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Reddit’s r / WallStreetBets just acquired a hedge fund. You will love what comes next.
As a member of r / WallStreetBets, a popular Reddit forum, I want to tell you this: it should never have happened. Our happy group of investors had to use our little corner of the internet to exchange risky equity investment ideas, not to bring down one of America’s most prominent hedge funds. Source: Mehaniq / Shutterstock.com Yet here we are. Over the past week, traders reading WSB and other forums have pushed GameStop (NYSE: GME) and a host of other heavily shorted stocks to impossibly high levels, with at least one hedge fund going out of business and several platforms stopping trading. Wall Street’s response was so clumsy that Congressmen Ted Cruz and Alexandria Ocasio-Cortez, long-sworn enemies, even managed a coordinated tongue wag (Twitter wag?) At the U.S. financial system. But as Citadel picks up Melvin Capital’s pieces and Reddit users find their next short-squeeze target, people are starting to wonder, “What’s next?” InvestorPlace – Stock Market News, Stock Advice & Trading Tips Reddit’s r / WallStreetBets Gives Citron a Taste Let me be clear: you won’t find my posts on r / WallStreetBets. As much as I love to read and enjoy the platform, my work and ethics keep me from talking about stocks I own. (Sorry, Elon Musk. I wish I were you.) Wall Street Bets was always about having fun. Many of the posts are deliberately moronic – think priceless appeal to failing retailers – and there are plenty of contributors showing screenshots of life savings going to zero. Profitable or not, it was all about finding the joys and absurdities of market speculation. In November, GameStop was one of these fun little businesses. And it all seemed like a pretty standard fare for the subreddit, billed as “4chan Finds a Bloomberg Terminal.” GameStop fans cheered on buyers as they cursed Melvin Capital for shorting the stock. All in the hope of realizing America’s favorite pastime: making a lot of money with as little effort as possible. But then Citron Research changed it all. Citron research? Meet r / WallStreetBets On January 19th, respected short-seller Andrew Left managed to finally pick the wrong target. As a longtime Wall Street outsider, Mr. Left made a name for himself by exposing companies like Valeant Pharmaceuticals, whose executives are pushing and driving up the prices of the life-saving drugs. He would have made a big WSB contribution if he were willing to put up with hate speech from 15-year-olds. But then something happened. The day before the presidential inauguration, Mr. Left to argue why GameStop stock was only worth $ 20. Perhaps Mr. Left was right when he turned to GameStop, a shrinking company that still awards its executives $ 20 million. Or he could have been wrong – at $ 20, GameStop would still be worth less than half of Best Buy (NYSE: BBY) adjusted for sales. But that didn’t matter at all. Suddenly, GameStop became more than a monetization venture for Redditors. It became a way to fight back against Wall Street greed; now it was war. How did WSB do it? In a financial system that values a stock based on the last trade price, even small transactions at foreign prices will revalue the entire position of a hedge fund. In other words, a few well-timed purchases can cause chaos, especially in stocks with few sellers. That’s exactly what happened to GME. Until then, short-term interest rates had remained relatively stable. Market makers, the foundation of the American financial system, did their job matching orders and sales. That all changed on Wednesday as prices jumped from $ 150 to $ 350. As market makers seized, the markets started to go wild. That meant problems for Robinhood. On Wednesday, Robinhood stopped trading for GameStop and nearly a dozen other companies. “In order to protect our business and protect our customers,” Vlad Tenev CEO later told CNBC’s Andrew Ross Sorkin, “we had to limit the purchase of these stock.” Can Robinhood go under? In the trading world, the most conservatively run platforms have no problems managing liquidity. As long as you hold enough capital and maintain disciplined margin requirements, it is rare for your clearing house to force you to raise new capital. But when it comes to Wall Street, financial companies all seem to run into the same problem: When your customers are making that much money, it’s hard to resist the temptation to join them. Financial regulators have long known these Wall Street shenanigans. Banks from Bear Stearns to Barings all went under when they tried to trade client money as their own, leaving taxpayers and shareholders to pay the bill. Many more have experimented with an absolute minimum of capitalization – only later to realize their disastrous mistakes. So over the years, smart governments have occasionally found the willpower to ban such practices and enforce strict margin and capital requirements. (Often these rules were overturned by even smarter financial lobbyists.) Today, many platforms use a loophole to lease clients’ securities for profit. And when GME shares can be rented to short sellers at 25% interest, these financial companies are tempted to double dip. Robinhood did that? Possibly. Despite Robinhood’s claim that the trading stop was proactive, the company still pulled capital lines and banned users from buying more GameStop stock – a signal that Robinhood itself may be short of capital and stock. (Since Robinhood is privately held, we may never know the truth.) But will Robinhood run into regulatory trouble? Almost certainly. The company banned trading a dozen stocks on Wednesday during the spike in investment demand – reportedly because the company needed time to raise new capital. So while private investors watched from the sidelines, hedge funds were cashed in at otherwise lower prices. In essence, Robinhood has arguably saved institutions billions of dollars at the expense of investors. Should we be afraid? As Wall Street picks up on the remnants of Melvin Capital and the fallout from GME, two things have become clear. 1) “Dumb money” isn’t that dumb after all, and 2) “smart money” is taken to the woodshed. First, let’s take a look at what Wall Street has long termed ‘dumb money’, the private investor. Most of these people are like you and me – they invest most of their savings in long-term stocks for retirement, while playing with a small portion for fun. And aside from the cheerful absurdity of r / WallStreetBets, most retail investors often know what they’re buying (even if they get the valuations wrong at times). The top 100 Robinhood stocks represent a wide variety of consumer-related companies that have grown in both real-world popularity and stock-related fame. Second, the GME fiasco has revealed ‘smart money’ for the absurd bets they sometimes make. While a long-short hedge fund can help investors flatten their gains, they are often as bad as what they call ‘stupid money’ to cover losses. For example, Melvin Capital lost 30% of its net worth in the first three weeks of January. But it took another six days (after the stock had gained another 250%) for the hedge fund to finally relinquish its gigantic position. Since then, other hedge funds have joined in to replace Melvin in this high-stakes game of ‘pass the hot potato’, as if trying to prove that hedge funds will always try to make more money from mainstream investors if they believe the odds are right to be. GameStop also exposed the revolving door behind hedge funds and market makers. When Ken Griffin’s Citadel LLC, a $ 35 billion fund, rescued Melvin Capital, Twitter users quickly pointed out that Citadel is also a market maker serving none other than Robinhood. Where are you going? Investors looking to drench the financial system would do well to buy index funds and stick with them forever. You may not get the happy joy of seeing a hedge fund explode, but companies like Citadel that rely on retail money will see revenues dry up. But for those who want to invest wisely, consider this. With the renewed power of retail investors, you can expect short sellers to think twice about selling a business. Andrew Left of Citron Research has already vowed never to publish short-seller reports again. Other hedge funds are watching nervously. That means hot stocks will move faster than ever. As Reddit users learned this week, it doesn’t take much to influence stock prices when only marginal trading counts. And because no one is willing to short-sell stocks in the face of an angry crowd, price spikes will become more common. You can expect many winners and losers. After all, the stock market is usually a fixed-value game. But for long-term investors, the same truth still holds true: The road to consistent wealth has always been to buy a group of high-quality investments bought at a reasonable price. Practice that discipline with your core portfolio, and you’ll have a blast reading with me about the trials and tribulations of others on r / WallStreetBets. At the date of publication, Tom Yeung held (neither direct nor indirect) positions in the securities mentioned in this article. Tom Yeung, CFA, is a registered investment advisor with a mission to bring simplicity to the world of investing. More from InvestorPlace Why Everyone Invests in 5G All WRONG Top Stock Picker Reveals Its Next 1,000% Winner It doesn’t matter if you have $ 500 in savings or $ 5 million. Do this now. The post Reddit’s r / WallStreetBets just took down a hedge fund. You will love what comes next. first appeared on InvestorPlace.