The surge in Gamestop's (GME) share price in early 2021 was a remarkable event, driven by multiple factors in what many refer to as a simultaneous short and gamma squeeze. Could this perfect storm culminate once more?
A Short Squeeze
A short squeeze is simple. It's when investors or institutions who placed bets that a certain security's price would decline are forced to cover to minimize their losses when the price of that security begins to rise past the price that they initially borrowed it for. For example, I borrow "X" amount of stock for $10 a share then sell it to the market hoping to buy that same stock back sometime later for cheaper, say $5, and profit from the difference. Instead, the security's price rises to $15, above my cost basis of $10, and I'm forced to buy back the borrowed position due to fear of additional losses or margin requirements which then adds to any existing demand pressures.
Gamma Squeeze
A gamma squeeze is a little more complicated as it involves the derivatives market. It typically occurs when a large number of call options have been written or sold by market makers and traders. If the underlying security's price starts to rise significantly, the gamma of these options increases. As gamma increases, market makers and option writers may need to buy the underlying security in larger quantities to hedge their positions effectively. As market makers and option writers buy the underlying security to hedge their short call option positions, this increased buying activity can drive up the price of the security itself. In turn, this leads to more option contracts being "in the money," increasing gamma further and causing additional hedge-related buying.
Tulip Mania
When I think of the meme stock frenzy, I can't help but think of the tulip craze in the 17th century where tulips (yes - the flowers) were growing so popular as a median of exchange that people began to trade tulip futures, and what followed was the astonishing value of tulips trading for the cost of some small houses at the time. Although not a direct comparison, the tulip craze bares an eerie resemblance to that of meme stocks. The only difference is that the price of meme stocks never reached as comparably high as Tulips did due to the direct interjection of market makers and broker-dealers. There are of course striking differences between the two such as the fact that meme stocks actually have a distinguishable value by being tied to their respective companies and, at the time, there was also heavy investor optimism surrounding Ryan Cohen (the co-founder and CEO of Chewy Inc.) joining Gamestop to help establish a turnaround.
Supply and Demand
With that being said, the demand for meme stocks has seemingly held strong since early 2021 whereas what caused the Tulip prices to crash and the mania to end was a sharp decrease in demand once people realized that their investment was not based on any fundamental or realistic value. If anything, retail demand has seemingly increased for meme stocks after their price's began to fall, causing a divergence in well-established supply and demand dynamics. Even after giving back most (if not all) of their gains, there is still a seemingly large number of loyal retail investors who refuse to sell. This, coupled with some recent and apparently bullish news, such as Ryan Cohen being named CEO of Gamestop and the release of the Gamestop movie "Dumb Money", could possibly once again spark a meme stock rally late into the year. Even some mainstream media sites are turning bullish on Gamestop all of the sudden.
Timing
The timing of everything is undeniably interesting. Since the beginning of September, the markets have seen some corrections due to the overall bearish sentiment towards equities as a whole, in part because of skyrocketing yields. If we begin to see a market-wide sell-off and meme stocks do not lose their demand, another rally may be in the cards. Since the last Gamestop stock squeeze, short interest has again creeped up to where it currently sits at 18 days to cover for short sellers. Typically, days to cover falls between 3 to 7 for most stocks. Given the current climate, the heightened short percentage, steady demand, and loss of liquidity from a falling market, meme stocks could potentially rally higher in the short-term until they've reached an organic peak where supply and demand dynamics exist cohesively once again. Conversely, if demand suddenly drops due to other factors, Gamestop and other meme stocks as a whole could be dead in the water.
Valuations
This post is pure opinion and speculation. In no way am I endorsing or recommending purchasing any meme stocks as I do believe they are not tied to the underlying, fundamental value of their respective companies. Gamestop, for example, currently trades at a price-to-earnings ratio (P/E) of -51.0 (at loss). Although, on the plus side, Gamestop's P/E is higher than in 2021 when it stood at -73.5. For comparison, the P/E ratio on average for companies on the S&P500 is ~20. Sometimes however, fundamental values and typical price valuations do not coincide with the actual price of a security; just take a look at Tesla.
Disclaimer
The information provided is for educational and informational purposes only. It should not be considered as financial, investment, or legal advice. The content shared is based on personal opinions, research, and general knowledge. Financial decisions should always be made after consulting with a qualified financial advisor or professional who can take into account your specific financial situation, goals, and risk tolerance. No one should make investment decisions solely based on any information we supply. Investing in financial markets carries inherent risks, and past performance is not indicative of future results. Always conduct your own research and due diligence before making any investment decisions.
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