Three Reasons Why The Surge In GameStop’s Stock Doesn’t Break Efficient Markets

p has gathered increasing headlines over recent weeks. The stock as doubled, quadrupled and is now up around 16x since the start of the year. This is believed to be driven by retail interest seeded by the Reddit message boards of r/wallstreetbets. Short squeezes such as what we’re seeing with GameStop are not all that unusual.

At this point the GameStop stock chart looks more like some sort of theoretical mathematical curve than the movement of any stock. However, there are a few reasons why this doesn’t necessarily break efficient markets. Here are three of them.

Completely Efficient Markets Are Not Realistic

Even staunch advocates for efficient markets, generally don’t believe markets are accurate everywhere all the time. There needs to be some so-called friction in markets in order for investors to exploit and make money.

Who would make markets efficient if there were no rewards for doing so? If hedge funds, or indeed the members of r/wallstreetbets can’t find inefficiencies then why should they bother analyzing prices? And if prices aren’t being analyzed, why should markets ever trade efficiently?

So even the proponents of efficient markets can’t eliminate the idea of friction in markets. The fact that such frictions make headlines when they may occur supports efficient markets rather than breaks it. We don’t see this sort thing every day, or even every decade.

Relatively Small

Even at its current lofty valuation GameStop is around 0.1% of the value of the S&P 500 and has been at what might be considered wild prices for perhaps 2 weeks, if that. So a very small stock trading out of line for a week or two doesn’t contradict the idea that markets are generally efficient.

At the moment, GameStop is about the size of Delta Airline
or Bridgestone Tires in its market value. Though that will change tomorrow in one direction or another it’s still a small part of the market. It would need to rise another 100-fold to match the size of Apple

So yes, all eyes are on GameStop and similar ‘short squeeze’ names right now, but this is a fraction of the markets over a compressed time-period. If we’re still in this situation come 2022 then maybe we should reconsider, but temporary blips in small corners of the market, however extreme don’t mean all asset pricing is broken.

Risk/Reward May Be In Balance

Another test is if the markets are not efficient, then where is the free money to be made here? I’m afraid, there doesn’t appear to be free money on GameStop today. Would you short it when others who have done the same are seeing their entire hedge fund shut down and the costs to doing so have risen materially? There are even suggestions that those who have back-stopped the weak hedge fund, may now be in trouble too. If a long-term winning trade ends your hedge fund, and even then disrupts the business that looks to bail you out, perhaps it’s not a winning trade.

Equally, going long at these levels clearly carries risk too. If the trajectory from here is uncertain and there’s no free money on the table for either longs or shorts, then where’s the inefficiency?

In some sense the eye-popping returns we are seeing are necessary for long positions to take on the extreme risk. I think most would argue they won’t last, which is why returns have to be high as this continues, and, indeed they are.

We may look back on this episode and say the decline in the stock from here was obvious. However, precise timing is critical, you may be challenged to put that trade on today. It matters a great deal to your profits whether you chose to go short today or even a day earlier. If there’s not an obvious path to financial gain here, where’s the inefficiency? If you think the short is obvious, then tell that to Melvin Capital.

Ultimately Prices Are Where Buyers And Sellers Meet

Finally, prices are where buyers and sellers meet. No one argues that efficient markets are broken when a company that’s due to be taken private at a fixed cash price doesn’t see it’s stock rally because it reports a strong quarter before the deal closes.

In this case, the mechanism is similar. There is the issue is forced buyers of the stock, rather than more traditional forced sellers. The short interest in GameStop on recent data was incredibly high at over 100%, and many of those shorts are being forced out of the trade for reasons from risk management to margin calls. If you need to buy a massive amount of stock over a very short period, then seeing the stock rise in price is economics at its most simple level.

Today the market is punishing those who, in aggregate, decided to short over 100% of the shares of GameStop. That was likely a very inefficient move. They likely won’t rush to do that again, for a while at least. Of course, the other side of the trade came from an unexpected place, but that’s exactly how markets ideally operate in a self-correcting fashion over time.

Maybe the market is a far more efficient mechanism than we realize.

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