Day traders are typically held in contempt by professional traders. Photo: Hakan Nural / Anadolu Agency

The great GameStop short squeeze involved the biggest market manipulation in stock market history. A handful of yet-to-be-identified operators used day traders’ social media sites like Reddit’s WallStreetBets as a screen for the mother of all short squeezes.

By piling into heavily-shorted, small-capitalization zombie stocks with depressed prices and low trading volumes, the cabal pumped up their prices to the point that established long-short equity funds had to cover their shorts.

By salting the social media sites with rumors, the cabal drove small day traders into the target stocks as a screen for their operation. As the big players exit – which they began to do Thursday – the small day traders will be wiped out.

The short squeeze stocks whose sudden flight crushed some long-established hedge funds began tanking today, with the two favorites, Gamestop  and AMC, down 35% and 54% respectively.

Identifying the perpetrators is a matter for the Securities and Exchange Commission, which has the technology to trace the trades back to their beneficial owners. But the evidence is overwhelming that the short squeeze was something else than the madness of crowds.

It’s one thing for day traders on platforms like Robinhood to bid up the price of Tesla, which rose tenfold from about $80 last March to $844 on January 28. Tesla might be overvalued, but it has a great story to tell, with a huge factory opening in China and another soon to come online in Germany.

The short squeeze stocks are all dogs without the sizzle – let alone the steak – of profitability. Statistically, the short-interest ratio is a robust predictor of equity market performance (the short-sellers usually are right), and the valuation models employed by many hedge funds use this ratio as one of several inputs to generate buy and sell signals. That creates a natural bias in the market for excessive short positions,

The New York Stock Exchange Index returned 4.4% between November 1, 2020, and January 28. The 12 stocks with the highest short interest ratio (the number of shares shorted divided by the stock’s average daily trading volume) returned between 125% and 2,300%.

These are stocks from a dozen different industries, most of them running at a loss in 2020 and projected to keep losing money in 2021 – including GameStop, Bed Bath and Beyond, Virgin Galactic, AMC, FuboTV, Sunpower, Gogo, and Accelerate Diagnostics. Apart from their miserable performance, they had nothing in common but the fact that long-short hedge funds marked them for early demise and sold their shares short.

Remarkably, the greater the short interest, the better the equity price performance.

Gamestop (GME) is an outlier, to be sure, but the relationship between short interest and equity price performance is statistically significant at the 99.5% confidence level even if GME is excluded from the regression.

This makes nonsense of the notion that a mob of quarantined twenty-somethings betting their federal handouts drove this particular rally. The financial flashmob story has been repeated endlessly in the popular media, more or less in the same way that Elizabeth Lopatto wrote in Verge January 27:

Day traders, such as the ones on r/WallStreetBets, are typically held in contempt by professional traders, and they are acutely aware of this. The professional short-sellers who created the possibility of a short squeeze underestimated the day traders’ sophistication, and r/WallStreetBets pounced. Time to troll Wall Street out of a f**kload of money!

The fine people of r/WallStreetBets decided GameStop was undervalued, and the stock would go up, so they put up a bunch of posts about how they were buying GameStop options. This drove up the stock price for GameStop, as their counterparties had to load up on stock to balance, and then more stock as more people bought options and so on. The soaring stock meant some shorts had to cover, sending the stock up further.

Except the numbers don’t add up. Robinhood, the brokerage of choice for the WallStreetBets flashmob, claims to have 13 million brokerage accounts, with an average size somewhere between $1,000 and $5,000. The market capitalization of GameStop at the peak was $24 billion. If the Robinhood accounts owned  GameStop, then the average Robinhood account would have owned $1,846 of GameStop equity.

There simply aren’t enough small players to pull off operations like this. Even if there were, day traders follow stories, not technical. There is a WallStreetBets user group devoted to finding short squeezes, but it has only 4,500 members (out of WallStreetBets’ 5 million members). Most of the group’s recent posts are complaints about the Robinhood brokerage. In the age of social media bots, it is hard to establish the provenance of many of the posts.

A high proportion of the short squeeze forum’s posts, moreover, complain that the whole business is a scam. “Anyone else feel like barfing when they hear “short squeeze” now?” wrote one member. “They think pump and dumps are short squeezes.”

Others allege that Robinhood didn’t allow its customers to sell short-squeeze stocks when they tried to liquidate positions. Writes one poster: “Dear Robinhood … You haven’t shown your true colors, and they certainly don’t support the spirit of the name you bear. Instead, you have taken from the poor to line the pockets of your Wall Street cohorts.” Other posts exhort investors to take GameStop “to infinity and beyond,” touting price targets close to $10,000 a share.

The involvement of large numbers of small investors, though, makes it hard for regulators to crack down on larger players in a short squeeze. The short-interest ratio is a matter of public record and widely reported on public websites. Even if the small investors didn’t have the resources to produce 20-fold increases in stocks like GameStop, the big operators can hide behind them and claim that they only followed a popular trend.