Wall Street’s dirty secret went public this week. Fundamentals don’t always matter. Human beings are irrational.
Asset prices can bend the limits of statistics and common sense before cold logic takes over again. And once the market starts swinging like this, there’s not a lot of point in fighting the tide.
Just ask the hedge fund managers who sold troubled companies like GameStop Corp. (NYSE:GME) and AMC Entertainment Holdings Inc. (NYSE:AMC) short because, from an objective perspective, the stocks had nowhere left to go but down. In theory, those short positions were easy money. Most of my Wall Street peers had done the math and decided that GME was, at best, worth around $13 and fair value on AMC was $2.50 at best.
The stocks were stalled until a few market mavericks realized that the bears had gotten in over their heads. As long as enough people were willing to defy Wall Street consensus, the bulls could go on the offensive.
And when the bulls started accumulating these once-neglected companies, the short sellers soon got desperate. Shares they needed to cover their positions were no longer circulating around the market.
Desperate short sellers will pay ridiculous prices to limit their losses. A month ago, AMC was stalled at a lowly $2 per share and GME had trouble holding $18.
Here we are now with GME spiking above $400, and there’s no ceiling in sight. Should we laugh at the bulls for hanging around? Or were the hedge fund managers wrong?
‘Fair Value’ Is Situational
GME is the kind of stock that would horrify investors like Warren Buffett whose goal is to identify robust companies, buy in at a good price and hold on forever.
The used game business becomes less relevant every year as new consoles come to market and render old software obsolete. Every effort to change course has faltered.
Sales peaked in 2012 and are looking to deteriorate another 18% this year. Even in the best scenario, it’s going to take another 2-3 years to turn the trend around.
Meanwhile, the chain bleeds money most of every year. It is meaningless to even try evaluating GME on an earnings basis.
Break it up and sell off the assets, and the whole company is worth about $11 a share. Tack on another $1 for the business as a going concern, and you’re left with Wall Street consensus.
At $300, GME commands a sales multiple bigger than Amazon.com Inc. (NASDAQ:AMZN). While I am not a big fan of Amazon’s CEO Jeff Bezos, his company at least is profitable and growing at a reasonable rate.
Which company would you rather buy and hold forever?
AMC is an even gloomier story. The balance sheet shows negative book value of $49 per share and I don’t see a clear path toward the company ever operating profitably again.
Shut it down, break it up and shareholders are unlikely to achieve a good outcome here. But here we are, with the stock above $13 as the hedge funds reel.
I think that’s the lesson every professional trader needs to absorb here. AMC is not “worth” $13 to Warren Buffett, but if you’re a hedge fund desperate for shares at any price, $13 may even look like a bargain.
You can lose infinite money when a short position goes against you. That’s why my subscribers don’t short stocks when they want to bet on the downside.
We buy put options instead. The worst that can happen with a put is that your contracts expire worthless, which stings if you don’t have the right discipline in place.
(I’ve just rolled out a new capital management system for 2-Day Trader that’s working well. We squeeze out returns of about 50% a year by following these rules.)
The hedge funds, on the other hand, got greedy and they got lazy. They’re reaping the results now. And the retail traders using apps like Robinhood to accumulate “worthless” stocks are laughing all the way to the bank.
The Better Short Universe
Of course, I had to check out the system that the Robinhood traders are using. Believe it or not, they aren’t simply leaping onto the most heavily shorted stocks and waiting for the hedge funds to feel the squeeze.
GME was heavily shorted. AMC, on the other hand, didn’t even have enough short interest to trigger my automated screens.
If anything, the most heavily shorted stocks in the S&P 500 aren’t soaring because they just aren’t calling the Robinhood crowd to the party.
Dry cleaning company EVI Industries Inc. (NYSE:EVI), for example, would force the short sellers to buy back every share that comes to market in the next two months if they see the tide turning against them.
That simply hasn’t happened. Robinhood traders don’t care about dry cleaning. They’re really interested in buying brands they know as consumers and watching their money make a difference.
After all, many of the stocks that soared 100% or more this week aren’t heavily shorted at all. They’re shopping mall standards like Express Inc. (NASDAQ:EXPR) and headphone maker Koss Inc. (NASDAQ:KOSS).
While some hedge funds were betting against these companies, the “squeeze” is really more a matter of eager retail investors running with their own self-induced bullish urges.
When those urges fade and stimulus checks are spent, new buying interest will once again drop and these stocks will become dead money again. Institutional investors aren’t interested.
But in the meantime, these stocks can be a great ride. I’m considering adding a few of these hot money “meme” ideas to my Turbo Trader. Let me know if you’re interested.
Just remember that what goes up like a rocket can drop like a rock. If these valuations scare you, don’t worry about the market… but the outcome for these particular stocks is not great in the long term.
I’m talking about all of this on my Millionaire Makers radio show. Now there’s a podcast (Spotify)(Apple) as well to keep you focused on opportunities to build real wealth while avoiding obvious threats.