Although 2021 is barely three weeks old, it looks like the financial markets are exceeding it in terms of exuberance and frothiness. The latest instance is Gamestop's (NYSE: GME) remarkable short squeeze which culminated in the stock climbing more than 70% on Friday to a peak of $76.76 before closing at $65.01.
The stock bottomed in March 2020 at $2.57 which means at Friday's high, it had a gain of 2,886%. While some parts of this move can be attributed to fundamentals, the latter parts seem like a short squeeze. What is so unusual is that many traders on Reddit's WallStreetBets message board coordinated the trade and bought out of the money call options.
Drivers of the Stock
In essence, when a dealer sells call options, they tend to buy some of the stock to hedge their exposure. Thus, a massive number of people buying these calls can lead to heavy dealer flows. On top of this, the stock had a huge short interest which can compound the pressure, leading to even higher prices. As prices rise, short-sellers are sitting on bigger losses and may be forced to cover their shares which leads to even higher prices. Thus, every now and then, we can see some epic short squeezes. However, this is unique in that it was organized and promoted via memes on a public message board.
Beyond this catalyst for the short squeeze, there was some modest improvements for GameStock. The company was essentially priced for bankruptcy during the spring due to issues with physical retail, video game sales moving online, and high costs in terms of rent and labor. However, the drop in interest rates was helpful. Additionally, the coronavirus resulted in an uptick in video game sales. Additionally, the release of two new consoles after many years was another driver of sales. Further, the future of video game sales is certainly online but today, many are still sold in stores.
Outlook
Given these recent gains, GameStop is overvalued and overbought. It still hasn't' solved the fundamental challenges of its business. Video game companies are increasingly going direct-to-consumer and selling games via download. Additionally, many newer games are free but monetized through in-game purchases. It's also likely that GameStop may take advantage of its inflated share price to issue shares.
Given these factors, GameStop shares should be treated as a trading vehicle rather than a long-term investment. Just like buying a stock with good fundamentals on weakness tends to work out in the long-term; selling a stock with poor fundamentals on strength tends to would it in the long-term as well.