The Stock Market Is Broken, Now for All to See

This article was written by Wolf Richter and originally published at Wolf Street

It has finally blown into the open for all to see. The stock market has been broken for a while, for a long time, actually. The idea that the stock market is where price discovery takes place on a rational transparent basis, with ups and downs, and some amount of chaos, but free of rampant manipulations – that idea has now totally imploded.

What has been visible for a long time but now blew into the open is just how manipulated the market is, by all sides, how overleveraged the big players are because the Fed encouraged them to, and how enormous the risks are, and how crazy the trading strategies are.

And the stock market soared to record out-of-whack valuations, in a terrible economy where at least 10 million people have lost their jobs and are still out of work, and where entire industries have gotten crushed. The whole thing is propped up by stimulus and bailout payments to consumers and companies alike.

And then came a new force – or rather the force wasn’t new, but the magnitude was: regular folks ganging together in the social media, particularly on Reddit’s WallStreetBets, and they were deeply cynical about the fake markets and they saw an opportunity, and they conspired to make a ton of money and push some hedge funds over the cliff, by buying long the most shorted stocks, in other words, they conspired to engineer a historic short-squeeze.

This coordinated buying by the crowd on WallStreetBets, of a handful of small most-shorted stocks, drove up their prices sometimes by 100% or more in a day, which pushed the hedge funds that were short these stocks to the brink. And it pushed online broker Robinhood to the brink. And it revealed for all to see just how broken the stock market has been.

You know it’s serious when the New York Times puts a stock chart at the top of its front page which it did in its Saturday morning edition – and not any stock chart but a chart of GameStop, one of the stocks targeted by what likely became the biggest and most widely organized and most effectively manipulated short squeeze in history.

GameStop started surging in April last year. GameStop is a brick-and-mortar retailer of video games whose annual revenue has plunged by over 50% since 2016. This is a company that has gotten caught up in the brick-and-mortar meltdown before the Pandemic. And the Pandemic made everything a lot worse.

In early April it was still trading at around $3 a share. By the end of August, it had more than doubled to $7 a share. By Thanksgiving, it had doubled again to $14 a share. By mid-January, it had more than doubled again, trading at $31 a share. Which means the share price had multiplied by 10 since April.

And then all heck broke loose and it spiked ultimately to $483 a share last week, with vertigo-inducing volatility, surging and plunging by huge amounts in a matter of hours. On Friday it closed at $323 – up by over 100 times from $3 in April.

Other stocks went on different gyrations. For example, on Friday, a heavily shorted stock, Siebert Financial, which hadn’t gotten the full treatment, suddenly jumped by 400% in early trading, on no news whatsoever, soaring from $3.75 at the close the day before to $18.50 before plunging partway back to earth throughout the day and in afterhours trading ended up at $7.33, amid enormous trading volume.

People are chasing lottery-type returns.

The folks on WallStreetBets that openly conspired to create this short squeeze – their number is heading toward 10 million people – well, they didn’t create the situation. They just took advantage of an opportunity to manipulate those share prices their way.

They saw that these most shorted stocks were incredibly vulnerable to a short squeeze, and if enough buyers got together, they could push those overleveraged hedge funds that had shorted the stock at $10 or at $20 or at even $50 over the cliff.

It was highly effective stock manipulation. And it outdid by a huge margin the stock manipulation schemes that those hedge funds had undertaken to push down the share price. Those hedge funds look practically amateurish with their reports that they spread across the media in order to crush those shares they were short.

Thanks to the people on WallStreetBets, now everyone gets to see the manipulations, even on the front page of the New York Times which has for years purposely ignored just how badly the market is broken.

The trading strategies that blew up and that blew the whole schmear into the open is that overleveraged hedge funds have been shorting the already “most shorted stocks,” which are stocks with a relatively small float that can be easily manipulated. And they’re doing this on one side, while being long other stocks. This didn’t start with GameStop. It started a long time ago. Tesla’s stock is a primary example in recent history.

The hedge funds that were short were taking massive losses in the shortest amounts of time as the most shorted stocks jumped. To get out of the trades, the hedge funds had to buy these shares back, and so a mad scramble ensued to find those shares and buy those shares at whatever price, and shares soared further.

Because these hedge funds were losing so much money on their short trades, they attempted to lower their risk profile, as determined by a formula called Value at Risk, which is what they use to make their own clients feel better about the hedge fund not just blowing up one day and taking their money down with it.

As the hedge funds sold their long positions, those prices began to slide, and so hedge funds were losing money on their shorts, and they were losing money on their longs, and they’re leveraged out the wazoo and they were blowing up.

A lot of wealthy people gave their money to those hedge funds to beat the market with and make a killing, and now their money was going down to heck in days or hours.

And some of the hedge funds, at the brink of collapse, got bailed out by other hedge funds.

For the crowd on WallStreetBets, this was a huge victory. Not only were they sitting on lottery gains, but they’d blown up a trading strategy and nearly some hedge funds.

They’re now something like the world’s largest and most chaotic and decentralized hedge fund, and since their schemes are public, other investors, including other hedge funds, trade along with them. It’s a power trip they’re getting a huge kick out of. They had a plan, which was to make a ton of money and in the process push the hedge funds over the cliff, and they executed that plan.

Hedge funds have long done everything they could to manipulate stocks their way. Short sellers came out with devastating reports about a company. Some of the facts were true and some were false, but it didn’t matter. This is the game of “short and distort.”

The report would be released before the start of trading. All the financial media would jump on it. The short seller would appear on CNBC and explain why this stock would collapse, etc. It was all a big manipulation scheme and it worked most of the time, and at least for a brief period the stock plunged, and the short seller could take a profit. A reverse of the classic pump and dump.

On the long side, the same has been happening for eons at the highest level of Wall Street, with bullish reports about crappy companies and strong-buy recommendations, and all kinds of fabricated stuff…

I mean, just look at Tesla’s shares. The hype machine behind that stock is huge. It’s Musk himself with his promises that may materialize years behind schedule or that don’t materialize at all and were just empty promises, all of them designed from get-go to manipulate up the share price.

And there are the Wall Street banks that make a huge amount in fees every time Tesla raises money. Tesla raised over $12 billion in 2020 alone. So these banks have huge financial incentives to manipulate up the shares.

Then there is the army of Tesla fans the crawl all over the social media, and they take no prisoners. They work tirelessly to pump up Tesla shares.

The thing is as long as the shares are manipulated higher, everyone is good with it, and regulators support it. It’s the oldest game in town.

The Fed is a big proponent of it through its monetary policies. It has a word for it, the “Wealth Effect.” President Trump jumped on the bandwagon as soon as he was elected. Everyone’s doing it.

But now that millions of individual investors are conspiring on WallStreetBets to drive up share prices of the most shorted stocks to push a bunch of hedge funds over the cliff, it rattled some nerves.

But these traders are collectively also taking huge risks, and in the process, they were just about to push their own trading platform Robinhood over the cliff.

So the blame for the enormous risk appetite out there, the reckless leverage, the crazy trading strategies by hedge funds, and the huge incentives to manipulate goes to the Fed.

It printed $3 trillion in a few months – and $6 trillion in 12 years – to create exactly those kinds of financial markets where no one cares about anything anymore, where everyone is just chasing after the wildest returns, and where investors that follow prudent strategies are ridiculed and earn near-zero returns. And that’s what the Fed got. That’s where the blame is. The Fed is the biggest market manipulator out there.

Its primary target are the credit markets. But it has a strong effect on the stock market, and the Fed knows that, and counts on it as part of its monetary policy. It made clear, it wants asset bubbles, it wants blind exuberance, it wants reckless risk-taking and huge leverage, and it has shown that when those bets blow everything up, it will step in and bail out the biggest bettors.

In the current short-squeeze, huge profits are being realized by institutional investors – from private equity firms to pension funds – that had been holding the shares of GameStop and other most shorted stocks whose prices have spiked to high heaven. Some of these institutional investors have now dumped their positions and cashed out at these ginormous prices, earning billions of dollars in lottery-style gains.

They effectively sold their shares to hedge funds that were short and were scrambling to buy shares to cover their short positions; and to traders that were trying to ride up those shares. This happened across the most shorted names.

For example, GameStop disclosed on Thursday that Korea-based MUST Asset Management, one of its largest shareholders, sold its entire stake, 3.3 million shares, that it had bought sometime before March 19, 2020. And if it sold those shares at Wednesday’s closing price, it made about $1.1 billion in gains.

AMC Entertainment, the movie theater chain trying to stave off bankruptcy, is near the very top of the most shorted stocks, and its price exploded from around $2 a share in mid-January to $20 on January 27, multiplying by 10 in two weeks. Well, its second-largest holder, private equity firm Silver Lake, disclosed that it sold its entire stake of 44 million shares for $713 million at an average price of $16 and 5 cents each.

The Ontario Teachers’ Pension Plan, in Canada, sold its entire 16% stake in US mall landlord Macerich, another one of the heavily shorted stocks, whose shares had doubled in January.

They all made their lottery-style returns and they took the sales proceeds and put them in Treasury securities or whatever and they’re outa there.

Amid this chaos, Robinhood imposed draconian limits on trading of 50 stocks, including the most shorted stocks. As justification, it said on Friday that its clearing house had demanded a massive increase in the deposit that Robinhood has to keep at the clearing house. Robinhood had to raise $1 billion from its existing investors and get another $500 million from a bank credit facility.

The clearing house – National Securities Clearing Corp. which is owned by Depository Trust & Clearing Corp. – demanded the additional capital in order to guarantee those trades amid the huge volume and the enormous volatility of the shares. It wants to protect itself in case Robinhood blows up.

Whether or not the Robinhood fallout can be contained remains to be seen.

Other brokers too imposed some trading limits, including Schwab, which raised its margin requirements for those stocks and imposed some limits on options trading, but none were as draconian as Robinhood.

Robinhood is free for its users. It makes its money from selling its users’ order-flow data to investment firms. This is real-time data about which stocks its users are buying and selling. According to Robinhood’s regulatory filings with the SEC, it generated $271 million in revenues in the first half of 2020 from selling its clients’ order-flow data. Much of it from Citadel.

The SEC nailed Robinhood for misleading its users about the sales of their order-flow data and about not trying to find the most competitive rates for executing orders. In December, Robinhood agreed to pay $65 million to the SEC to settle the charges. But it still sells its users’ order-flow data – because that’s the way it makes its money.

Robinhood isn’t alone in selling order-flow data. For example, TD Ameritrade, which is now owned by Schwab, earned $560 million from selling its users’ order-flow data to investment firms. Lots of brokers are doing it.

Those relationships between Robinhood and the firms that execute its orders, and its clearing house, and the firms that pay for the order-flow data are now coming under further scrutiny, after the trading halts in those stocks, amid allegations that those halts were imposed to prevent the hedge funds from blowing up and making serious dents into the billionaires that are behind these hedge funds, investment firms, and clearing houses, many of them affiliated in various ways.

Congress is now seeing a dual opportunity. On one side, the millions of infuriated retail traders that got locked out from trading the most shorted stocks. And on the other side, the teetering hedge funds that are now giving their rich clients and owners the willies.

So Congress promised to look into it. It’s doing what it knows how to do best: On one side, it’s trying to coddle up to the millions of infuriated traders that got locked out from trading. Those are the voters. And on the other side, it’s creating pressure on those hedge funds and their wealthy owners and clients to unleash a tsunami of campaign contributions to get this situation under control.

As first step, Congress woke up the SEC, which then issued a statement on Friday that said that it’s working with other regulators “to ensure that regulated entities” – and here the SEC is likely talking about brokerage firms, clearing houses, etc. – “uphold their obligations to protect investors.” And it said that it would “pursue potential wrongdoing.” It said, “We will act to protect retail investors when the facts demonstrate abusive or manipulative trading activity that is prohibited by the federal securities laws.”

Also on Friday, Texas Attorney General Ken Paxton issued 13 civil investigative demands, which are the civil equivalent of subpoenas, to various entities of Robinhood, TD Ameritrade, TD Bank, E-Trade, WeBull Financial, Interactive Brokers, Citadel Financial, Apex Clearing Corporation, and others.

Paxton said, “This apparent coordination between hedge funds, trading platforms, and web servers to shut down threats to their market dominance is shocking, unprecedented, and wrong.”

Meanwhile, Fed officials from Powell on down have been busy deflecting criticism that their reckless monetary policies have caused this kind of crazy exuberance and risk-taking and leverage across the board, from smaller traders to overleveraged hedge funds.

What all this shows, for all to see, is just how massively the stock market has been manipulated, from the Fed on down. Most of these manipulations attempt to manipulate prices up. But some manipulations are aimed at pushing prices down. What the millions of people conspiring on WallStreetBets to the exact their pound of flesh accomplish was nevertheless enormous: They showed for all to see just how completely broken the stock market is.

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