Respect, Don’t Restrict, Retail Investors

Watching the wild gyrations of the stock market this week—and some of the reactions to it—brings to mind Ronald Reagan’s observations of the bureaucratic mindset when it sees something new in motion. “Government’s view of the economy could be summed up in a few short phrases,” Reagan said in his 1986 remarks to the National White House Conference on Small Business. “If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.”

As certain stocks are moving as they have never moved before, due to technology enabling the participation of more retail investors than ever before, the best course again is to watch and observe before rashly taxing or regulating something no one at this time fully understands. We don’t want to move to the third stage of Reagan’s maxim where something “stops moving” as a result of red tape, and the result is either halting progress toward true financial inclusion or causing a counterreaction in which subsidization is contemplated.

This is not to say that government shouldn’t act if it finds clear violations of law, such as deceptive promotion of a stock on a message board. But generally, this week’s battles between the shorts and longs should be viewed as creative disruption that is best left to play out as it could produce innovation and market discovery, as well as offer a lifeline to many struggling companies.

What appears to have happened is that threads on social media, most notably the “WallStreetBets” subreddit community of the Reddit platform, discussed strategies for buying shares and options to buy shares of companies with iconic brands that were heavily shorted. Ordinary “retail” investors utilizing Robinhood and other trading apps followed these strategies, pushing prices up for companies such as GameStop and then causing a “short squeeze” that forced short sellers to “cover” their bets, which they do by buying shares to prevent further losses from stock price rises. (For more on how a short squeeze works, read this excellent description).

The result was that GameStop stock price rose around 1700 percent this month and 135 percent on Wednesday. Other Reddit-targeted stocks saw dramatic upward price swings as well. Many observers pointed out that this was in excess of any market valuation for the companies. For Sen. Elizabeth Warren (D-MA), this apparent overvaluation is justification for the Securities and Exchange Commission (SEC) to issue new regulations and “guidance” dramatically expanding the definition of “market manipulation” that could ensnare ordinary investors discussing strategy on social media. In her letter sent to the SEC today, she proclaims that “while investors work to outmaneuver each other in search of short-term profits, working families continue to suffer, underscoring the growing disconnect between the stock market and the real economy.”

I would argue that there is a disconnect between financial markets and the broader economy. To some extent, there will always be, as the market factors in perceived conditions of the future rather than the facts on the ground today. But to a significant extent, the disconnect of recent decades has been due to lack of participation in financial markets because of red tape such as Sarbanes-Oxley and Dodd-Frank and because of lack of access to the technology the “fat cats” possess. On the latter, social media and innovative trading apps are now leveling that playing field. And the result may be a partial reconnection of the stock market to the economy.

Just as short sellers benefit a market by reducing information asymmetry (I have long defended shorts and opposed regulations that restrict them), so do the “new longs” add information about the hidden value of certain companies. All of the companies targeted by the Redditors have engendered good will through their business history and brand names. The surge in stock price could communicate to financiers that the companies could have much value with a retooled product. The share price of GameStop in particular probably won’t stay near the high it reached this week, but the prices and valuation of these companies may remain higher for a long time may stay higher than they were before the price swing, as the market may have rediscovered some of their intrinsic worth

In addition, the mere fact of a stock price going up can have immediate benefits to a company, its shareholders, and its employees. For instance, the theater chain AMC was able to pay off $600 million of its corporate debt when the private equity firm Silver Lake elected to have AMC convert the corporate bonds it held into stock. As Polygon notes, “Although the theater chain’s stock price has tumbled and soared since the move, the debt relief is permanent.” This unexpected debt relief, combined with the fact that more people will likely go to theaters again as vaccines take effect, led Yahoo Finance anchor Zach Guzman to say that the company considered on the verge of bankruptcy less than a month ago could actually be considered a “long-term play.”

To the extent public policy concerns itself at all with the “new longs,” it should be focused on opening, rather than closing, doors for retail investors to participate in financial markets, including alternatives to the Reddit-led short-term trading. As House Financial Services Committee Ranking Member Patrick McHenry (R-NC) put it on CNBC, it’s time to focus on “those antiquated rules like the accredited investor standard, and other things along those lines, to ensure that we’re not cutting people off from additional access to markets, and therefore leaving them to activities like we’ve seen with GameStop and a few other tradable securities.”

Disclosure: This author owns shares in AMC.