Dumb and Dumber – a screwball comedy starring Jim Carrey and Jeff Daniels – is an amusing (if mindless) way to spend an hour and a half.
Recently, Dumb and Dumber has been playing on Wall Street.
The ending, however, is likely to be more predictable, less funny and – to millions of new traders – a lot more expensive than a couple of movie tickets.
Let’s start by identifying our main characters…
Dumb: Hedge fund managers and other investors who shorted already-beaten-down stocks with substantial short interest, knowing full well that they left themselves vulnerable to a classic short squeeze.
Dumber: New investors on Reddit and WallStreetBets who just arrived at the party and are trying valiantly to keep the buying mania going, against all logic and common sense.
Not to mention the law of gravity.
Last week, for example, GameStop (NYSE: GME) soared 400%. AMC Entertainment (NYSE: AMC) rose 278%. While a handful of other stocks with heavy short interest rose a mere 50% to 120%.
Many on social media characterized this as a classic “David vs. Goliath” moment, where tens of millions of small investors outmaneuvered “the suits” on Wall Street.
And it’s true. At least so far.
The traders – some sophisticated, some brand-newbies – deserve credit for seeing opportunities and taking advantage of them.
Opportunities, I’ll point out, that hedge funds have seized themselves for decades, as they busted one another’s short positions.
Short interest is public information and updated regularly. And early investors here were plenty savvy.
The “dumber” ones are the traders who just arrived at the party… and the ones who plan to stay a long time.
They will be badly hurt when these stocks come tumbling back to earth.
As. They. Will.
Wall Street Journal columnist Holman W. Jenkins Jr. noted over the weekend, “Day traders might be able to drive GameStop shares temporarily from $20 to $483. They can’t make GameStop a $483 company.”
The same can be said of AMC, BlackBerry (NYSE: BB) and other highfliers with heavy short interest.
Calling these shares “overvalued” is a bit like calling the sun “hot.”
Yet social media warriors continue to egg each other on with inane comments like “Hold the line!” and “Buy high, hold forever.”
Short selling is nothing new, of course. It has been going on for centuries.
Nor is it a nefarious activity.
Short sellers provide liquidity, narrow spreads and help keep inflated stock prices in check.
But betting against a stock where the entire float has been sold short – as some hedge funds did – is a classic example of asymmetrical risk.
Lots of downside. Very little upside. (After all, the most a stock can fall is 100%.)
Early investors realized that as short sellers were forced to “buy to cover” to meet margin calls it would drive these shares higher.
But now many of these stocks have risen to levels that can’t be justified by traditional measures of corporate value, like sales, earnings or book value.
And just as it’s risky to bet against a heavily shorted stock that is scraping the bottom, so is it silly to plow fresh money into overvalued shares that have recently skyrocketed in value.
Yet try telling that to the unruly masses intent on getting rich in the next few hours. Or by Wednesday at the latest.
If nothing else, they are providing entertainment for the rest of us.
And – who knows – they may eventually have an epiphany, like Jim Carrey’s character at the end of Dumb and Dumber:
“Hey… the town is back that way!”
Click here to watch Alex’s latest video update.