The mistake of betting that a stock will fall, then getting crushed when it doesn't, goes back a long way.
In August 1719, as the first stock market bubble in history was gathering steam, the mercurial Scottish financier John Law made a bet with Thomas Pitt, the earl of Londonderry and uncle of the prime minister, William Pitt, that the price of British stocks would fall in the year ahead. Law was at that time the master of the French financial universe, the man in control not only of the Mississippi Company, which held a monopoly on trade with the French territory of Louisiana, but also of the Banque Royale, and hence the French money supply. He was long France, short England.
Law sold 100,000 pounds of British East India Company stock short for 180,000 pounds (that is at a price of 180 pounds per share, or 80% above face value) for delivery on Aug. 25, 1720. The price of the shares at the end of August 1719 was 194 pounds, indicating Law's expectation of a 14-pound price decline.
At first, Law's "long France" trade was all that seemed to matter. Shares in his Mississippi Company soared by a factor of 20, from 98% of their face value to 1965% in November 1719. But at that point the Mississippi bubble burst. Within a year, the stocks were down to 200%.
To compound Law's woes, he was also on the wrong side of a short squeeze. Far from declining, by April 1720 the price of East India stock had risen to 235 pounds, and it continued to rise as investors exited the Paris market for what seemed the safer haven of London (then in the grip of its own less spectacular South Sea Bubble). By June the price was at 420 pounds, declining only slightly to 345 pounds in August, when Law's bet fell due. As much as the bursting of the French bubble, it was his big, bad short that ruined Law.
Contemporaries agreed that Law's grand financial experiment had been a disaster. From London, Daniel Defoe was scornful: the French had merely "run up a piece of refined air." So incensed was one Dutch investor that he had a series of satirical plates specially manufactured in China. The inscription on one reads: "By God, all my stock's worthless!" Another is even more direct: "Shit shares and wind trade."
As far as investors in Amsterdam were concerned, the Mississippi Company had been trading in nothing more substantial than wind. As the verses on one satirical Dutch cartoon flysheet put it, Law's scheme had been "wind and smoke and nothing more."
Fast forward just over three centuries, and wind and smoke are back in financial markets in ways John Law's critics would immediately recognize. It was already obvious last summer that the Covid-19 pandemic was creating conditions of irrational exuberance in U.S. financial markets. Near-zero interest rates, checks from the government and shelter-in-place orders: these, along with the no-commission trading made possible by online platforms such as Robinhood, had opened the gates of the stock market to a new generation of financial barbarians.
The rise to fame last year of Dave Portnoy was just one symptom. Portnoy boasted of his two rules for making money in stock markets. Rule one is that "stocks only go up." Rule two: "When in doubt whether to buy or sell see Rule One."
Coarse, sunburned and perpetually dressed for a sophomoric spring break, Portnoy brought to investing what Donald Trump brought to politics: the sweaty smell of populist excess. On the other side of the big, bad short were "the suits" — professional hedge fund traders such as Andrew Left of Citron Research and Gabe Plotkin of Melvin Capital Management LP. Like a lot of smart guys last year, Left and Plotkin were betting that the stocks of traditional bricks-and-mortar retailers like GameStop Corp. or Bed Bath & Beyond Inc. would fall. After all, weren't they on the wrong side of both technological change and coronavirus lockdowns? Quarterly disclosures made those short positions public.
It wasn't Portnoy but "u/Jeffamazon" who four months ago proposed "The REAL Greatest Short Burn of the Century" in a Reddit post to the r/wallstreetbets group. The argument was simple: The scale of the short positions against GameStop was much too large in relation to the amount of stock available to be traded. "GME'S ACTUAL SHORT INTEREST IS OVER 110%," wrote u/Jeffamazon. "Shorts are beyond trapped in their position. … GME's balance sheet is healthy with $100M in net cash … so they aren't going bankrupt anytime soon."
"Thanks to MMs [money managers] literally not using their brain and relying on ze maths to configure their entire business, we can take advantage of them sleeping at the wheel for a few seconds." But the stated rationale for this classic short squeeze was not purely financial. As befits a populist insurgency, it was to deliver "a kick in the shorts' teeth" because "the only way to beat a rigged game is to rig it even harder."
For journalists and politicians also spending way too much time indoors (just spending it less lucratively), this was an irresistible story. While they had been appalled by a mob of several thousand MAGA and QAnon types storming the Capitol, the political class was enchanted by the spectacle of two million subscribers to wallstreetbets storming Wall Street itself.
The story found its shaman in the person of Keith Gill, a dude in a red headband who goes by the name "Roaring Kitty" on Twitter and something unprintable on Reddit. The foot soldiers of this insurrection were exemplified by the Reddit subscriber who commented on Jeffamazon's post: "I don't understand any of it, f*** it im in."
This was a movement, gushed the Wall Street Journal, of "ordinary investors, stuck at home in the pandemic, swapping tips and hatching trading strategies on online forums … often buying things Wall Street has bet against. Many tout their long-shot wagers with the expression 'YOLO,' or, 'You only live once.'"
Politico couldn't resist: "The Internet-driven populist sentiment that helped propel politicians to national office is now coursing through global markets … Some segments of the younger generation, flush with extra cash in part due to stimulus payments and weighed down by boredom during the Covid-19 pandemic, are looking to exact a measure of vengeance on big Wall Street hedge funds."
Any journalist who ventured to question this narrative — for example, my Bloomberg Opinion colleague John Authers — was soon sifting gingerly through an inbox full of invective: "How much did Melvin pay you to write this garbage? shill. Literally trying to protect an industry trying to fleece jobs from low income workers. Sleep well chump." And: "Plus 1 for the little guys." And: "The American dream and being able to make your own way. This isn't a casino. This is a riot." And: "Bloomberg defending the suits. Not surprised. They're just mad the rubes are in on the joke now."
As the mania grew in magnitude and spread to other uncool stocks — notably AMC Entertainment Holdings Inc. (the cinema chain) and BlackBerry Ltd. — and from there to silver and even to the joke cryptocurrency Dogecoin, the plot thickened. First, the short burn caught fire, as planned: From below $20 on Jan. 12, GameStop stock soared to above $347. AMC leapt from $2.29 to $19.90. But then Robinhood began to restrict trading in GameStop. "I've never been more convinced about market manipulation and hedge funds controlling the game than today," complained Portnoy to Fox News's Tucker Carlson. Ted Cruz chimed in.
Now, let's look at how the smart and the dumb money worked. Robinhood itself is one of a new generation of online brokers, catering to smaller "retail" investors — the outsiders. Robinhood's service is free to the outsiders. It gets paid by the insiders: among others, the market maker Citadel Securities LLC, part of Ken Griffin's Chicago-based hedge fund and financial services group, for funneling transactions its way. When Robinhood had to post additional billions to the National Securities Clearing Corporation in response to the volatility of stocks such as GameStop, the money — a cool $3.4 billion — was provided by some of the biggest names in venture capital, including Sequoia Fund Inc. and Andreessen Horowitz, as Gillian Tett pointed out last week, as well as the hedge fund Tiger Global. The key point about Robinhood is that if they really were outsiders, they would have blown up because they would have lacked that kind of support.
The conspiracy theory that Robinhood froze new purchases of GameStop shares in response to pressure from the hedge funds makes no sense, however. Citadel and Point72 Asset Management LP injected $2.75 billion into Melvin Capital on Jan. 25. Two days later, Melvin announced that it had closed out its short position in GameStop. It was only after that, on the 28th, that Robinhood froze new purchases of GameStop shares — not to help Melvin, which had already exited the trade and realized its losses, but to help itself.
Notice, too, who has been cheering on the "Gamestonk" — none other than the richest man in the world, Elon Musk, who has an ax of his own to grind when it comes to short selling. "Here come the shorty apologists," Musk tweeted on Jan. 28. "Give them no respect Get Shorty." One of the worst trades of 2020 was shorting Musk's electronic car company, Tesla Inc., a trade that has burned some famous fingers, notably those of Jim Chanos and — surprise! — Gabe Plotkin of Melvin Capital. The Tesla shorties lost more than $39 billion last year.
But if the biggest beneficiary of the Tesla short squeeze was the richest man in the world, this sure ain't the sequel to Occupy Wall Street. As for who the biggest losers of this episode were, that's easy: the outsider retail investors who bought GameStop or AMC at or near the top of the bubble.
Finally, remember the crucial role of access to credit. The Fed has created the conditions for multiple bubbles by promising zero rates and quantitative easing as far as the eye can see, and never mind if inflation goes above 2%. "Frankly we welcome slightly higher … inflation," Fed Chair Jay Powell said last month. "The kind of troubling inflation people like me grew up with seems unlikely in the domestic and global context we've been in for some time."
Maybe. But general asset price inflation and a rash of bubbles are pretty much guaranteed. Margin debt is currently growing at its fastest rate in 30 years — faster than in the dot.com bubble, faster than on the eve of the global financial crisis. When the first margin calls go out, needless to say, they will be to the little guys.
Of course, if Powell is wrong — if the combination of mass vaccination, post-pandemic euphoria, yet more fiscal stimulus and an overflowing monetary punchbowl does reignite inflation expectations, as Larry Summers warned last week — then all stock market investors, insiders and outsiders alike, may be in for a rude awakening. According to a recent and exhaustive analysis of long-term equity returns in 39 developed countries over the period from 1841 to 2019, there is "a 12% chance that a diversified investor with a 30-year investment horizon will lose relative to inflation."
That might not have surprised John Law. But in times like these, financial history offers the kind of perspective that all market participants — yes, even Dave Portnoy and Keith Gill — badly need and are mostly short of.
Niall Ferguson is the Milbank Family Senior Fellow at the Hoover Institution at Stanford University and a Bloomberg Opinion columnist. He was previously a professor of history at Harvard, New York University and Oxford. He is the founder and managing director of Greenmantle LLC, a New York-based advisory firm.
Disclaimer: This opinion first appeared on Bloomberg, and is published by special syndication arrangement.