Stock market secrets: 4 lessons from the GameStop (GME) saga

The crazy rise and fall of GameStop stock has been 2020’s biggest market story. But what should investors learn from this wild roller-coaster ride?

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So far in 2021, the major UK and US stock-market indexes have had a positive start. Since 2020, the FTSE 100 is up roughly 275 points (4.3%) and the S&P 500 by over 175 points (4.7%). Furthermore, the past month has been one of the most exciting periods in years.

That’s because the market dynamic in the US was suddenly subverted and destabilised by a mass movement. This new crowd is the R/WallStreetBets (WSB) Reddit posse — and their most successful target to date has been US retailer GameStop (NYSE: GME). Here are four lessons I’d offer from GameStop’s spectacular rise and fall. 

1. Shorting can be a graveyard

Excellent analysis by popular players on WSB revealed that more than three-fifths (60%) of GameStop’s stock had been lent out and shorted. Shorters make money by borrowing stock, selling it, and then buying it back later at a lower price to pocket the difference. By combining in a mass-buying frenzy, the WSB crowd drove up GME, forcing it relentlessly upwards. This forced shorters to purchase GME shares at ever-rising prices, triggering more waves of buying. As a result, hedge fund Melvin Capital lost more than half of its funds in January. Ouch.

2. GameStop can stay irrational…

“Markets can stay irrational longer than you can stay solvent”. Although this shrewd quote is often attributed to famous economist John Maynard Keynes, it’s not found in print before the late 1980s. Whatever its origin, it has long been one of my favourite market sayings. For long periods, stock values can become unhinged from reality — indeed, for far longer than any rational person would expect. At its depths in 2020, GameStop stock crashed to a lifetime low of $2.57 and closed last year at $18.84. At the peak of buying mania on 28 January, it had skyrocketed to $483. How’s that for irrational markets?

3. Smart money early, dumb money late

I was temping in the City of London in maybe 1987 when I asked one top trader for his secret to successful trading. I’ll never forget his awesome reply. He said, “Smart money early, dumb money late“. In other words, when it comes to riding trends for maximum profit, it’s best to get in long before the crowd arrives. He added that as trades get more crowded, returns get more widely dispersed and, therefore, the game is all but over. After 29 January, trading in GameStop remained very lively, but this bubble was bursting. GME stock has fallen in seven of the past 11 trading days and has crashed a massive nine-tenths (89.7%) from its $483 climax. Yikes.

4. What goes up (like GameStop), must come down

In nearly 35 years of investing, I’ve tried to avoid any and all shares with a bad smell. This malodour might stem from rumours of accounting issues, fraud, deception, or other suspect behaviour. But one of the worst smells comes from stocks that are obviously being manipulated, as with GameStop. With the price being driven up into the stratosphere, it was unclear when this bubble would pop. But it was only a matter of time before financial gravity would eventually overwhelm GME’s buying momentum.

And the final lesson for UK investors? Thankfully, this kind of market madness is still rare in London, but it could take off. Please don’t blow up your ISA chasing bubble stocks and manipulated shares. The big money comes from long-term investment and reinvesting dividends!

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be considered so you should consider taking independent financial advice.

Cliffdarcy has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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