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Wednesday, 23 June 2021

The Robinhood bubble

What was under the hood in the latest scheme to attract small investors to the US financial markets

Mahmoud Mohieldin , Tuesday 9 Feb 2021
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As people grapple with the coronavirus pandemic and its repercussions on their health and economic conditions, the world’s financial exchanges have been witnessing events that are not only telling of their divergence from the real economy but also their detachment from real life.

New phenomena in the global exchanges are forming from an amalgam of entities comprising free-of-charge digital platforms for trading in stocks, such as Robinhood, forums for exchanging information, striking pre-agreements on deals, and targeting specific financial operations, such as the widely used Reddit website used for communication between groups on selected topics. All these are empowered by easy money obtained by individuals from governments in the form of cash subsidies to counter the coronavirus fallout.

This three-pronged alliance between digital platforms, social networking forums, and flows of money has eased the way for scores of amateur small investors to enter the stock exchanges. There are eight million followers of Wall Street stocks on Reddit.

These retail investors have not been satisfied by the high returns they have accumulated through the exchange’s leading stocks, the indices of which have hiked over the past few months regardless of the economic downturn, the rise in unemployment, and the spread of coronavirus infections.

Instead, they decided to challenge the establishment itself in a move reminiscent of the populist trends witnessed recently in politics that have expressed, via people’s votes, an inclination to choose politicians other than the orthodox alternatives of whom people had grown weary. Their choices, however, were extreme.

The move started when masses of amateur small investors publicly agreed to target certain stocks, the prices of which had collapsed due to heavy losses and the apparent absence of any chance of their revival. They collectively poured their money into the shares of poorly performing companies such as GameStop, a chain of stores that sells electronic toys. The company had lost its customers to online rivals before the coronavirus outbreak prevented its remaining direct-shopping customers from buying its toys.

The small investors also traded in BlackBerry, the once-famous phone manufacturer whose value plummeted due to its failure to innovate in a highly competitive market, and other companies which have suffered as a result of their poor performance and the low prices of their shares.

As a result, due to the rising demand, GameStop’s shares hiked by 8,750 per cent over a few weeks to record $350 per share. In 2013, a GameStop share was priced at $57 before falling to $4 and then rising again during the current saga. The recent enormous price hike was the result of reckless trading on the part of small investors that is devoid of any investment logic in a company that does not have a future, even in the post-coronavirus world, because it had been making losses even years before the outbreak and its games were being sold by rivals online.

At the time of writing, GameStop shares have spiralled down by 80 per cent over just a few days to reach $64 per share in a downward trend that ultimately reflects the fair value of a company that is not making profits today and has no prospect of doing so in the future.

The situation far exceeds the rise and fall of shares or even the extreme fluctuations in prices caused by financial bubbles that soon explode. The political economy of the world’s financial markets cannot simply be ignored in the digital age. Some observers may like to portray the phenomenon as a competition between small and vulnerable investors and the heavyweights of investment and hedge funds and large investors in derivatives and options.

What is meant in this case is that investors in short-selling operations, expecting a decline in the share price, borrow shares from their owner, sell them, and then buy them again at a lower price before returning them to their original owner. The investor thus makes a profit, but only on the condition that the stock price decreases.

Robinhood investors on Reddit attempted what investment and hedge funds have been accustomed to doing by raising share prices. But then Robinhood enforced a set of regulations and restrictions on dealing in targeted stocks such as GameStop, accelerating falls in prices against the wishes of investors and causing them to incur heavy losses.

These events led US congressmen, including rivals Alexandria Ocasio-Cortez, a Democrat, and Ted Cruz, a Republican, to call for urgent hearings to get to the bottom of the phenomenon. It seems that the financial regulators are now intent on monitoring Robinhood to investigate practices ranging from small-investor trading, price hikes, and the sudden restriction on transactions. But this will not compensate the small investors for their losses.

Renowned economist Mohamed El-Erian said he sympathised with the small investors. But he also reminded us of a lesson he had learned early on, which is that “you have no friends on Wall Street.” The small investors thought that Robinhood was a friend, until they found out the truth when they incurred heavy losses.

One agrees with an observation made by Jeffrey Frankel, a professor at Harvard University in the US, that small investors and traders tend to blame the party that warns them about losses instead of those who misled them into chasing illusory profits not made through any recognised economic activity in the first place. This is exactly what happens in cases of financial fraud known as Ponzi schemes and in the fraudulent investment schemes that have been used to deceive laymen and hopefuls outside regulated markets in the region.

In a nutshell, this is gambling cloaked as investment. There is nothing in companies such as GameStop that is worth investing in. Instead, it is a gamble calculated by the shepherd and uncalculated by the sheep. Laying the groundwork for this gamble were the free digital trading platforms, social networking forums that target certain shares using information of varying degrees of accuracy, and easy money that found its way into the hands of people seeking quick profits.

All this has been taking place in the absence of adequate regulatory and supervisory functions which have not developed the tools to observe the markets and their developments in the digital era, resulting in the creation of a bubble whose repercussions affect the innocent before the guilty.

The hearings in the US Congress and the actions by the supervisory authorities may identify aspects of the violations and the violators who created the bubble. Maybe there will be new legislation to regulate trade in the digital age. But it is more important to follow up on increasing the separation between a company’s performance and the price of its stocks and limiting the dependence on financial sources based on inflated financial assets as a result of a temporary decline in interest rates and temporary cash support for the economy.

This will leave the financial markets to re-examine prices, unveiling, whether softly or aggressively, the necessity and extent of corrections.

 

An Arabic version of this article appeared on wednesday in Asharq Al-Awsat.

 

*A version of this article appears in print in the 11 February , 2021 edition of Al-Ahram Weekly

 

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