If you’ve been following the stock market over the last few days, or just the news in general, one of the most talked about stories is the meteoric rise of GameStop’s stock. A stock that was trading around $20 at the start of the year rapidly rose to over $400 in just a matter of days. How is this possible? There are a few reasons why the stock has risen so rapidly. But we strongly suggest avoiding jumping into the fray.

What are stocks and how do they work?

Before diving into the fancy buzz words you’ve likely heard like “ short-selling ” and “ short-squeezes ”, we need to start at the beginning . . . What is a stock? A stock is simply ownership in a company. As a stock holder you are an owner, and as such, you generally have the right to vote on certain company matters (like electing the board of directors) and are also entitled to earnings from the company if the company decides to pay a dividend.

When looking at stocks, you’re not just looking at how the company is doing today, but also evaluating future expected cash flows . A common calculation of this is looking at the Price to Earnings Ratio (P/E Ratio). What this metric tells us is how much we are paying for the stock based on its current earnings. (Another calculation is price to expected earnings, which takes into account future expected cash flows).

As a simple example, if a company reports earnings (profits) of $0.50 a share for the year, and the stock is trading at $10, the PE Ratio would be 20 (10 / 0.5).

Who decides how much a stock is worth? Well, the market does. Buyers and sellers enter and exit the market based on their expectations of the future cash flows from owning that stock , and the future prospects of the company. As a result, some compan ies will trade much higher than their past earnings (have a high P/E ratio), and others lower. Much of this has to do with the anticipation of future growth of the company. Companies that are well established and have relatively predictable earnings and growth tend to trade at a lower ratio. For example, Coke (KO), currently has a P/E ratio of about 25. Companies that may not be profitable yet, but are expected to have substantial cash flows in the future, may trade at a higher ratio. For example, Tesla (TSLA), currently has a P/E ratio of about 1,600 ! This is considered reasonable by investors because they expect the future earnings to be much higher than current earnings . If you use future expected earnings, the P/E ratio is much more reasonable.

Put simply, stocks are forward looking investments based on the expectation of future earnings of the companies you are invested in , and shareholders being able to participate in those earnings (and increased earnings) in the future.

How does GameStop stack up?

For those unfamiliar with GameStop as a company, they are a retailer that primarily deals with the selling of video games and video game accessories. A large part of their business model is purchasing used games, and then reselling them for a profit. As more and more individuals turn to shopping online, and video games become digital instead of needing to purchase a physical disk, this puts a strain on physical retailers who sell physical video game products, and GameStop is no exception.

Any publicly traded company is required to disclose their financial information to investors and regulatory agencies. These are reported quarterly on the 10-Q statement, and annually on a 10-K statement. These documents are publicly accessible by the Securities and Exchange Commission . As of GameStop’s last quarter, which ended on 10/31/20 and was reported in December, they reported a loss on their 10-Q statement . Going back to the P/E ratio calculation before, this means that GameStop (GME) has a negative P/E ratio! They are also not a new company. They have been a publicly listed company since 2002, and were established before that .

If you invested in GameStop as of the most recent quarterly report, you would be buying into a company that is currently not turning a profit. Also, they are currently not disrupting an industry (ex: Amazon or Tesla) and are not developing any ground-breaking technology or products (ex: medical advances, artificial intelligence). They primarily sell games and gaming products. Based on the fundamentals, it’s up to you to decide if you would like to own a company based on these metrics.

Then why has the GameStop price risen so much?

If the company losses and unimaginative business operations are leaving you scratching your head as to why the stock has jumped substantially, you’re not alone. But there are a few reasons why the stock has gone up so much and it starts with short-selling .

What is Short-Selling?

When many people invest, they are purchasing a stock or fund and holding it for the future (long-term). The simple strategy is to “buy low, sell high.” Short selling has the same goal, just reverses the order, sell high, buy lower. When you purchase a stock, your anticipation is that the company is going to do well in the future and if that happens, and earnings increase, the stock will likely rise with it. Short-sellers are expecting a company to perform worse in the future, and the stock to decline, so they sell it at a “high” with the hopes that it will drop further and they can buy it back at a lower price.

Ex: XYZ company is trading at $100 a share. John Doe sells a share is and takes in $100 (now short 1 share). The stock later drops to $80. He buys the stock back for that price and keeps the $20 difference ($100 – $80).

How do you sell something you don’t own?

This is where things get a little more complex. Since you don’t own the stock, the brokerage firm needs to go out and “borrow” shares. If they allow you to borrow it , you can then sell the stock without owning it, with the expectation that you will pay for the sale with a purchase (buy-back) at a later date.

What is the risk of short-selling ?

There is a substantial risk to short-selling and we strongly discourage our clients from doing it. When you purchase a stock, the risk is known. If you buy XYZ company for $100 the most you can lose is your investment ($100). However, there is no limit to how high the stock can go. If the company is doing well, and future earnings are bright, the stock may climb to $150, $200, or even $1,000! Not to mention, if the company decides to pay a dividend you get to keep the income too.

Short-sales have the exact opposite risk profile. The maximum gain is known, but the potential loss is not. In the same example, if you sold XYZ company for $100 and it goes bankrupt (now trading at $0), you just made $100. However, if it does well and is trading at $150, and you buy back, you lost $50. If it’s trading at $1,000, you lost $900!

Since the risk is theoretically unlimited if the stock continues to climb , and you don’t buy back the shares , your brokerage company may force you to close it, or do it on your behalf. There are ramifications for selling a stock short, and if the purchase goes against you, you can’t let it increase forever. Since there is only a limited gain potential, you don’t receive any dividends, and there is an unlimited loss, we strongly discourage any of our clients from “investing” this way.

What is a short-squeeze ?

A short-squeeze is a large part of why GameStop’s stock has increased in value so quickly. Prior to this week, GameStop was one of the most shorted stocks in the stock market. This means many individuals, and in this case also institutions (some hedge funds), had a bleak outlook for the company. However, when investors (many who came from online discussion forums) started pouring into the stock , it caused it to increase in value. As discussed before, when you’re short a stock and it increases in value your losses increase. When this happens, some of those investors who are short the stock now purchase back to either cut their losses or are forced to because the losses are too great. When the stock is bought back this way, these are more buys into the stock, which causes the stock to increase in price further. As the price continues to climb, more short sellers may need to cover causing more buy orders and a continuation of the price increase.

In GameStop’s case, much of its rapid advance in the last few days has come from short-sellers being forced to buy back, causing a continued increase. But this doesn’t quite tell the whole story. . .

Euphoric Investors

Another big part of the rapid increase is investors hopping into the stock because of the headlines. Many of the new buyers into the company may experience FOMO (fear of missing out). They see the stock increase rapidly, don’t want to miss out on an even higher increase, so purchase the stock without much (or any) due diligence. This continues to push the price of the stock higher, which causes more short-squeezing, which pushes the stock even higher. The spiral continues.

This is nothing new

The rapid rise of GameStop was certainly something no one was expecting at the start of the year. But these rapid stock increases not due to fundamental factors is nothing new. We believe that over the long-term the stock market is efficient, but in the short-term things can get a little out of whack. Whether it was unprofitable dot com companies during the tech bust of 2000 o r struggling photography company Kodak jumping on the cryptocurrency train in 2018 , o r investors confusing the stock ticker ZOOM (Zoom Technologies) with ZM (Zoom Video) by purchasing an unintended stock – all can make the short-term market very volatile.

In all these cases, and many more, some stocks increased rapidly in price for reasons other than their business outlook , b ut the increase was short-lived. Eventually, these stock prices came back down after the euphoria ended . A struggling company at $10 a share is still a struggling company at $500. Unless you have an expectation for things to improve, if they go bankrupt you still lose 100% regardless of what price you bought it. Jumping onto the hype train and becoming overly euphoric can lead to financial disaster if you’re not careful.

Putting it All Together – Speculation vs. Investing

When buying a stock or fund are you speculating or investing? It’s crucial to know the difference. Clearly what happened with GameStop is strictly speculation , largely due to extensive short-selling. This may make one wonder if investing in the stock market in general is also speculation? When done properly, the answer is no.

When investing in a diversified fund, like the S&P 500 , you are purchasing 500 of the largest US companies. These companies make products and provide services across various industries. Most generate profits and many even provide dividends to shareholders from th ose profits. Over the long-term, these companies grow because the economy grows. When the economy grows, they are able to sell more products and services and increase their profits. If some companies are unable to adapt and decrease in relevance they are removed from the index and are replaced with new , innovative companies. When you purchase a diversified fund like this you are not speculating on what a single company will do, but more that the US economy as a whole will continue to grow over the long term. There will be bumps on the way, but historically , economic activity has continued to increase over time as companies, and more importantly, the people that work for them, become more efficient and productive .

Speculation is when you’re investing in a single company, or a narrow group of similar companies (ex: only technology stocks, stocks located in Denmark, Whiskey distillery companies, marijuana stocks, etc.). You’re taking a gamble on a certain company or industry. No one can predict with certainty that a certain company or sector will do better/worse than others. Global macroeconomic trends and events will dictate what occurs, and this is not something you can predict or control . There i s not necessarily anything wrong with having a speculative hunch, but it’s crucial you understand the risks, and know what you can afford to lose. Having a small sandbox account is perfectly acceptable as long as it’s not interfering with your overall long-term goals.

Summary

What has happened with GameStop, and some other stocks, over the last few days has been interesting to say the least. Speculation on both sides, one with the expectation of the stock going down and the other fueling the rise , has made the stock swing wildly. But the question to ask when buying a stock or fund is “are you investing, or are you speculating?” The financial details of publicly traded companies are available, and you can personally review the financials of GameStop and others. Would you invest in a company that is losing money, has been around for decades, and is not really innovating in any way , after it has increased substantially in price?

It’s important to remember that this isn’t the first time that a company has increased rapidly in value based on speculation, and not fundamentals. Before buying any stock or fund it’s critical to understand what you are getting into and the risks involved. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisors .

Disclaimer: Not intended as investment advice. Investing involves risk of substantial loss. Past performance does not predict future results. Index performance does not include fees or taxes. Consult a qualified advisor about your specific situation before taking investment action.