What should we make of the spikes in the stock prices of companies like GameStop and AMC Entertainment? Has the pandemic suspended the laws of economics as they apply to share prices? Is there something more nefarious going on?
Some brokerage firms have stopped customers from buying certain suddenly volatile stocks. Others have curtailed traders’ use of margin lending to take larger positions than they would otherwise be able to afford. Some politicians have called for banning so-called short selling of stocks on the theory that short sellers in these stocks are being “squeezed” and forced to cover their positions by buying back shares at inflated prices.
Despite the craziness and crazy talk, the laws of economics still hold, said Bruce Weber, dean of the Lerner College of Business & Economics and professor of business administration at the University of Delaware.
“However, the risk is that unsettling price fluctuations lead to restrictions that could impair the market’s ability to incorporate all information into prices,” Weber said.
When such extreme situations arise, Weber said, it’s important to review the fundamental activities in markets and the regulations that have been put in place to prevent abuses.
- Speculation occurs in commodity and financial markets: The price of any stock or commodity such as crude oil, corn or gold, is a consensus on the value and scarcity. If someone has an opinion that a price is too low, they can buy and benefit if they turn out to be more knowledgeable than the other participants. Prices are more efficient and informative if more readily bullish and bearish sentiment can be expressed through buy and sell orders.
- Shorting is very common although not well understood: Farmers effectively short sell when they enter into forward arrangements or futures contracts to deliver crops or livestock in the future for a fixed price today. They have not planted their crops or raised their cattle but they hedge the risk of prices being low at harvest time. That is effectively a short position. You sold something you do not own or have in your possession.
- Borrowing: Short sellers of stock first need to borrow the shares from an investor owning them. The lender earns a fee and can ask for the shares to be returned at any time. The short seller hopes the price falls and that they will buy the shares back at a lower price and return them. It is risky to short sell because, unlike buying stock, the losses on a short position are unlimited.
- Buyer’s risk: A buyer can do no worse than a 100% loss, but a stock sold short at $10 that is bought back at $50 has generated $40 a share in losses for the short seller. A buyer’s risk is capped at $10. Risk keeps most ordinary investors away from short selling. Companies with highly uncertain prospects (e.g., on the verge of bankruptcy, or heavily hyped and dependent on an uncertain outcome such as an FDA drug approval or a patent lawsuit) attract short sellers far more than stable companies. When the “short interest” on a stock is large, it attracts other traders that may be more optimistic who know a large quantity of buying could be triggered by “short covering.” Volatility will probably be heightened until the uncertainty is resolved.
- Impact of online chatter: Many observers are also concerned about online bulletin board and social media threads pulling novice investors into classic “pump and dump” schemes or spreading rumors to drive prices up. Bubbles in price can occur but investors also learn that when euphoric buyers rush the door, not all will exit profitably or comfortably. When it comes to financial assets, there is no systematic way to identify an irrational bubble. Trying to prevent them creates other problems for markets and market participants.
- Legality: What requires close watching, though, is whether any market actors are involved in illegal stock price manipulation, and should be charged by the SEC. There is a legal standard for stock price manipulation, and an investigation should be carried out to determine if any actions violated the standard. Also concerning is how restrictions on short selling do not appear to be enforced, and that companies can have short interest exceeding the number of shares outstanding. By rule, shares need to be borrowed before they can be sold short. If more shares are shorted than are outstanding and the short sellers all seek to cover their positions there are not enough shares to go around.