by Julius Koschnick
“People are madder than ever to run into the stock and don’t so much as pretend to go in to remain in the stock but sell out again to profit.”
It seems like a very apt comment on what happened to GameStop’s stock over recent days. We’ve seen its share price go up by 2701% between the 8th of January and the 28th of January—all of this fueled by an army of hobby traders coordinating on Reddit and trading on smartphone apps like Robinhood. Certainly, the GameStop frenzy was not propelled by an actual belief in the value of what is, after all, a Covid-struck dinosaur from the retail age. Instead, hobby traders successfully managed to pull a “short squeeze,” forcing hedge funds betting against these companies to abandon their positions, then cashing in on it for themselves. It sounds like financial wizardry, only this time done by a group of Muggle traders. It sounds unprecedented. But is it?
To start, the introductory quote does not refer to GameStop, nor to today’s markets, nor even to those of the last century. The comment was made by the banker Richard Cantillon in 1720 at the height of the South Sea bubble, the first “modern” financial bubble. Perhaps less known is that it was also the first financial crisis created by opening the market to a broader base of investors—non-professionals that, in some respects, do not look too different from the Reddit and Robinhood traders of today. We will see that the fate of today’s Reddit traders will be akin to that of the amateur traders of 1720; financial innovation opening the playing field to amateur traders creates bubbles with big initial wins, but also many a lost fortune at the end. But before going deep into history, we first need to understand what a “short squeeze” is and ask with which wizardry amateur traders were able to shackle the Goliath of Wall Street hedge funds.
We’ll start with some textbook basics on financial potions. If you bet on a stock, there are two positions: a “long” position betting that the stock price is going up and a “short” position betting on a falling share price. For a “long” position, a trader simply needs to buy a share and sell it again once the share price has risen. “Shorts” are notoriously more difficult and not even possible in all markets. A simple “short” works like this: a trader lends shares from a brokerage, promising to return the shares at a later date. Then the trader sells the stock at today’s price and buys it back at the time of the promised return. If the price of the stock has fallen in the meantime, the trader cashes in the difference.
And here comes the trick: hedge funds had heavily shorted the Covid-hit GameStop retailer betting on big losses in its share price. Traders on Reddit’s WallStreetBets coordinated to go “long” on GameStop shares (also making smart use of call options), thereby collectively pushing up the price. Next, with each point of the share price rising, the potential losses for short sellers increased. They now faced a dilemma: either they could stick to their short position, believing in an ultimate collapse of the share price but risk even greater losses if share prices continued to rise, or they could quickly rebuy the shares, minimizing their initial losses. As it turned out, hedge funds like Citron Research and Melvin Capital were forced to rebuy the shares they had shorted, thereby pushing the share price even further up. It is at this point that successful “short squeezers” would have sold their shares and cashed in a spectacular prize difference. Yet, in the case of GameStop, the rally continues. Some got rich. Some are playing the game even further.
It was not the first successful short squeeze on Wall Street—yet it was remarkable in the way it was carried out. Pulling a successful short squeeze requires two things. First, it usually takes deep pockets to actually move stock prices. This has been replaced by an astounding feat of coordination among many small traders through Reddit. Second, a short squeeze usually needs a commitment device. After all, traders could just cash in their money after only a small rise of the stock, not believing that they are strong enough to make the hedge fund abandon its short position. And it takes a really sharp rise in prices to force a hedge fund to abandon its short. However, the Reddit traders of today seem to have found a commitment device not available to professional traders; what has been seen on the Internet is a mixture of anger against Wall Street hedge funds and an enthusiasm for pulling the David vs. Goliath feat. Many of the amateur traders are not only in it for greed—they want to see the hedge funds fail. Much of the language online resembles the images and spirit of “Occupy Wallstreet” from 2011. It is actual anger—and enthusiasm. The traders have the feeling of being part of something greater than themselves. It is a feeling of rebellion. And it is this collective spirit that serves as a credible commitment device. Irrational sentiment can be a very successful strategy for group coordination, enabling successes that are not available to rational egoistic individual players.
There have been two recent innovations on financial markets: universally-available trading apps and the ability to coordinate and build unprecedented group sentiment among traders. With this in mind, do we see a revolution on the stock markets? Are the innovations of Reddit, universally-available trading apps, and a new generation’s feeling of rebellion powerful enough to change the picture of the stock markets?
It’s not the first time that we’ve seen a financial innovation of this kind. In 1720, the famous South Sea bubble also witnessed the sudden expansion of a previously highly professionalized market to the wider public and a collective groupthink resulting in a trading frenzy pushing up stocks to levels before unseen. Of course, it was only so long until the bubble burst.
So, what happened in 1720? In 1710, the South Sea Company was founded to conduct trade with Spain’s South American colonies. However, due to war between Britain and Spain in 1718 and 1720, there was never much actual trade happening (except for some slave-trading journeys). Yet, at the same time, the company acquired the privilege to invest in the majority British government debt and then went on to sell its company shares. This was a major financial innovation. Before this, buying government debt had been mainly reserved for large financial actors. But now the company’s shares became very close to small liquid and tradable chunks of government debt. This innovation suddenly opened the market of government debt to everyday investors (who were significantly wealthier than the Reddit traders of today) and gave them access to the option to resell shares to buyers who were optimistic about the future. It sounds familiar to today. Take the new access to government debt through the company’s shares as the Robinhood of the day. For the first time in their lives, small scale wealth holders could properly engage in large-scale financial speculation. They did so enthusiastically. Soon, a bubble emerged.
There is a long academic debate on how the South Sea Bubble started. Let it suffice for now that once shares started to rise significantly, individuals saw their chance of “riding the bubble;” the underlying business of the company became less and less important. Instead, people started to buy shares and sell them later, cashing in the difference. The movement was further fueled by collective sentiment, a sense that it was a patriotic act to buy into the national debt. At the beginning of 1720, the share price of the company was at 130 pounds. By June, it had reached 1,000 pounds. At the height of the crisis, other actors tried to repeat the success of the South Sea Company. New ventures of doubtable value were founded, with the only aim being to give people other objects for speculation. Soon, the ideas bordered on the absurd: one company specialized into the production of squared cannon balls, and another did not even reveal its business purpose. Initially, investors happily made use of these new objects for speculation. But with this renewed supply, the upward pressure on the South Sea stock thinned out, and the bubble eventually burst in the late summer of 1720.
Thus, this first “modern” bubble already displays all the standard characteristics of a bubble that we can also see in the Great Wall Street Crash of 1929, the Dotcom Bubble, and the financial crisis of 2008:
- Bubbles are fueled by new financial innovations broadening the base of potential speculators.
- The average volume of stocks traded increases.
- Bubbles burst once new supply in the objects of speculation arrives.
In the end, the bursting of the South Sea Bubble sparked financial havoc among many of the private players, spread to politics, and ended in a wide public scandal. One of the amateur investors was the famous scientist Isaac Newton, who was master of the Royal Mint at the time. Before 1720, he had invested his money in stable securities, avoiding frequent changes of his portfolio and speculative moves. Yet in 1720, the frenzy of the South Sea Bubble also captivated the mind of the scientific genius. At the peak of the bubble in July 1720, he began to buy huge amounts of South Sea Company shares. Three months later, share prices were down by 66%. Eventually, these speculations in the South Sea Bubble brought him a loss of at least £10,000. This financial misfortune supposedly prompted him to remark that he could “calculate the motions of the heavenly bodies, but not the madness of people.”
This brings us back to the madness of today. How does history inform our understanding of current affairs? For one, it shows us the cyclical patterns of rare events. It also allows us to look at the more systematic drivers of what appears like nothing but madness at the moment.
We see that today’s Reddit and Robinhood revolution has broadened the base of speculants to a new group of amateur hobby traders. With the size of markets today, this only came to matter once Reddit users discovered their chance to pull a short squeeze on a few singular stocks. Concentrated, they could move the market, pull a short squeeze, and thus, for the first time, enter the full game of financial speculation themselves.
Of course, the story does not end with the successful short squeeze on GameStop. GameStop’s share price still continued to soar between the 25th of January and the 1st of February. Furthermore, Reddit users have recently turned to other heavily shorted firms, including cinema chain AMC and apparel retailer Express. On Monday, they also started to attack the price of silver. Nobody can say whether these next attacks will work. But overall, it looks like the movement has now reached the same level as the South Sea Bubble of 1720. Share prices are helplessly overvalued following the recent attacks, and the volume of trading has skyrocketed. Many an amateur trader is in on this with significant parts of their own money. It is a bubble for certain. With the arrival of attacks on other heavily shorted firms, it now looks as if the supply of speculation objects has widened, potentially signalling a crash of the bubble in the near future. By the time of finishing the writing of this article, it looks as if GameStop shares are already tumbling down.
In the end, it all seems to be the new repetition of an old rule: new financial innovations, suddenly broadening access to speculation for new non-professional actors, cause bubbles. Some riding the bubble early win spectacularly. Others lose when the bubble bursts. Signs like a widening of supply of objects for speculation suggest that the bursting of the GameStop bubble is not far off and that the current enthusiasm of Reddit traders will soon give way to a more sober view. Three hundred years later, we have yet to find a magical cure for Newton’s “madness” of financial speculation.
Julius Koschnick is currently completing his PhD in Economic History at the London School of Economics. His research interests include technology, human capital, and long-run growth.