The Tell: GameStop saga’s real lesson: ‘Don’t short troubled companies at the start of an economic cycle’

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Forget about David vs. Goliath.

The battle between day traders and short sellers over GameStop Corp. GME, -33.96% that’s blotting out everything else on Wall Street this week offers up an important but much more lasting and practical lesson for investors, according to Nicholas Colas, co-founder of DataTrek Research.

Here’s the lesson: “Don’t short troubled companies at the start of an economic cycle.”

In a Thursday note, Colas recalled that, as the firm had flagged in December, holiday retail spending and Google search interest in GameStop, the videgame retailer, did not look horrible.

“‘Not horrible’ is good enough when capital markets are rallying due to optimism over the future,” Colas said. And that’s what stocks were doing as they extended the rebound from the early 2020 pandemic selloff to push further into record territory in the new year, buoyed by continued optimism over COVID-19 vaccine rollouts.

Plenty of supposedly sophisticated investors ignored that lesson, at least when it came to GameStop, where short interest exceeded 100% of the company’s float. That made it an obvious target for investors looking to foster a short squeeze.

See: This chart shows the most-shorted stocks have seen the biggest gains since the end of last year

GameStop’s meteoric rally was kicked off by individual investors targeting those short sellers. While that offered a new wrinkle, such squeezes, in which a rising stock price forces short sellers to cover their positions, creating a feedback loop, are old hat on Wall Street.

“Retail investor wolf packs are new, but if you’ve ever sat on a hedge fund trading desk you know squeezing shorts has been a Wall Street blood sport for decades,” Colas said.

Explainer: How an options-trading frenzy is lifting stocks and stirring fears of a market bubble

GameStop shares were swinging wildly between gains and losses Thursday and were recently down around 24% after having quintupled between Friday and Wednesday. They remain up more than 1,300% since the start of the new year.

Major U.S. stock indexes tumbled Wednesday as beleaguered short sellers were forced to liquidate profitable long positions to raise capital, but rebounded sharply on Thursday, with the Dow Jones Industrial Average DJIA, +1.89% up around 575 points, or 1.9%, and the S&P 500 SPX, +1.99% up 2%.

Read: How will this wild GameStop saga end? The ghosts of trading catastrophes past offer clues

But Colas also played down the role of Reddit-inspired day traders, arguing that the “comatose state” of value investing, a strategy that’s been on the ropes for over a decade, offered a compelling explanation for the market’s initial underpricing of GameStop.

After all, buying “lousy assets” at the bottom used to be the bread and butter for value investors, who made fortunes in the early 1990s off that exact strategy. Colas wondered if investor obsession with growth stocks ended up weakening the market’s ability to accurately price the option value of subpar companies that managed to survive 2020, or if perhaps “there just aren’t enough value players left to balance markets any more…”

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