Do GameStop’s wild moves portend a stock market bubble?

Does a battle over GameStop shares that has pitted defiant online investors against big Wall Street firms mean we’re in a stock market bubble?

There’s been a lot of news lately about investors — inspired by conversations over Reddit and the online stock trading platform Robinhood — who have been trying to beat professional Wall Street short sellers that are betting that down-in-their-luck stocks like GameStop, AMC and Bed, Bath & Beyond will drop in value.

A short seller borrows stock they believe will decrease in value by a future date, sells it to buyers willing to pay the market price and later buys the stock back to return to the original lender. If the stock has fallen in price by the time the short seller repurchases it, the short seller captures a profit.

Short selling is a risky trading strategy. If a stock’s price does not fall but rises significantly instead, the short seller faces substantial losses.

In recent weeks, a tidal wave of at-home traders converged in the “wallstreetbets” Reddit chat room to encourage each other to keep buying stocks that had been targeted by Wall Street short sellers, forcing those short sellers to lose money.

In the process, these traders have dramatically driven up the stock prices of companies like GameStop.

What is a market bubble?

A bubble occurs when the price of an asset or class of assets like stocks skyrocket well beyond a normal trading range to heady levels that greatly exceed the underlying fundamentals of the asset or class of assets.

For example, a company’s value will typically be evaluated by looking at the company’s earning potential — its ability to generate a profit in the coming year or years. When a company’s stock rises exponentially, while the company’s earning potential does not materially change, this may suggest that some investors are not considering the company’s underlying fundamentals when deciding whether to invest.

Bubbles form when numerous investors jump into buying an asset (or class of assets) because they are confident the asset’s price will continue to rise as it has risen in the recent past, and they are afraid of missing out on an opportunity to make money quickly. That surge of money propels asset class prices into nosebleed territory.

Do we have a stock market bubble now, and is it different from past bubbles?

Many stock market experts believe that U.S. equities are in a bubble and that it is only a matter of time before this record-long “bull market” — a market in which stock prices are rising — comes to an end and the bubble bursts. Google searches for the term “stock market bubble” reached a record high in January 2021.

Employees of companies like GameStop can suffer.

In the past, it was said that when shoe-shine boys and store clerks start talking about investing in stocks, a bull market has already reached its peak and stock prices will fall as professionals who manage the “smart money” start to sell their stocks.

What’s different this time is the power of technology to harness an army of small investors to place targeted bets on specific stocks.

Who loses in a stock market bubble?

If a stock market bubble bursts, and stock prices start to fall, investors can lose money if they sell their stocks at lower prices than they paid to buy them.

Some investors borrow money to buy stocks and are forced to sell those stocks at lower prices when the borrowed money remains to be repaid. They remain on the hook for the money they borrowed, and may lack the means to repay it.

In the cases of companies like GameStop, AMC and Bed, Bath & Beyond, employees of the company may have bought their employer’s stock at high levels or received stock as part of their compensation, and may lose out if their employer’s stock crashes.

A massive and extensive overall loss of wealth can destabilize a country’s economy.

What were previous market bubbles?

Tulipmania gripped Holland in the 1930s when the price of some tulip bulbs (yes, flower bulbs!) traded at higher prices than some houses.

More recently, the Dotcom bubble of the 1990s triggered extensive and broad buying stoked by the popularity of the then-new internet. Some stock prices for companies jumped on the mere news that the companies were launching a website.

The Fed is less successful in bursting stock market bubbles.

There was a U.S. housing bubble from the late 1990s to early 2000s when many investors borrowed extensively to purchase numerous homes that they planned to “flip” — that is, re-sell a short time later — on the expectation that the houses would be worth more in the near future.

When the housing market ultimately crashed, the stability of the U.S. financial system was endangered, and United States tipped into the “Great Recession.”

How can regulators prevent or curtail bubbles?

The U.S. central bank, known as the Federal Reserve, is better at releasing some air out of bubbles if they relate to a broad credit boom, such as the 2000s housing crisis. The Federal Reserve, or Fed, can also force banks to tighten their rules for lending money.

The Fed has been less successful in bursting stock market bubbles, like the Roaring 1920s stock-buying frenzy that led to the Great Depression.

Three questions to consider:

1. How did the current GameStop bubble occur?
2. How is a short seller different from other investors?
3. During the COVID-19 pandemic, have you seen the prices of some items rise too quickly and too high?

Betty Wong was global managing editor of Reuters from 2008 to 2011, with 29 years of experience at the Wall Street Journal and Reuters. She covered white collar crime on Wall Street from Ivan Boesky to Michael Milken in the 1980s, led U.S. corporate news coverage from the dot-com bubble to rubble and was global equities editor for Reuters.