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  • For some reason, people are cheering the GameStop bubble as a victory for the retail investors.
  • Those retail investors are going to lose their shirts when this bubble pops.
  • Disconnecting stock prices from enterprise value leads to stupid outcomes.
  • This is an opinion column. The thoughts expressed are those of the author.

There is this bizarre narrative that the Reddit-driven GameStop stock bubble amounts to a way for ordinary investors to “stick it to the man” by causing some hedge funds to lose money. That those funds have been taught a lesson for selling short. Like GameStop’s current share price, this narrative doesn’t make any sense.

As of this writing, GameStop’s share price of around $340 gives it a market capitalization of roughly $23 billion. For comparison, Best Buy is worth $29.5 billion. But Best Buy is a far larger enterprise – it has about three times as many employees as GameStop – and more importantly, Best Buy makes money. It earned profits of $1.5 billion in 2019, while GameStop lost $471 million.

The original, putative theory behind the Reddit-driven push to buy GameStop was that the company had a good turnaround plan and would successfully shift to online game sales and start making money again. Whatever the merits of that theory when the markets valued GameStop at less than $1 billion, it’s out the window at a market cap of $23 billion. Even with a turnaround and rosy expectations of future profits from the GameStop business, the valuation of the company at this point is not justified by actual business fundamentals.

Retail investors getting caught up in a ridiculous bubble is not a win for the little guy

Given the divorce of the price from the actual underlying business, GameStop’s stock has been turned into a purely speculative asset, like a cryptocurrency.

Yes, some hedge funds lost money, and a lot of retail investors are up, for now. But they can’t access those gains until they sell. When they sell, the price of GameStop will fall, and the retail investors who bought late will lose money, because there’s no fundamental reason for other people to buy at such a high price.

And why should we assume the net losses on this price roller coaster will accrue to institutional investors? Some shorts got popped with the run-up in GameStop, but a fading, money-losing business with a sudden market cap over $20 billion for no good reason is surely attractive to new short-sellers, who will gain as the new retail buyers lose.

If GameStop is overvalued by $20 billion right now, that's $20 billion of losses waiting to accrue, largely to ordinary investors who got caught up in a fad. And while some of the more online traders have gotten cheered for buying at the top by their internet friends, this is far from a desirable democratization of Wall Street - this is just a new way for regular people to lose their shirts.

I am not a salty loser

Before you call me a "crybaby loser" whose short position blew up - as a number of you have been doing on Twitter for the last couple of days - I want to be clear: I don't do any short investing, which is prohibited anyway by Business Insider policies. This rule is so that I can call you an idiot from a position of objectivity. I have never had any financial interest in GameStop, except for the very small long position I hold due to my ownership of total market index funds. My shirt is not the one getting lost here.

And who decided short selling was a bad thing? Shorts play a valuable role: they help identify companies that aren't worth what they appear to be, so those companies don't waste more of investors' money.

Actually, short selling is good

I realize shorts seem like huge spoilsports and killjoys for betting against the futures of specific businesses. But the purpose of the stock market is to allocate capital to productive businesses, so that useful investments are made in the real economy. It doesn't always work perfectly, but fomenting irrational froth in businesses with no fundamental reason to soar in value only makes the markets less effective at that goal, while short campaigns against overvalued companies make it more effective.

"Short sellers have alerted us to problems in companies before the government and others did, like at Enron," notes Jason Furman, professor of practice of economic policy at Harvard and former chairman of Barack Obama's Council of Economic Advisers.

Shorts more recently helped reveal the financial fraud at Wirecard - over the objection of German regulators, who defended the payments company when short-sellers accused it of accounting shenanigans.

If you want to see what a market without short selling looks like, look at the private markets, which have in recent years blown bubbles public investors wouldn't tolerate, like at WeWork and Theranos. If it had been possible to sell Theranos stock short, maybe it wouldn't have taken a decade to figure out the company didn't actually have a product.

Not everything should be democratized

I understand people feel frustrated by low interest rates, which mean you can't park money in a risk-free asset and earn a significant return. This encourages investors to seek risk.

But the idea that retail investors have been deprived of the opportunity to make real money through vanilla investments isn't true. If you bought broad stock funds three months ago, or a year ago, or five years ago, you've done quite nicely. And since the GameStop speculators by definition are people who had some money to put in the stock market, that avenue was available to them. So the idea that these people - bored people with money - are a downtrodden class engaged in a righteous fight against Wall Street just doesn't wash.

The best thing to do to improve returns to vanilla investments that are appropriate for retail investors is to improve the long-run growth of the economy. And I do have one note of sympathy for the investors who complain there's no yield to be had without nonsense like this.

One reason to favor a significant fiscal stimulus (besides that it will provide relief to the sort of people who don't have money sitting around to throw at Reddit investing trends) is that if it "overheats" the economy - that is, tighten the labor market and cause prices to rise - that might tend to push interest rates up. This is not a switch the Fed itself can just decide to throw; rates are low because growth expectations are low. But boosting demand and output can boost those growth expectations and make higher rates appropriate again.

And in addition to increasing the return on safe assets, a rise in interest rates would, hopefully, take the gas out of investing bubbles, like this especially ridiculous one.

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