Governments and central banks around the world have pumped $12 trillion into their economies in the wake of the pandemic. Money is fungible. It does not necessarily stay where it has been put. A whole lot of individuals with spare time on their hands and little excitement in their locked-down lives have taken to retail investment on the capital market. Brokerages like Robinhood in the US, which offers zero commission on trades and makes its money from selling data on what kind of trades take place on its platform, have driven new, young investors to trade online.
Bounteous liquidity washing through the financial system has made all stock prices rise. Interest on 10-year government bonds in the US is about 1 per cent. Applying such a low discount rate to the stream of future earnings of a company to determine its current value leads to the impression that high price-to-earning ratios are perfectly rational. Rookie investors have made good returns and consider themselves financial geniuses, who no longer feel the need for institutional vehicles for deploying their savings in the capital market.
Such investors noticed that a physical retailer of games and compact discs, GameStop was being shorted by large funds. What is shorting? If you expect a share’s price to fall, you enter into a contract to sell the stock at a price close to its current, higher value, and, when the price does fall, buy it cheap and sell it to whoever was silly enough to buy your contract. Suppose the stock is trading at 10, and you expect it to fall to 6. Enter into a contract to sell it at 10 a month from now, if you can find an idiot willing to take that offer, buy it at 5 or 6 or 7 one month later, and sell it to the poor sap who undertook to buy it at 10.
There is a risk, however. Suppose the stock price does not fall. Suppose a whole lot of investors decide to buy the stock and take its price high. Then the short trader becomes desperate to buy the stock and have it ready to sell at the contracted time. His purchases add to the price rise. This is called the short squeeze.
This is what happened to GameStop. A bunch of small traders rallied, around a Reddit forum WallStreetBets (search r/WallStreetBets), and decided to teach the short traders a lesson. Their movement caught on and this penny stock that analysts had determined had no future became a stock market star. Short traders lost billions and are licking their wounds.
Investors started similar purchases into other penny stocks such as AMC, a cinema chain, Nokia and Blackberry. Robinhood put restrictions on these trades resulting in widespread backlash. The markets regulator SEC is concerned, the new Treasury Secretary Janet Yellen is watching the development. And the retail investors who made all this happen are thrilled. Their public chafing has made Robinhood relent, and the social-media-powered manipulation of stock prices is now a thing.
So, what is it in for us in India? We have to be wary, on several counts. One is the general proposition that stock prices can be totally delinked from the company’s performance in the real economy. With stock prices bobbing up and down on a frothy layer of sentiment atop an ocean of liquidity, lots of stock prices have already turned unreal. But the added social media buoyancy makes the whole thing even more volatile. Prices could crash and the trigger could be anything, not excluding a butterfly flapping its wings inside the Amazon jungle. If the retail investors who have turned into trading geniuses have borrowed money from banks to fuel their ride on the markets, any collapse in stock prices could not only bringing IQ levels crashing down on to the trading floor, but put bank money at risk as well. Further, if sentiment turns sour on a large enough scale, the market could crash. It would have a ripple effect across the world, including in India.
Does concerted action by unrelated parties to drive up a stock price amount to manipulation? Can there be a law against it, without infringing on basic freedoms? How can ordinary investors be protected from the collateral damage of a general market rout because of a flight of small traders from the market in the US, following some adverse development that does not change anything fundamental but hurts retail sentiment?
These are questions to ponder, if not to lose sleep over—certainly in Mumbai, if not in Seattle.
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)