Why Are Soaring Meme Stocks Driving Down Dow And S&P 500?

The theory behind stock prices is that they reflect all the information that investors use to project a company’s future cash flows in today’s dollars.

If that theory had any validity, shares of meme stocks — such as GameStop GME , AMC Entertainment Holdings AMC  and others that are soaring — up over 50% each in January 29 trade, according to CNBC — would not be going up so much.

Nor would the broader market indices plunge — The S&P 500 and NASDAQ NDAQ fell nearly 2% on the day — when these stocks soar — or vice versa.

But you only have to look at this week’s trading to realize that something else is going on here — something that can be better understood by answering four questions (with my short answers in italics):

  • Why did investors bet so heavily that companies like GameStop and AMC would go down? Poor business strategies and shaky finances.
  • Why did the stock prices of these heavily shorted companies soar? Coordinated call option buying by redditors triggered a buying panic.
  • Why did Robinhood and other retail brokers limit retail trading in these stocks? Stock clearinghouses demanded more collateral than the brokers had on hand.
  • Why are the broader markets plunging as these heavily-shorted stocks soar? Short sellers are liquidating their holdings to raise the cash they need to repay their stock loans before shares rise further.

I do not know how this will end. But a potential weakness in the system could be a lack of sufficient collateral to satisfy the stock clearinghouses.

Let’s take a closer look at these four questions.

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Why Are GameStop and AMC So Heavily Shorted?

To profit from a company that’s in trouble, short sellers borrow shares from a broker, sell them in the open market, and hope that the stock price drops so they can buy it back at a lower price and pocket the difference.

If the stock price goes above where it was when the short seller borrowed the shares, the broker will demand immediate repayment — forcing the short seller into the market to buy back the shares to repay the broker. In that case, the short seller loses money — the amount is limited only by how high that stock price can go.

GameStop — 138% of its shares were sold short earlier this month — and AMC (38% short interest) both looked to short sellers as over-valued.

Last September, GameStop looked like it had strong odds of going down. After all, its revenues were shrinking fast, it was burning through cash, and while it was aiming to compete with Amazon AMZN in the gaming industry, it lacked the capabilities needed to do that well.

Meanwhile, last month I saw plenty of reasons to be concerned about AMC — which operates a chain of movie theaters. After all, for the first eleven months of 2020, domestic box office was about $2 billion — a whopping 82% below the $11 billion industry average over the previous five years.

AMC had an awful third quarter of 2020. According to its CFO, domestic attendance was 97% below the prior year’s third quarter. At the end of September, AMC had $418 million of cash ($11 million of which is restricted) while it burned $324 million in cash during the quarter.

The good news since? On January 25, AMC has raised $917 million in a bond sale, according to Bloomberg. Is that enough to keep it going until people return to movie theaters? I don’t know.

Since last September, GameStop shares have popped 2,670% while AMC stock is up 245% since I wrote about it last month.

Why Did Their Stock Prices Soar?

Redditors bought call options on shares of these heavily shorted stocks. Call options give their owner the right — but not the obligation — to buy shares of a company at a specific price and future date.

If the market price on that date is below the strike price, the call option owner loses the amount they paid for the option. If the market price on the exercise date is above the strike price, the owner of the call option exercises the option and profits to the extent that the market price is higher than the strike price.

The call option enables its holder to control more shares than they could if they bought them directly. Moreover, the market maker who provides the call option is seeking to minimize exposure to price movement by buying stock in the company on which the option is written, according to the Wall Street Journal.

As noted above, with so many shares of these companies sold short, the rising prices prompt the brokers to demand that the short sellers buy shares in the open market — as the price is rising — to repay the shares they borrowed from the broker.

Why Did Robinhood and Other Retail Brokers Limit Trade In These Stocks?

When a retail investor buys stock, two days elapse between when the buyer buys the shares and the seller delivers them to the buyer. As Bloomberg explained, if I buy 100 GameStop shares for $400 each on Monday and the shares drop to $20 on Tuesday, when Wednesday comes along I do not want to pay you $400 for each share which the market now values at $20 apiece.

The risk that the buyer will not want to complete the transaction two days later is handled as follows: the retail broker works with a clearinghouse — the Depository Trust & Clearing Corp (DTCC). During that two day period, the retail broker — e.g., Robinhood — must post collateral with DTCC.

The bigger the gap in price between the stock price on day 0 and day 2, the more collateral must be posted. DTCC told Bloomberg that “by the end of [January 28] industrywide collateral requirements jumped to $33.5 billion, up from $26 billion. Brokerage executives rushed to figure out how to come up with the funds.”

Robinhood scrambled to meet the clearinghouse collateral requirements — drawing down “at least several hundred million dollars” from its bank credit lines and raising over $1 billion from its existing investors, noted Bloomberg.

Simply put, all this high volume, high volatility stock price movement creates the need for significant increases in collateral to settle the trades. It would be bad for the functioning of the market were DTCC to demand more collateral than retail brokers can quickly raise.

Why Are The Broader Markets Plunging As These Meme Stocks Soar?

Meme stocks like GameStop and AMC are moving inversely with the broader markets. When the brokers open up trading in these stocks, their prices soar. That forces short sellers to buy shares in the open market at ever higher prices.

My theory is that the short sellers get the funds to make these loss-producing purchases by liquidating profitable holdings — which causes the broader market indices to fall.

Conversely when Robinhood and other brokers throttle buying in these meme stocks, their shares plunge and investors look to buy the broader indices which fell for reasons unrelated to any change in the component companies’ cash generating prospects.

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