions. Some of these forums are focused on investment opportunities, where users participate by discussing and sharing investment ideas. The biggest stock discussion community on Reddit is Wallstreetbets which has over 8.3m ‘Degenerates’ as they are fondly called. The number of Degenerates has increased by an amazing 6 million in the last week alone a direct result of the massive publicity it has received on the back of its ‘moonshots’. A moonshot is the colloquial term stockbrokers once used to describe a stock that is headed to the moon, or in traditional terms is expected to substantially increase in value. As many a stockbroker would tell his client in the old days, ‘Strap on your space suit this baby is headed for the moon!’.
The majority of the people participating in these communities simply share ideas and comment on other members’ opinions. Participants generally do not suffer fools gladly, and are never afraid of shouting out a bad idea, ‘Dude, that is a shit stock!’ Most explain in their posts that they are holders of XYZ stock and that they believe it is destined for great things for one reason or another. However the rocket emojis pointing to the moon at the end of most posts are a dead give away as to a members true intentions.
These Reddit communities allows investors to bring their favored stock to the attention of a very large audience. Because the majority of small or micro cap stocks are generally illiquid, meaning the stock is in the hands of the owners and a few key investors, it only needs a few buyers to push up the stock price significantly. A well written post by someone who has credibility in his or her community is likely to gain momentum and lead to rapid and massive price spikes, which is exactly what has been happening on the various Reddit forums. Of course Reddit isn’t the only platform where this is happening, the same is occurring on Telegram and Twitter.
A little about how these communities operate. Each Reddit forum has a moderator, these are sometimes the people who set up the community. Believe it or not most communities do have some basic rules which ‘members’ are expected to follow. Wallstreetbets rules include:
- No Market Manipulation
- No Pump & Dump, Crypto Discussions, Schemes or Scams
- No Political Bullshit
- No Advertisement, Self-Promotion, or Begging
- No Bullshitting
- Bad Positions Screenshot
- No SPACs
An Explanation of the Recent Shenanigans
They say it is a David vs Goliath story. David is represented by the day traders and small investors who populate the Wallstreetbets community and Goliath are the fund managers or the Wall Street establishment who have been guilty of betting against certain stocks i.e. shorting them.
GameStop was the first notable stock on the Wallstreetbets radar after a few canny participants noticed it was heavily shorted. On January 11th GameStop announced that three new directors were joining the board. That was the catalyst for things to come. The announcement led to an increase of 13% in its share price. A few days later the price rose by 57% and then 27%. The community quickly got behind AMC, Blackberry, Macy’s and many others that had also been heavily shorted by hedge funds. GameStop was up 1,587% from the beginning of January.
The huge demand created by the Wallstreetbets community led to a massive increase in trading volumes particularly at the online startup stockbroker Robinhood.
Robinhood has grown exponentially on the back of the huge interest in day trading particularly since the corona virus when people were sitting at home looking for ways to occupy their time. However like most startups they were unable to cope with the unexpected demand deluge and as a result restricted the purchase of these ‘moonshot’ stocks. Their initial list of restricted stocks totaled 50, a number that is down to only two at the time of writing (AMC Entertainment $AMC and GameStop $GME ). During these restrictions investors were not permitted to add to their positions if they held above a certain number of shares (GameStop’s restriction is currently based on a holding of no more than 100 shares or 100 option contracts). There were no restrictions on sales.
These restrictions understandably sent the community into a mad frenzy. Robinhood blamed the imposition of these restrictions on an unexpected $3B demand from their clearing house. There were over 100,000 complaints. But Robinhood has ridden the storm and has even managed to gain customers in the turmoil whilst heroically raising an additional $2.7B in new capital. However Robinhood’s tricky Bulgarian co-founder will have to answer some uncomfortable questions when he appears in front of the House Financial Services Committee to explain his company’s recent actions. To be fair Robinhood wasn’t the only one to restrict trading in these ‘moonshot’ stocks IG Group and TD Ameritrade were two other culprits.
The Winners and Losers
At the end of last week one or two people were feeling sorry for the hedge funds (only one or two though!). One firm, Citron Research, felt so victimized they decided to move into a new line of work, finding opportunities for the same Reddit crowd who were responsible for their losses. Hedge funds lost over $19B at one point betting against GameStop.
But the tables were turned on Tuesday 2 February. GameStop shares tanked, falling by 60% wiping $9B from its market cap. In fact ‘moonshot’ stocks lost $167B on Tuesday as the Reddit crowd continued to preach defiance.
Although the rallying cries from the stalwarts on Wallstreetbets continued, people were selling. The ones that heeded the calls lost out. Some called it a ‘social experiment’ and were sanguine about their losses. Most appeared unconcerned that the market had taken an axe to their stocks. They were in fact more angry at Robinhood for restricting them from buying more stock.
The reality is although many small investors got burned in this massive pump and dump they remain undeterred and will go again. It is certain that the only winners were the shrewd investors who invested early and got out leaving something on the table for the next person. Maybe they didn’t see the full 1,500% return but as the old saying goes, what goes up must come down. And these moonstocks may be a fun ride but they have no fundamentals supporting their valuations and are destined to return to their previous levels before the pump.
What does Pump and Dump mean Exactly?
A scheme that attempts to boost the price of a stock through recommendations based on false, misleading, or greatly exaggerated statements. The perpetrators already have an established position in the company’s stock and sell their positions after the hype has led to a higher share price. (Source: Investopedia)
Are Pump and Dump Schemes Legal?
Pump and dump is an illegal scheme to boost a stock’s price based on false, misleading or greatly exaggerated statements. Pump and dump schemes usually target micro and small cap stocks. People found guilty of running pump and dump schemes are subject to heavy fines. (Source: Investopedia)
But what is happening on Reddit isn’t as cut and dry as these two definitions make out. There are no doubt a few bad actors orchestrating their own pump and dump schemes but in the main many of the participants are simply following the crowd and the rallying calls from the many ring leaders. Here are a few of the rallying cries from the ring leaders on Wallstreetbets, the first one would make Braveheart buy stock.
Don’t be this guy — a glimpse into the future
Close your eyes. It’s Friday, the sun is peeking through the curtains and you’re eating your Weetabix with no worries on your mind. You’re content.
You sold your GME shares at small loss at the start of the week as you continued to watch the share price plummet due to market manipulation. You got out, you survived.
It’s 9:28am, you’re returning from the school run. Your BMW 1 series seats make you feel safe and important. Your house, although small, is affordable and the mortgage repayments don’t put too much pressure on your paper wallet.
Your phone goes off as you enter the house. You sit on the sofa and turn on NBC as you open Whatsapp. You have 17 unread messages.
Your eyes pan up, the news anchor is shouting. You read the title at the bottom of the screen — ‘The Short Squeeze Is Happening”. Jim Cramer is crying. You quickly open your Whatsapp group chat and only see dollar signs being spammed by your friends. You open Yahoo Finance and see the share price at 600.87, it’s still rising. Your heart skips a beat. You open I-phone calculator and work out that your 17 shares would now be worth just over 10,000 US dollars. You feel sick.
The share price is still rising. You receive a call from your best friend Mickey, he’s crying too. He’s telling you about how you were right and he’ll be able to pay off his student loan soon. Also his wife is pregnant. You congratulate him with a fickle grin and fake laugh. You look back down at your phone, 828.16. 830.00, 838.26.
WallStreetBets has crashed due to the traffic.
You realise everything you stood for is coming true, but you paper handed too soon.
You ignored the threads, the experts. You ignored DeepFuckingValue.
You ignored your god given right to a better life for you and your wifes boyfriend.
You try to buy back in, but you have no money. You begin to laugh, and laugh. Despair and anguish turn into humour.
You pull the Glock from your $16 AliExpress safe and load it. You hold it to your head, you shiver.
You don’t pull the trigger. Your paper hands can’t do it, and never will be able to do anything of any meaningful value. You drop the gun and admit defeat.
As the camera pans out of your window and over your neighborhood, we see Wall St burning in flames in the distance. The transfer of wealth begins, fade to black.
DON’T BE THAT GUY
Massive ladder attack going on! Do not sell! I repeat do NOT sell!! They’re not allowing us to buy, so that they can continue pressuring the price down! This is their last attempt to get out of this! Hole the line!!🚀🚀🚀🚀
And then there’s this guy…
I bought $80,000 worth of $GME Stock at its peak. Down 80% and allI can do is think of that Wolf of Wall Street scene where Matthew McConaughey says he jerks off twice a day to destress.
It isn’t just stocks that have been receiving the pump treatment. Other communities on Reddit such as CryptoMoonshot and Satoshistreetbets and Telegram have been pumping cryptocurrencies for a while now. In 2018 for example an extensive survey revealed more than 3,700 different pump messages and signals on two popular cryptocurrency messaging boards over a period of just six months. That figure is no doubt substantially higher today. A small or micro cap cryptocurrency that catches the attention of the community can double in price in a few hours. Dogecoin and XRP, two coins with arguably limited prospects were both pumped in the last week. Dogecoin, with a bit of help from Elon Musk, increased in value by over 800% and XRP increased by 45% after a coordinated effort of a group of 250,000 crypto enthusiasts on Telegram.
Read this article ‘Looking for Value outside the Usual Suspects’ about investing in small cap cryptocurrencies for more information.
And Now Commodities
Of course this frenzied buying isn’t limited to stocks and cryptocurrencies either. The Reddit party has even turned their attention to silver. After a coordinated effort, again by investors on Wallstreetbets, the price of an ounce of silver reached $30, the highest for a decade.
Are Fundamentals Irrelevant Now?
There is a fine line between pumping a stock that is considered undervalued where the stock price does not represent its true worth and one where it is fairly valued. In the first example investors believe, based on the net asset value of the business or its earnings potential, that a stock deserves a higher rating and thus a higher price. Stockbrokers have been publishing research papers for years analyzing a company’s prospects and rating a stock as a buy, a hold or a sell. This is called fundamental analysis. A buy recommendation from a leading analyst working at a prestigious bank will probably lead to an increase in the target company’s share price. That was the traditional way.
The same thing is now happening in communities such as Wallstreetbets but in a less formal way. The difference is the supporters in these communities are loyal, they buy and rarely sell. They hold on for dear life even if it looks like the company’s prospects are falling through the floor and their decision making is based on emotions not fundamentals. Look at XRP for instance, a cryptocurrency which has a huge following of loyal investors who have totally disregarded the fact that the coin could be worthless after its parent company was hit with a billion dollar complaint from the SEC.
In many of the pumps going on in the stock and crypto world the price is being driven by buying pressure rather than fundamentals. The problem with these types of price increases is that they are not sustainable. Whilst there is much loyalty among small investors it only takes a few speculators to sell and the market adjusts the price quickly downwards instinctively knowing that the price always returns to the mean.
Despite the market correction early in the week where the moonshot stocks fell in most cases by over 40% and silver by 10% (XRP fell by 50%) the communities are still alive and well and optimistic about the future. Even the billionaire Mark Cuban has pitched into the debate. He believes Reddit traders won’t go away just because they lost money. And he is right. This is just the start now they realize the power they have at a touch of keystroke.
Legal and Regulatory Ramifications
Is this all legal? We looked at this earlier where we discussed the definition of a pump and dump scheme. In reality many of these stocks, cryptocurrencies and other assets are being blatantly ‘pumped’ by a few individuals. Some of the coordinators post comments like, ‘Let’s pump this baby to the moon!’ But we can’t see anything wrong with this. As long as they are not disseminating misleading information to entice others to invest then there is no problem.
However it is worth making a point here. All good things come to an end because of the actions of a few. It is the community and the moderators responsibility to keep the blatant chancers in check, those who are coordinating regular pump and dump schemes by circulating misleading information using multiple accounts (some are even using bots, repeating the same message over and over again). If these people are not weeded out this will inevitably lead to a clamp down by either Reddit or big brother himself, the SEC.
A Few Useful Tips for the Small Investor
As a private investor these forums/communities are an extremely valuable source of information bringing to their attention assets which would otherwise be off their radar. We have to recognize however that we are in the wild west now. That is a double edged sword. Investors are able to make multiples of their investment but can equally see their investment disappear faster than ever before. Despite all the rhetoric about remaining loyal to the cause and holding the line for an investor to benefit from this new craze he or she must introduce a few important disciplines into their trading to help navigate the new wild west and come out on top.
- Always do your own research
- Don’t follow the crowd, set your profit or loss target and stick to it
- Find an alternative to Robinhood — Once bitten twice shy
- Work with the community to route out bad actors so they don’t ruin it for the rest of us
- And courtesy of Jim Cramer from Mad Money, ‘Don’t try to wipe out others’
And finally, always remember the words of uber successful investor John Templeton, “The four most expensive words in the English language are ‘this time it’s different.”
Read this article ‘A Beginners Guide to Trading Stock — A Random Walk Down Main Street’ for more information.
No Financial Advice
This article does not constitute financial advice in any way. The article should be treated as supplementary information to add to your existing knowledge.