From 12 Jan 2021 to 28 Jan 2021, GameStop (GME), a brick-and-mortar video game retailer, saw its stock soared from $7/share to as high as $120/share, a ~1600% move in a matter of weeks. During around the same time, another stock - AMC Entertainment (AMC) - a movie theater franchise, saw its stock skyrocketed from $2 to $20, a ~900% move. These stocks were the poster children of a phenomenon called "short-squeeze." They were also referred to as meme stocks because their popularity amongst non-professional market participants on social media and forums such as Reddit. The most recent blowup is Bed Bath & Beyond (BBBY). In a matter of about 10 calendar days from 5 Aug 2022, the stock soared from $6/share to $30/share. 

We want to explain these market phenomenon to you, and most importantly, warn about the potential spreading influence that these phenomenon have over our core investments and the broader stock market.  

What is a short-squeeze?

Were there any fundamental changes in these stocks, such as a sudden improvement of balance sheet, new customer orders, or margin expansion, to make sense of the moonshots? Absolutely not. The common theme amongst these stocks was that they were heavily shorted by many hedge-funds. Short-selling is when an investor borrows a stock at a price, hopes that the stock drops to a lower price and then buy back to cover the borrowed shares. In simpler terms, it's similar to when I borrow a pencil from you and later find the exact same pencil at a lower price to give back to you, while pocketing the price difference. 

These stocks were heavily shorted because they had deteriorating fundamentals. Take GameStop for example. It has tons of debt on its balance sheet, yet the business model becomes more and more obsolete as the boom of e-commerce allows for the fast and convenient experience of buying gaming consoles, video games and gaming accessories. AMC movie theater was also on the brink of bankruptcy, with movie theaters remained shut during the Covid pandemic, and the quick adoption of at-home streaming was rendering its business model obsolete.

The shorts were going well until a group of allegedly in-experienced, non-professional market participants got together on WallStreetBets - a group on Reddit - and decided to take a stance against these hedge-funds. It was a moment of the have-nots against the haves. These self-proclaimed AMC or GME "apes" found that these stocks were so heavily shorted to the point that the number of shares opened as short positions exceeded the number of actual shares available for the company. In other words, you only have one pencil yet I somehow found a way to borrow 5 pencils from you. 

The risk in shorting stocks is that when the stock price goes up (against your favor), at some point you will have to buy to cover the short positions in order to avoid outsized losses. If you own a company for $20/share, the company goes bankrupt, the stock goes to 0, you lose your $20. However, if you short the stock at $20/share, yet the share price climbs to $200/share, you now owe $180. The problem is, since these stocks had more shares opened as short positions than available shares, naturally there would be more buyers than sellers. When there are a lot of buyers, the price goes up. The higher the price goes up, the more short positions have to close (meaning buy), which makes the stock price climb even higher. This phenomenon is called a "short-squeeze." The "apes" were successful enough to rally social media communities to get the price up from the first place, initiating a cascading chain of events which led to higher and higher prices.           

Did any of these short-squeezes ever end well?

Before the memes, there was cannabis stock Tilray Brands (TLRY), which soared from $20/share in Aug 2015 to as high as $300/share in Sep 2015. In 2019, Beyond Meat (BYND), a producer of plant-based vegan meat, IPO'd at $50 and soared to $240/share in a matter of 2 months. The most recent blowup is Bed Bath & Beyond (BBBY). In a matter of about 10 calendar days from 5 Aug 2022, the stock soared from $6/share to $30/share.

In 2015, Tilray crashed back down to $20/share in less than a year. In 2019, BYND came back down to IPO price after 6 months. In 2021, GME came from $120 to $10 in a handful of days. AMC went from $20 to $5 in a blink of an eye. Last Wednesday, BBBY traded as high as $30/share. The stock closed out the week at $11/share. What did all of these events have in similar? They all had similar moments of market euphoria, but most importantly, subsequent despair.

Do these blow-ups affect the market?

We never touch these meme securities, so frankly, the fact that they go up and down doesn't interest us one bit. However, we need to be mindful of potential effects that these events have for the overall stock market. We examined the market in periods following meme stock short-squeezes. We found that these meme blow-ups are usually followed by an intense amount of pain for the overall stock market, especially the tech-heavy Nasdaq Composite.

We think this time, the same trend will play out: euphoria in these handful of junk meme, followed by some pain in the market. We believe we're beginning to see the pain taking place. Bed Bath & Beyond (BBBY) fell from $30 to $11 between Wednesday and Friday. The Nasdaq Composite Index sank 2% on Friday and 2.6% for the week. 

We have a couple of thoughts on why the pain in these meme stocks are spreading over the entire market. One, the hedge-funds that got burned in these short-squeezes (in either directions) now have to come up with cash to cover their positions or pay for their losses by selling other positions in their portfolios. This creates some selling momentum in the market. Two, the rational, fundamental investors see these events as signs of frothiness in the market, and decide to take precautions such as reducing risks or take on short hedges. This also creates selling pressure for the market. Bottom line, the causation can be a combination of factors, listed here or not, but there is convincing correlation that following these meme mania, there will be pain for the Nasdaq Composite.