Why Did Everyone Buy Gamestop?

In early 2021, markets were still reeling from the ongoing COVID-19 pandemic and its effects on economic activity. In the middle of that turmoil, though, an army of retail investors turned the underperforming stock of video game retailer GameStop (NYSE:GME) into the most famous of what have come to be known as meme stocks.

How did GameStop’s surge happen, and just why was everyone buying GameStop at outlandish prices in January of 2021?

The Rise of Meme Stocks

Before looking at GameStop specifically, it’s important to understand the environment in which the meme stock’s rise took place.

In 2020, the combination of stay-at-home orders, high unemployment and government stimulus checks contributed to a massive surge in day trading. This was also made possible by the rise of platforms like Robinhood that catered to retail investors.

Going into 2021, the market was saturated with relatively inexperienced investors looking for large, short-term gains. GameStop, as it turned out, would be the stock that caught the most attention from this group.

The GameStop Thesis and How it Played Out

Although GameStop has since become iconic as a meme stock inflated by senseless speculation, it’s important to recognize that there was something along the lines of an investment thesis behind the company early on.

In 2020, activist investors were buying shares of GME at rock-bottom prices. The hope among these investors was that the company could pivot from physical retail to selling digitally. With its already well-known brand in gaming sales, the reasoning was that GameStop could prove massively undervalued if such a pivot was successful.

One of the first investors to lay out this case was Michael Burry, best known for his accurate prediction of the subprime mortgage crisis.

Burry had bought 3 percent of GME in 2019 before the events of 2020 added further headwinds to the company. His Scion Capital Management fund ultimately sold that stake in Q4 of 2020. By then, however, activist investor Ryan Cohen had purchased an even larger 10 percent stake in the company.

The real story of GameStop, however, began with a belief that the stock was primed for a short squeeze. Because of its fragile position, GameStop became a major target of short sellers in late 2020 and early 2021.

At one point, more than 140 percent of the stock’s float was sold short. This created a set of circumstances under which short sellers would have to buy aggressively to cover their positions if stock prices rose.

Beginning in January 2021, exactly such a rise in share prices began to happen. Cohen joined GameStop’s board alongside two other members who specialized in eCommerce. GME shares closed at $17.25 on the first trading day of 2021, but they rose to over $38 less than two weeks into the new year as investors responded positively to the company’s apparent change in direction.

From here, a virtuous cycle began between retail investors on one side and institutional short-sellers on the other. The retail investors, organizing largely on social media platforms, recognized the need for institutional shorts to cover their positions.

By driving prices up through concentrated buying, these retail investors were able to force the shorts to pay higher and higher prices for shares. The result, as long as demand remained high and liquidity remained low, was an almost unprecedented increase in GME share prices. On January 28th, the stock peaked above $500 per share.

The deflation of this bubble, however, happened just as quickly. Two of the largest short sellers, Citron Research and Melvin Capital, were able to cover their positions, thus bringing down pressure on the shorts. Robinhood also briefly halted trading in GME. While a second spike occurred later that year, prices came down steadily afterward.

Today, GameStop trades at just over $11 per share, and investors who bought it during the early 2021 run-up and failed to get out while prices were still rising have taken enormous losses.

The Role of WallStreetBets

It’s all but impossible to untangle the story of GameStop’s surge from the Reddit forum WallStreetBets.

As early as mid-2020, prominent user Keith Gill had begun making posts on the amateur investing forum about the potential upside of GameStop, especially in the event of a likely short squeeze.

Gill’s influence on the eventual momentum behind GME was so large that he was eventually asked to testify during a Congressional inquiry into the volatility surrounding GME.

WallStreetBets was among the major social media channels that drove retail investors in GME shares and options. Driven by users like Gill and cheered on by peers, retail investors threw huge sums of money at GameStop shares and, in the parlance of the forum, held on with “diamond hands.” Holding was essential to further elevating prices, as low liquidity required shorts to make ever higher bids for shares.

It’s interesting to note that the actions of the WallStreetBets community were also to some extent driven by ethical objections to short sellers. The argument, often cited on the forum, was that short selling constituted a form of market manipulation.

Though the same argument could be and has been made about the synchronized activity of the retail investors, WallStreetBets often framed itself as a group of average individuals taking on Wall Street’s smart money. In a sense, the short squeeze became as much about inflicting losses on hedge funds as it was about realizing actual returns.

It’s also important to understand how much the WallStreetBets traders differed from traditional investors. Users of the forum often joked about losses and displayed what would traditionally be thought of as extremely irresponsible financial behavior.

In one prominent example, a young German software engineer borrowed $75,000 to trade alongside the WallStreetBets community and promptly lost the majority of it.

So, Why Did Everyone Buy GameStop?

GameStop attracted attention from popular Reddit forum WallStreetBets that led to a virtual crowdfunding purchase of GameStop shares, driving the price higher.

Prior to that, GameStop investors believed the shares could generate real returns. Cohen’s activist investment had the potential to turn the company around. Even earlier, Burry, a veteran Wall Street contrarian, had seen latent value in the business.

Combined with the heavy short activity, there was a legitimate argument to be made for buying GameStop before the rush started. Even early WallStreetBets investors, including Keith Gill, purchased the stock for basically sound reasons.

Past a certain point, however, a combination of irrational exuberance and crowd mentality took over. Day traders attempting to drive prices artificially higher, squeeze short sellers and saddle hedge funds with losses bought with little or no regard to the value of the underlying business. GameStop truly became a meme stock, with most of its buying activity driven by the persuasive power of social media.

Another driver was the well-known phenomenon of fear of missing out (FOMO). As GameStop’s share price surge became national news, retail investors saw their peers making enormous on-paper returns in a matter of days. This nudged many into buying the stock in an attempt to capture similar gains for themselves, even though the prices they paid were far beyond any reasonable valuation for the company itself.

Ultimately, GameStop proved one of investing’s most famous axioms: “In the short run, the market is a voting machine. In the long run, it’s a weighing machine.” This observation was made by Benjamin Graham, the intellectual founder of value investing and Warren Buffett’s personal mentor.

GameStop surged on market sentiment as investors voted with their dollars. Once the business was weighed according to its actual value, however, share prices quickly returned to more reasonable levels.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.