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Jeff Meli Ryan Preclaw

Episode 32

Jeff Meli in conversation with Ryan Preclaw

Will retail investors continue to upend the stock market?

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Reddit chat r/wallstreetbets (WSB) has dominated attention in recent weeks with much of it concentrated on the dramatic moves in the US video game retailer GameStop*. The power of social media platforms has enhanced retail investors’ ability to coordinate and drive market activity, affecting valuations and volatility.

In episode 32 of The Flip Side podcast series, Jeff Meli, Head of Research, and Ryan Preclaw, Head of Investment Sciences, debate whether retail investors will continue to upend the stock market, what this could mean for institutional investors’ approach to short-selling, and the role of regulation in ensuring that the markets play their appropriate function.

  • Jeff Meli: Welcome to this episode of Flip Side. I’m Jeff Meli, the Head of Research at Barclays. I’m joined today by Ryan Preclaw, who’s our Head of Investment Sciences, one of the teams focused on integrating modern data methods and alternative data into our investment research. Thanks for joining me, Ryan.

    Ryan Preclaw: Thanks for having me, Jeff.

    Jeff Meli: Today we’re going to talk about the latest fervor that’s gripped the stock market, the wild swings in some individual securities by retail investors who are loosely coordinated on social media platforms like Reddit.

    Ryan Preclaw: The obvious stock that gets attention here is GameStop, and that has been one of the most volatile and highest profile names affected. There are more investments that have experienced some wild swings associated with this phenomenon. AMC, Blackberry, and it’s even been tied to big moves in the price of silver and Dogecoin.

    Jeff Meli: Yes, this trend has generated an enormous amount of attention from investors obviously, but also pundits, politicians, even regulators. Now originally the focus was on what was happening, particularly as the prices of a few stocks were rising very rapidly, but I’m actually more interested in any longer-term implications from this experience.

    Ryan Preclaw: So Jeff, I think that from this we will see an increasing role of retail in valuations and volatility, and that’s going to affect prices, of course, but also how institutional investors have to manage their portfolios, and I think it’s going to particularly affect how investors need to approach short selling.

    Jeff Meli: Ryan, I see the retail angle here as just the most recent in the long history of fads or bubbles. They play out for a short time. It’s almost as if every generation of investors needs to experience the high and the inevitable crash for themselves. I actually think the longer-term implications are going to be on regulation, so how should we rethink the protections and guardrails placed around the system.

    Ryan Preclaw: So before we get into the debate, I think it’s worth briefly reviewing what’s happened. So GameStop is a company that mostly sells video games in their brick and mortar stores. It’s been under operating pressure for a long time, and that pressure accelerated during COVID.

    So it started 2020 with revenues that were already 30 percent below their all-time peak, and then the consensus is that during the last year they fell another 17 percent. Now because of those operating challenges it was heavily shorted, and around the middle of January GameStop added three new board members that were recommended by an activist shareholder. The stock price immediately started making these huge jumps really going up every day, and the stock went from $18 to $350 in only a couple of days.

    Jeff Meli: That activist pressure was potentially going to drive a transition into ecommerce, which of course could be a path to reimagine what was formerly a brick and mortar business. And just to be clear when you were talking about hedge funds being short a stock that means that they make money when the price goes down and they lose money when the price goes up.

    Ryan Preclaw: That’s right. Now, as it started rising, the stock also became a top focus in social media discussions about stocks and the stock market. Now particularly on the WallStreetBets channel on Reddit some of the members of that group had already pitched the fact that the stock was heavily shorted as an opportunity, so they started buying both outright and via options in order to leverage their positions.

    The stock started rising quickly. Then that fed on itself as it drew first more investors in and then because it started to force some of the short sellers to cover their positions, which means they started to buying, too, to close out those shorts.

    Jeff Meli: Right, but after a pretty fierce rally it’s not fallen a good chunk of the way back towards its original price. Ryan, to me this is really an old story. It’s one we’ve seen in various forms throughout history, albeit this one has some modern twists like the role of social media.

    So you get some hype on a particular investment. Investors get excited about the potential to make a quick buck. You combine that with some leverage, in this case using options. And the result is big short-term price swings, but eventually reality intrudes and the bottom falls out.

    So this is the classic finance example that people learn about in business school, about the Dutch tulip bulbs from the 1600s, but there’s lots of other examples out there, too, that are recent. So look at the dot com bubble as an example. We didn’t have Reddit back then. Instead we had RagingBull.com, but that had 500,000 users and 12 million daily posts in 2000 when there were only one-third as many internet users as there are today.

    Now in some ways we’re lucky that the volatility we just experienced was concentrated in only a few stocks and lasted only a short time.

    Ryan Preclaw: Yes. In some ways I agree that this is nothing new in terms of the basic pattern. It’s the old shoe shine test when even these very casual investors are really deeply into something it’s a good indicator that it’s the top. It’s just that in the past all of that enthusiasm used to travel over the phone and through personal conversations. They just weren’t out there on the internet for us to count.

    Jeff Meli: So you think this is much to do about nothing?

    Ryan Preclaw: Well not quite. So this particular trade might be starting to fade away, but we’ve actually seen the influence of WallStreetBets on Reddit well before this particular GameStop example. Now it wasn’t quote as eye-popping, but the financial media was writing about it nearly a year ago.

    And as a result of GameStop we’ve seen a huge increase in participation on at least that particular forum. Participation has grown more than exponentially. They’ve added, what, something like four million users just in January after starting this year with only two million users.

    So I think this could become a recurring theme. We've got stocks, commodities, any other form of investment gets hit with this spotlight, and suddenly volatility spikes and fundamentals get put to the side.

    Jeff Meli: I suspect that a lot of the interest in this was because there’s just not that much else to do in the current environment. Our spend trends analysis of U.K. payments using Barclays credit and debit card data shows pretty clearly that payments into brokerage accounts go up during lockdowns, but I think the interest will fade once everyone realizes that the bubble inevitably pops.

    So the whole world saw the rise and the fall of the stocks under question here. It became too public. It wasn’t in the background like it was early in 2020, and I feel like for retail investors it’ll be fool me once, shame on you, fool me twice, shame on me.

    Ryan Preclaw: Well Jeff, I think to start with you may be a little too optimistic about how quickly people can learn these lessons and how generally they're going to expand something that they learned here to other experiences.

    Now I also think you're defining the role of retail a little too narrowly. So as you know our strategy team under Maneesh Deshpande has done a lot of work studying the rising influence of retail investors. Retail is big net buyers of 2020’s biggest winners, and that includes the big, mega-cap tech stocks in ecommerce names.

    They're also a huge force and a growing force in options, so they're now buying options in big enough size to influence the market directly. And that is also having spillover influence on regular equity prices of the underlying securities.

    Jeff Meli: Ryan, it’s a good point that the valuation of some of the high-flying stocks, the big, mega-cap names may be influenced by a larger presence of retail investors. Now, of course, we don’t know the counterfactual. Maybe the current prices are the quote/unquote, “right prices.”

    We don’t – we don’t really know, but I also think there’s a big difference between suggesting that some stocks are a little bit over-valued because of some particular source of demand versus generating over 100 percent returns a day multiple days in a row and then having the prices collapse just as quickly.

    Ryan Preclaw: Yes, I think both of these are going to force institutional investors to rethink their approach, and in fact those two phenomenon are linked. So when the prices of certain stocks move in response to retail flows it could be natural for institutions to want to take the other side, especially if they think that the prices have moved a lot away from their fundamentals.

    Jeff Meli: Yes, well that was definitely behind a lot of the short positioning that we saw on GameStop.

    Ryan Preclaw: Yes, but what social media facilitates is a form of coordination amongst those small investors, and that I think is what’s new to this episode. It really changes the risks associated with taking the other side of that retail trade.

    Jeff Meli: Yes, I guess you're referring to a short squeeze. So since retail investors are typically long stocks the other side of the position is to be short like we said the hedge funds were in some of these high-flying names.

    That's actually a reasonably well understood (route) to short squeeze. It's one that sophisticated investors are aware of and manage, although of course, short squeezes do still occasionally occur.

    Ryan Preclaw: Right, but all of this retail activity means that they could become more common, and that risks associated with shorting that stock is going to need to be rethought.

    Whatever you thought the chances were of getting into a short squeeze before, if you know that six million people on Reddit could get together and start to buy it's just going to change the calculus that you have to make in terms of what the risk is of that actually happening. And that could just meet that institutional investors become less of a counterweight to the influence of retail, so that that influence of retail on prices grows.

    Jeff Meli: Yes, that's one possibly, Ryan. I guess another is that sophisticated investors start mining the social media feeds for information about the next trendy stock. So, we've already seen interest in our approach to scraping these feeds where we use some of the modern techniques like natural language processing to see how trends are evolving.

    Ryan Preclaw: Yes, now I'm sure that's true and I'm sure there are people out there doing it. On the other hand, we've actually found it's pretty hard to get ahead of these trends, at least from what we can see so far. You do see them happening very clearly in real-time, but by then the prices are already moving and if you've got a big short position it might be too late to unwind it or at least to unwind it very easily.

    I think the other issue that differentiates this current environment from prior (pre-areas) is that trust in the system is pretty low amongst these retail investors. Actually one of the specific draws of the GameStop trade I think was that it was a chance to show off some of those big hedge funds and stick it to the Wall Street establishment. People were posting on Reddit that they were happy to lose some money if they could be part of that movement.

    Jeff Meli: I have two comments on that. First, the trust in the system goes both ways. We've already seen this trend get co-oped by bad actors. Our analysis suggests that a large number of the posts on these feeds are from bots.

    That's basically someone automating the process of making a post in an effort to try to generate a specific outcome, in this case what I'd call an old fashioned pump and dump. So, you drive the price of a stock up so that you could sell it – sell it to someone before it collapses.

    I think that folks that joined what they thought was going to be sort of a pure community intending to be a clubhouse, talk about trade ideas, maybe go after some established hedge funds by squeezing some shorts, they're less likely to be interested in being a pawn for some scheme driven by a bunch of bots.

    Ryan Preclaw: Yes, it is entirely possible that some of those original users might exit, but there really are a lot of people on there now. Like I said, the number of members has tripled in January alone.

    Jeff Meli: My second comment, Ryan, is why is everybody so down on short-sellers?

    Ryan Preclaw: Now that is something I think we agree on. I also don't thing that there's anything inherently evil about short selling. It fulfills a necessary function in terms of making it easier to figure out what the right price is supposed to be.
    But, that's another reason to think that these changes will have an effect on markets. Amongst all the commentary from pundits and politicians, there certainly wasn't a lot of sympathy for the losses that were being taken by hedge funds that had been short.

    Jeff Meli: Yes, I don't think we should be celebrating one group of investors concentrating their positions specifically in an effort to cause financial losses for another group of investors, regardless of who the victim is there. That also sounds like a recipe for reducing trust in the system.

    And you know hedge funds manage money for all sorts of end investors, pension funds, endowments, universities, but actually I think that's a nice segue into where I do see some lasting changes coming, which is potentially on regulation. I think that we might have to rethink the guardrails put in place to protect retail investors from the potential perils of some of their activity.

    Ryan Preclaw: Yes, that is interesting because I (would say) that the initial comments were the exact opposite. There's a pretty serious blowback when a few of those brokerages restricted trades.

    It was from users, it was from politicians, it was from pundits in the media, and it turns out that all of those restrictions were really due to costs that brokerages were incurring, mostly from collateral calls associated with those trades.

    So a lot of the commentary, or at least a lot of the early commentary about the restrictions being some sort of pro Wall Street conspiracy seem in retrospect like they were a bit too wild compared to what turned out to be sort of boring technical reality.
    Jeff Meli: It is true, Ryan, that the initial push was pressure to allow more of these trades and not to restrict them. But, I take the view that this whole episode just set up the retail investors who joined the party too late to lose serious money.

    So sure, early on in the process it may have squeezed some hedge funds out of the market and their losses were the gains for some of these early adopters in this trend, but at some point the price of GameStop got over $480, that wasn't hedge funds buying it at that point, that was almost surely other retail investors. They have now lost something like 70 to 80 percent of their money depending on the latest prices. That's no joke.

    Investing isn't really supposed to be a parlor game and regulators actually have a stake in ensuring that the markets play their appropriate function. I'm a little confused why the sort of populist impulse, which you were hearing from both sides of the aisle, by the way, was to effectively cheer the (lemmings) on while they charged off the cliff.

    This may have started as a David and Goliath story, but that's not where it ended and in the end the losses are really coming now from other retail investors who joined too late.

    Ryan Preclaw: Right. And Jeff, some of that may just be the timing of the kinds of comments that we're talking about, because I can tell you that looking at the posts on Reddit, WallStreetBets forum now, there are certainly lots of people on there talking about the big losses that the incurred when they bought at the wrong time and then now seeing the price fall down.

    I do think that there's still a risk here for regulators that it's going to end up look like they've ridden to the rescue of Wall Street and I think that goes along with the trust issues that we were talking about earlier. You could have a hard time convincing people that you are saving them from themselves.

    Jeff Meli: Look, on the one hand people should be able to buy or sell whatever stocks they want and I do think that's an important principle. I think the focus really should be on the use of leveraged instruments and sophisticated investment strategies.

    So, for example, in this instance we think options played a big role in the run-up. Options obviously give you the potential for very high returns if things work out, they can also generate excessively large losses if they don't.

    And we've seen leverage used inappropriately by unsophisticated households in the past. So for example, during the housing crisis we think that highly structured mortgages that had a lot of embedded leverage led to some folks losing their homes and arguably they didn't understand all of the structural leverage that they were taking on when they took out those mortgages in the first place.

    Ryan Preclaw: Right. And it's also true that margin accounts, which are what you need to have to be able to trade options are already more tightly regulated than just a regular account. And so, it might just be the case here that when regulators come and look at this they see that they've already gotten the example of regulating these things more aggressively and they're just going to have to lean into that.

    Jeff Meli: It will be interesting to watch this play out, particularly as we have new leadership of the SEC and other financial regulators, that's a consequence of the new administration.

    Well thanks for joining this episode of the Flip Side. Clients of Barclays can read “Measuring r/WallStreetBets” and “Bubble trouble or storm in a teacup”, our latest take on these trends, available on Barclays Live.

Authorised clients of Barclays Investment Bank can log in to access related reports on Barclays Live:

*Note: GameStop (GME) is not covered by Barclays Research

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About the analysts

Jeff Meli is Head of Research within the Investment Bank at Barclays. Jeff joined Barclays in 2005 as Head of US Credit Strategy Research. He later became Head of Credit Research. He was most recently Co-Head of FICC Research and Co-Head of Research before being named Head of Research globally. Previously, he worked at Deutsche Bank and JP Morgan, with a focus on structured credit. Jeff has a PhD in Finance from the University of Chicago and an AB in Mathematics from Princeton.

Ryan Preclaw is the Head of Investment Sciences, a group that creates investment insights by combining alternative data, data science, and traditional research. Previously, he was a Director in Credit Strategy, where he focused on special situations, event-driven strategies, and industries facing fundamental transitions. Prior to joining Barclays, Ryan worked as an economist at NERA Economic Consulting and London Economics International. Ryan received his MBA from the University of Chicago in 2008, his MA from Western University in 2001, and his BA from the University of Alberta in 2000.

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