Why the Freakout About GameStop?
2021-02-28 · Guest: Jennifer Schulp (Director of Financial Regulation Studies at Cato) · 52:17
The GameStop short squeeze and financial regulation
Bob Zadek and Jennifer Schulp of the Cato Institute discuss the 2021 GameStop short squeeze, exploring the roles of Reddit’s WallStreetBets and the Robinhood trading platform. They analyze the mechanics of short selling, the regulatory response to “gamified” trading, and the technical reasons behind trading halts during the volatility.
Topics: GameStop, short squeeze, financial regulation, Robinhood, WallStreetBets, market manipulation, payment for order flow, SEC, FINRA, DTCC, Elizabeth Warren
Speakers: Bob Zadek, Jennifer Schulp
Introduction to the GameStop Saga [00:17]
Bob Zadek: Good morning, everyone. Welcome to The Bob Zadek Show, the longest-running live libertarian talk radio show on all of radio. We are this morning and always the show of ideas, never once the show of attitude. Thank you so much for listening this morning.
This morning’s show, I thought I’d try something a tad different. I thought I’d have a conversation for the next hour which will cover a topic that has been in the news extensively—maybe too much, but from a fun standpoint, not nearly enough. We are going to talk about a topic which is part Kim Kardashian, part morality play, part an exposure of the fact that we have too much or maybe too little regulation in a very regulated economic activity in this country, and part just good old-fashioned the little guys, so-called, sticking their thumb in the eye of the big guys, so-called.
In short, we are talking about the recent episode in American financial history involving a no-name, relatively unimportant—financially unimportant, that is—company called GameStop. A company which was a bit down in the tooth, kind of uninteresting from a financial standpoint. It was a company which operated mall stores—remember malls? It operated mall stores which sold video games, hardly the wave of the future. Its stock was in the tank, more or less. Nobody was paying much attention to it, except perhaps waiting for it to fail. And then, all of a sudden, GameStop sprung into the news, and for weeks and weeks and weeks, the financial press talked about little else other than the GameStop saga.
No surprise, the GameStop saga caught the attention of Congress. Liz Warren was up there issuing press releases calling for regulation. It was quite a to-do while it lasted. Well, now it’s time to look back and reflect and learn what are the lessons of the GameStop saga and, in fact, what was the GameStop saga all about?
Introducing Jennifer Schulp [01:01]
Bob Zadek: To help us understand this, I’m delighted to welcome Jennifer Schulp to the show. She is a Director of Financial Regulation Studies at Cato. Before that, she spent a good part of her career working for FINRA, the Financial Industry Regulatory Authority. They oversee the securities market, bring disciplinary actions if there are wrongdoers under the statute. And before that, she was in private practice, again in the area of securities regulation. Jennifer has studied and spoken widely on the GameStop event, and I’m delighted that she was generous enough to spare an hour of her time this Sunday morning to help us understand, A, what happened because it’s a fun story, and B, what are the lessons for all of us regular folks that we can glean from the GameStop event. Jennifer, welcome to the show this morning.
Jennifer Schulp: Thanks for having me on. Glad to be here.
Bob Zadek: Now, there are a couple of key players, and we’ll be using their names during the show. So we’ll start with—I’ll just lay the very basic groundwork for the show and then have you explain briefly what happened, and then we’ll devote far more time to what are the lessons and the consequences of your narrative as to what happened.
So first, basic groundwork: GameStop, as I said, was a somewhat uninteresting, nobody paying much attention to it, publicly traded security. It operated mall stores, not the wave of the future, and its stock was, well, it was much lower than it was at another time. And there it is. And then, so here we have this stock which nobody is really interested in all that much, but it is still there, struggling along. What happened to bring GameStop and its stock out of obscurity onto the front pages of the financial press?
The Mechanics of the Short Squeeze [02:25]
Jennifer Schulp: Well, I think what’s important to note is that we don’t know exactly what happened here yet, and that’s something that the facts are going to come out on. But at the basic level, GameStop stock suddenly started to rise. And it rose little bit by little bit, and then very quickly at the end of January, it started reaching what can be best described as meteoric heights.
There could be several reasons why the move started. I think anyone that’s been following the saga has become familiar with a gentleman who goes by the screen name of Roaring Kitty, and also goes by a screen name that I cannot say on air. But he had been pushing on a forum, a Reddit forum called WallStreetBets, the idea that GameStop was undervalued. He thought that GameStop had a brighter future than a lot of other people did and had been encouraging people to invest in the stock.
At the same time he was doing this, there were a lot of people, mostly hedge funds, betting against GameStop’s future prospects, and they were doing this by short selling GameStop stock. That becomes important because that plays into not only the narrative here of the little guy sticking it to the big guy, but also plays into why the stock price took off at the speed that it did once things started rolling. The short selling—there was a lot of short selling interest in GameStop. In fact, so much so that there were more shorts out than there were total float of the stock, meaning that people really thought GameStop was going to decrease in value over time.
Defining Short Selling [03:41]
Bob Zadek: Now Jennifer, if I can just interrupt just for a moment to refresh the memory perhaps or to instruct our audience. The nature of short selling is when a trader or an investor quote “short sells” a stock, what the investor does is sell stock that it does not own. Now that seems a bit shady—how can you sell something you don’t own? Well, the market contemplates that, and the selling investor, the one who is selling stock it doesn’t own, it borrows the shares from somebody else. A very acceptable, conventional, mainstream transaction.
And the mindset of the short seller is, “I’m going to borrow stock today so I can sell it. When the stock goes down, as I believe it will,” this is the short-selling investor predicting, “when the stock goes down in price, I will then give back the shares that I borrowed by buying them in the then-lower market price. So I will have made a profit by buying low and selling high, but doing it backwards. I’m selling high first and then buying low later.”
And the characteristic of short selling, the thing that makes it kind of risky, is that when you buy stocks in the hope of having it go up in price, if you’re wrong, the most you can lose—if your stock that you bought becomes worthless—you can’t lose more than your investment. So you kind of have a limit, although it may be a high limit. When you short sell, what you could lose is unlimited, because the more the stock goes up in price, the more your losses are. And since it can go up to an unlimited amount, and unlimited is a high number, then you can’t control how much you’re going to lose. And sooner or later, as a stock goes up in price, you say, “Okay, I’m doomed. I better cut my losses even though my losses are huge.” So the nature of a short sell is the more you are wrong, the more you lose, with the possible losses being infinity. So I just wanted to make that point because the pressure on somebody who short sells grows and grows and grows, Jennifer, as the stock price increases. I wanted that dynamic to be clear to the audience.
Jennifer Schulp: Right. And that was a great explanation, Bob, because what’s important here is the concept that they then need to buy the stock back to cut their losses. As the price starts to rise, short sellers feel pressure to buy the stock in order to put a cap on how much they’re going to lose on this bet. When GameStop took off, that meant that short sellers started buying the stock as well in order to cut their losses. But that just added more demand into our supply and demand of the stock market, which caused the prices to rise even higher. So it kind of created a feedback loop, which is one of the reasons that the price kind of took off in a way that you don’t see it. This price rising, short sellers needing to buy in order to cut their losses, is what’s known as the short squeeze. And we saw that word, that concept, floating around out there in the media a lot over the course of the past month, which is probably something that you never thought about until GameStop became something that we were talking about on a daily basis.
The Gamification of Trading [05:31]
Bob Zadek: Now, part of the fun of the story was not only was this Reddit group comprised mostly of small investors—as a group, that’s a fair characterization—but they were having the time of their life doing so. It was to them a game, i.e., GameStop, no pun intended. And tell us a bit, because this got the attention of the media and the regulators both, tell us about the website under which they were buying the shares, the Robinhood website. Because the nature of that website was nothing more than—it was not just a cold trading platform with black and white fonts and nothing special, but the nature of the Robinhood trading website itself got the attention of the regulators. Tell us a bit about the environment in which these small investors were apparently playing, but seriously playing, at buying the stock of GameStop and others, but we’ll get to that a little bit later.
Jennifer Schulp: So sure. Robinhood has been getting a lot of press, not just for GameStop, but over the course of the past year. Robinhood and a number of its competitors—Webull, eToro, and a number of other new trading platforms—are what—well, they’re app-based first. So rather than kind of the old-style trading platform which was designed for you to use on your computer, these are designed to be used on your mobile phone. Use your iPhone to pull up your trading, so they’re designed much more sleekly. And probably, I think much more modern is the right word.
They are designed to appeal to a younger demographic. And what has gotten the regulators’ attention here is a couple of things. One, Robinhood, its ilk, as well as a number of discount brokerages that followed along, now offer zero-commission trading, which means that you can trade as much as you want on their app and you don’t pay a set commission on the trade. The world didn’t work like that prior to the end of 2019. If you wanted to make a trade, you generally paid $3, $5, maybe less than that a trade, but there was a charge every time you wanted to make a trade. Robinhood offered zero-commission trading and due to that type of pressure, a number of other trading platforms followed along, including some of the big discount brokerages: Schwab, TD Ameritrade, E-Trade.
In addition to this zero-commission trading, these apps, Robinhood included, incorporate elements that some view as more appropriate to games. Robinhood has gotten a lot of attention for having times where confetti goes off on its screen if you’ve made a trade or deposited money into your account. They have lists of stocks that might point you and say, “These are the top 10 most traded stocks on Robinhood today.” Some of these apps also incorporate things that say, “We see you bought X stock, you might also want to look at A, B, and C stocks.” So these apps have a lot of features in common with other apps that you would use on a daily basis. I think successfully they’ve brought in a lot of new people to trading and investing who otherwise may have been put off by clunkier systems, more difficult to use interfaces, or just a general stodginess about trading that might have been not only a pain in the neck to use but intimidating to newer investors.
Bob Zadek: And boring. Don’t forget boring.
Jennifer Schulp: And boring. I put the stodgy—I consider it to be boring as well.
Regulatory vs. Political Outrage [07:00]
Bob Zadek: So now that was picked up upon a lot, as if how dare you convert making money into an enjoyable activity? How dare you? How dare you expose trading in stock to be—have elements of a game or have elements of gambling? How dare you make our industry look like a casino, which of course in many ways it is, or it is at least used that way by those people who day trade in securities? So I think part of it was, “How dare you show us to be what we actually are?” was—now you’ve lived your professional life in the world of this regulated activity. How deep—am I overstating the sensitivity of the regulators and the people who do this activity for a living, the securities industry? How much were they concerned about people coming to realize that in this profession there are elements of both a game and gambling? How sensitive were they to that, or am I overstating it?
Jennifer Schulp: You know, it’s hard to say. I think most of what we’ve heard on this front has been coming from the political angles rather than the regulatory angles. FINRA has been looking at zero-commission trading and whether or not it’s consistent with broker-dealers’ obligations. FINRA also has announced that it’s going to be looking at these trading platforms to make sure that they comply with current rules. But most of the outrage on this front has been coming from Congress or others that are less familiar with the regulatory system that’s already in place.
So I don’t want to lay too much at the regulators’ feet here. I think there’s one exception to that, which I suspect we’ll end up talking about next, and that’s Massachusetts. But there are a lot of rules at play that FINRA enforces, that the SEC also has, that go to making sure that communications between the broker and their customer are not misleading. And most of that covers what’s happening here already. I’m not sure that this is necessarily something that the regulators are concerned with, “Oh no, trading is fun, we didn’t want trading to look fun.” But I certainly think there’s some members of Congress that think that.
Bob Zadek: So I was—I should have been—thank you for correcting me. I look upon respectfully regulators and government—I tend to lump them together. But you, having spent your career in the regulatory world, you are very, very aware, and indeed I may ask you a little bit in a little while, you testified before Congress—not before a regulator, but before Congress—for a very long testimony, which I’ll have you share with us to the extent that you can. It was public, of course, so you can. So what I did was I was guilty of lumping together two branches of government into one. I should have known better. So thank you so much for making that correction.
Was the Reddit Surge Illegal? [08:13]
Bob Zadek: So now going back, so now here we are. So the stock is going up and the merry band—the irony of the trading platform being called Robinhood and it being—having elements of a “take from the rich and give to the poor,” the way the legendary real Robinhood, if there was a real Robinhood, did. So right now we simply have a bunch of traders, small traders, who banded together—and I’ll ask you to speak to that, whether the banding together in and of itself is some kind of a market manipulation, is it in short wrongful? But we have a band of traders acting pretty much in concert to make buckets of money at the expense of the hedge funds, the insiders if you will, who had to cover their shorts and they lost a real, a very, very large amount of money because the stock increased in price beyond any pre-Robinhood expectation they could have possibly had. Therefore they sure didn’t factor in the degree of these possible losses into their calculation. So at the end of the day, as the factual part of our conversation comes to an end, we have a bunch of day traders who made a lot of money. Now, in anything that we’ve talked about so far, as far as is publicly known, did anybody break any laws or violate any regulation so far in our story?
Jennifer Schulp: Based on what’s publicly known at this point, I would say no. I’ll caveat that because there are things that can have happened behind the scenes here that I don’t have access to that might have constituted violations. There might have been information that was provided on WallStreetBets that was misleading, but was not obviously misleading when you look at it. There might have been problems with how the hedge funds were shorting the position. Again, I don’t know the facts that underlie any of that at this point. But what we have here are a bunch of people on Reddit who got together and said, “Let’s buy this stock.” The stock went up. We don’t have a legal problem here.
Defining Market Manipulation [09:54]
Bob Zadek: So if no laws were broken—and by the way, you mentioned WallStreetBets, another institution which is a player in this. Tell us what WallStreetBets is and where it fits into the story.
Jennifer Schulp: Sure. So WallStreetBets is the Reddit forum, the virtual meeting place of sorts, where Roaring Kitty and others talked about this stock. There are obviously other places where people were talking about this stock, but WallStreetBets was kind of the hub for activity in people talking about and getting excited about GameStop stock. It was an interesting place. It did not pop up specifically for GameStop. WallStreetBets has been a functioning forum for quite some time. There’s a community of people there that shared stock tips with each other and shared their research. And that’s where this started. But so WallStreetBets is kind of a—the congressional testimony brought in the CEO of Reddit to talk. But the way I see it, the fact that people were talking online is no different than if this were a cocktail party or some email or a conference of investment professionals talking about stock picks.
Bob Zadek: So there was nothing inherently wrong with a bunch of investors saying, “Let’s all buy GameStop stock today, right now, and let’s all put a bunch of money and take long positions on the stock. Let’s all do it together, and we know by doing so the price of the stock will go up, and then when we sell, we’ll make money.” That activity, while it has to the untrained eye it might sound like some form of market manipulation, that activity of “let’s all do it together right now,” that activity is not per se unlawful without more facts.
Jennifer Schulp: That’s right. And I think that we get tripped up a lot, particularly when we’re thinking about this when we’re reading news stories, about the word manipulation. Because the day-to-day use of the word manipulation and the legal definition here tend to be different things. Whenever I buy stock, I hope that it goes up. If I’m buying stock at the same time that there’s good news about the company or some research came out saying that this company’s a good buy, I’m buying that stock at the same time as other people also trying to make it go up because my demand could help move the price up. It doesn’t generally because I’m small. But really anytime we’re buying stock, we’re hoping or trying to change that price. That’s why the legal definition of manipulation isn’t so loose. Traditionally and in codified in some sections of the securities laws, manipulation requires some sort of false, misleading, or deceptive behavior in order to be a legal problem. I haven’t seen any evidence thus far out in the public domain that there was anything fitting that legal definition of manipulation here.
Payment for Order Flow [10:31]
Bob Zadek: Now, you mentioned a short while ago that one of the defining characteristics of Robinhood as the platform in which the securities were bought and sold was commission-free trading. And you mentioned very briefly a few minutes ago that that at least got the attention of the regulators. It’s interesting that this is yet another example of a consumer commodity—I think of Google, the free searches in Google, as another example—where a service is examined for having possibly misbehaving by giving away their service, having their business model be it is free to the consumer. Now what is there about free commissions per se that would even get the attention and not the praise of regulators?
Jennifer Schulp: Well, commission-free trading is an interesting beast because, of course, when you get a product for free, the person providing the product needs to make money somehow. So the typical statement now is, “If you’re not paying for the product, you are the product,” which is familiar to us in Facebook, Google, and others. But for commission-free trading, Robinhood and others, although Robinhood to a larger degree than others, makes money off of the trading by selling its order flow, aka the trades that you want to make, to another entity to execute those trades.
That is a practice that the SEC has looked at multiple times over the past 20-plus years and has blessed. It’s called—you’ll see payment for order flow is what it’s called, and the press has actually gotten pretty good about using the real term here. The SEC has looked at it several times and said that’s not a problem. What it does is presents a conflict of interest that brokers need to manage. Because when the broker is getting paid for the orders, the broker might not be incentivized to pick someone to execute the trades that’s going to give the customer the best price. And that’s what’s known as the duty of best execution.
So there’s a potential conflict between a broker offering zero-commission trading and giving the customers the best price for their trades. Again, the SEC has looked at this multiple times over a number of years and said that’s fine, you have to manage the conflict. So commission-free trading shouldn’t be a problem, but people need to understand that their broker is making money and is making money off of their trading, they’re just not paying an upfront commission to do so. It shouldn’t be a surprise and people ought to be able to have the freedom and ability to make a choice to use a broker that offers that type of system.
The Congressional Hearing and Trading Halts [12:01]
Bob Zadek: Now, this of course the GameStop saga got the attention, as we have said, of Congress. And you were, I’ll say privileged because I think it’s kind of fun to do it, but you had to do it, maybe you’d use a different label, but you were invited to and did testify before Congress. So Congress said, “This requires some attention because it’s in the media, and if it’s in the media, we want our name to be part of the story in a good way.” So that’s my cynicism, forgive me. So you get invited because you are an expert in securities regulation, you are invited to testify before Congress. What was the stated reason for Congress thinking they ought to look at this at all? What were they concerned about, and what kind of inquiry did they make of you during your five and a half, I believe it was, hours of testimony before Congress? What was the purpose of it all, and did they accomplish what they wanted to accomplish—they being Congress?
Jennifer Schulp: You know, I think it depends on the member what each individual one thought the purpose was here. I think as you said at the beginning of our conversation, there was a little bit of something for everyone here in this story. And there were I think a lot of differing purposes by members of Congress in having the hearing and in calling the witnesses that were called. I want to throw out there was one section of the saga that we haven’t talked about to this point and that was the subject of a lot of questioning during the congressional testimony, which was the fact that when GameStop’s stock price rocketed, there was a day that Robinhood and other brokers restricted customers’ ability to buy GameStop stock.
And that caught the attention of a lot of members of Congress, actually on both sides of the aisle. Because there was concern that Robinhood may have been improperly influenced by big Wall Street players. There was concern that by stopping the trading, individual investors lost out on the ability to trade. So that was a topic of a lot of interest by members of Congress on the Democratic and the Republican sides during the hearing. And I think you can ask me about what I think about that, but let me get back to the other question about did Congress accomplish what it was trying to do in that hearing.
Five and a half hours of testimony—I’ll say thankfully I was not answering questions for most of that five and a half hours because that is a long time to be testifying. But it’s difficult to say that the hearing really accomplished one unified goal. There were a lot of different types of questions asked. The committee chairwoman Maxine Waters had announced the beginning of the hearing that this was the first in a series of hearings devoted to the GameStop phenomenon, so to speak. Good God. So the purpose here was just trying to get out some facts. I think most of those facts had already come out in the media by the time the hearing took place. So it was allowing a lot of members of Congress to have their bite at the individual fact players, and that definitely was accomplished.
The DTCC Collateral Crisis [13:21]
Bob Zadek: I think that with reference to the Robinhood CEO, and going back to your explanation of what the business model is for commission-free trading at the retail level, it was the fact that Robinhood was had another institution executing the trades and that created, without getting too much in the weeds because it’s not the scope of the show, but that triggered regulatory events of simply Robinhood having the credit to back up the trades it was asking, I think Citadel, to perform. So that was kind of mechanical, in the weeds, a second-tier issue. And I think you would conclude, but I always enjoy being corrected, that that issue, that concern that Wall Street—whatever that means—Wall Street was getting the regulators and other big companies to snuff out the trading ability of the Robinhood traders, that was much ado about nothing, wasn’t it?
Jennifer Schulp: Yeah, I do tend to think that was much ado about nothing. The real problem that existed there was not with Citadel—Citadel’s involvement, although that was what some of the theories were saying, which was that Citadel jumped in to try to stop retail traders from being able to continue to buy GameStop. But the problem there was actually, as far as we can see the public information and this makes sense to me, was that the entity that handles settlement of stock trades, which is something we never talk about in the media because it just happens and it’s not something that the average investor needs to be worried about.
That entity requires brokers to put up collateral during the time that it takes trades to settle. Right now it takes trades two days to settle, and there’s calculations that happen as to how much each broker who’s engaged in this needs to put up. Well, because the price of GameStop had gone through the roof and was very volatile, that meant that the clearinghouse, the DTCC, which you might have seen thrown around, asked Robinhood for a lot more money for collateral. Robinhood didn’t have that money available when they asked for it. So in order to decrease the amount of money that DTCC was asking for, Robinhood proposed stopping investors from making new purchases in GameStop. DTCC said that that would reduce the amount of collateral. Robinhood then had that much collateral on hand, put it up, and was able to continue trading, but in that more limited fashion. That explanation makes sense to me. It makes less sense to me some of these crazy theories that have been floated or other theories that have been floated about kind of the invisible hand of Wall Street stepping in to squash the little guy here. But there was a lot of concern about whether individual investors had been unfairly hampered in trading on Robinhood due to these decisions that were made.
Bob Zadek: A minor observation: I don’t think Wall Street’s hand, your metaphor, is all that invisible. And if it—I think it’s very, very visible and strongly felt very often. So but we like to pay homage to Adam Smith.
Jennifer Schulp: I think that’s right. Invisible, yeah. Invisible as in we’re not quite sure which Wall Street entity might have been doing the pushing. But yeah, invisible—maybe a better word.
Bob Zadek: Sorry, anytime you want to make even an indirect reference to Adam Smith on my show, it’s always welcome. So you never have to apologize for any reference to anything Adam Smith has ever said. That’s always—if we can get a plug-in for Mr. Smith, I’m happy to do it.
Lessons Learned for Hedge Funds and Retail [14:42]
Bob Zadek: Now, is there—this was in a manner of speaking, this whole event was singular. It hadn’t really happened quite this way before. Sure there’s stocks that go up and down and there have been bubbles—this was hardly that. But it was in many ways it was singular and captured both the ink and the imagination of those people who pay attention to the financial markets. So my question with that introduction, my question is, are there lessons for anybody? Did anybody get smarter as a result of this happening? And I mean anybody—I mean regulators, Congress, day traders, speculators, gamers disguised as stock investors, hedge funds or the like. Who might be doing anything differently or be more encouraged or less encouraged by the event?
Jennifer Schulp: You know, I’ll take two groups that I think have learned some lessons here. One of them are hedge funds and big Wall Street players. And not—the lesson is in risk management and in making sure that you are considering retail investors and social media and some corners that you might not have traditionally looked at when you are making your investment decisions. What was singular about this event was that it was a short squeeze initiated by retail investors. I’m sure that the hedge funds here who held massive positions, short positions in GameStop, hadn’t been focused on the fact that there might be pressure from the retail sector, the retail investing sector, that they needed to be concerned about. I think that lesson was learned pretty quickly. And I think that we’ll see some changes made in how the short investors and other large investors view retail when they’re evaluating the risks in their own portfolio.
I think the other group here that’s learned are retail investors. I mean, first they learned that there’s some power in being able to do this in a smaller-cap stock. But for me, what I hope they’ve learned is a little bit about investing by doing. I think we’re fortunate that we have not seen very many stories at all about people who about individual investors who lost big in GameStop. And that’s not to diminish the fact that some people did lose. People are going to lose when they engage in this type of behavior. But I was heartened that a lot of people who lost—there was an article in the Wall Street Journal that highlighted some of what they considered to be the bigger losers from the retail sector here. Most of them acknowledged that they understood the risks and that they understood the risks in day trading, in speculating, in investing in a stock that’s on a massive upward swing in momentum. And I hope that retail investors who have jumped into the market in the past year are learning here about some of the risks that are attendant with this type of speculation. Learning by doing is great. I hope we see some more learning by doing in the retail section.
The Subjectivity of Market Value [16:13]
Bob Zadek: Now there has been—there’s a word or a word and its derivatives that popped up a lot during the saga, and it pops up a lot in any securities literature. And that is you will see the phrase that a stock is undervalued or overvalued. That stock price is too high for that security or too low. Now, I’m going to sound and maybe it’s accurate, kind of naive, hoping and delighted if you would correct my naivete. I’m focusing on the word value as applied to a security. Now, value doesn’t mean what the owner thinks something is worth. Just like when I apply for a job and I say I want 100k a year, that’s my opinion as to what a year of my time is worth. But my opinion doesn’t matter all that much if nobody is willing to pay it. So the point is value is a bilateral decision. It’s what—it’s where the value that the seller thinks something is worth and that exactly coincides with what a buyer thinks it’s worth. When those decisions coincide exactly, that fixes its value. So value is not what somebody thinks, it’s what will cause a sale to take place. With that introduction of the word value, how could a stock ever be overvalued? That is to say, Jennifer—and I’m asking you because this is your world—you have seen the phrase “stocks are overvalued or undervalued.” That cannot mean exactly what the word value means. So what does it mean—and I’m not asking you to give stock advice, obviously—but in your world, what does value mean when somebody says a stock is undervalued or overvalued? Because that was used every minute of every day in the GameStop reporting. Help us understand value, that word when applied to a security.
Jennifer Schulp: Sure. It is a funny word to use because you’re right, and the market here sets the price. The market decides what a stock price should be based on where people are willing to buy and sell at that price, where buyers and sellers meet. When you hear value when we’re talking about securities, it’s a much more squishy term which refers to the prediction that someone has in looking at a company’s earnings, revenue, expected future earnings, to determine where they think someone will value or want to buy that stock in the future.
It’s a pretty subjective number, and you’ll see GameStop notwithstanding, all of the big Wall Street firms that put out research on stocks have kind of a band of what they think a price target is for that stock, where they think the stock should be trading around, and whether it’s something you should buy now, something you should sell, something you should hold on to. And even the best research minds in the game don’t always agree on what they think that stock’s value should be.
And they’re operating with models that they’ve tested, and I think the GameStop phenomenon, maybe not so much on GameStop, but maybe when we’re looking at some of the other stocks that moved at the same time, should be a wake-up call to tell those that are looking treating value and quote-unquote “fundamentals” as some sort of gospel in truth as to what a company should be trading at, that they might be missing information and other factors might also be affecting what people are willing to pay for a stock. So that’s a long way of saying value is subjective too.
Bob Zadek: In other words, value when one is—when one concludes a stock is undervalued, an absurd concept as I say, but when one concludes that, that is a two-step conclusion. Step number one, you predict, you try to determine what certain arithmetic, certain facts will be in the future: earnings per share, yield on assets, whatever the calculation is. You make a calculation what some numbers will be sometime in the future. That’s arithmetic and that kind of requires you to understand the business. Step two, step two you say, “What will the hypothetical marketplace do with that information in the future?” That’s the key. And if you’re right about the first, but the marketplace in the future is unpersuaded by it, you were right in what the company will do in the future, but wrong about predicting how the market will react. So there’s an element of mind-reading in this whole process that’s kind of weird to me.
Now Jennifer, help our friends out there understand how they can follow the great work that you do over at Cato and tell us what projects, if any, you’re working on and how folks can follow you.
Jennifer Schulp: Great. Yeah, thanks so much for listening to me today. As Bob said, I’m at the Cato Institute, specifically in Cato’s Center for Monetary and Financial Alternatives. I do a lot of my work on retail investing at the moment, and look for more from me on that. All of my work is available on the Cato Institute’s website, cato.org. But you can also follow me on Twitter, and that’s @JenniferJSchulp (S-C-H-U-L-P). That’s the best place to find my work is. I say I also you can follow me on LinkedIn, but it’s Twitter or the Cato Institute website. And I always love having folks following.
Bob Zadek: Jennifer, thank you so much for giving us an hour of your time and for your insights on this great fun story. It’ll live forever in time. It was fun to watch it and it was fun to learn from it. So thank you so much, Jennifer, and thank you to my friends out there for giving us an hour of your time this Sunday morning. Have a good rest of the weekend.