In the words of world-renowned economist, John Maynard Keynes, “the markets can remain irrational longer than you can remain solvent.” GameStop has been proving Keynes right over the past couple of weeks as the stock surged another 135% yesterday to close at $357.51.
Gamestop (GME) has rallied a staggering 1,744% since the beginning of the year, giving it a market cap of over $24 billion compared to just $300 million a year ago.
The reason behind the massive rally is not due to the fundamentals of the company. In fact, looking at GameStop’s latest sales results for the 2020 holiday season, net sales fell 3.1% compared to the same period a year ago, and third quarter 2020 results showed a 30% decrease of year-on-year net sales figures.
Based on these fundamentals, many analysts on the Street and sophisticated investors have been bearish on the stock, with many large institutions selling the stock short, hoping to benefit from a fall in the share price.
Short selling involves borrowing stock that one does not own, selling it in the market on the expectation that the share price will fall and then buying the stock back at a lower price, locking in a profit.
The driving force behind GameStop’s meteoric rise can be explained by what is known as a classic “short squeeze”. This occurs when short sellers scramble to liquidate their short positions by buying back their stock as a result of the share price moving upwards instead of falling.
According to Barron’s, GameStop was the most shorted share on the Russell 2000 index at the end of 2020, with 144% of the shares available for trading (the float) having been borrowed by short sellers to bet against the share price.
Four months ago, a trader known as Jeffamazon wrote on Reddit’s popular WallStreetBets forum that GameStop could be “the greatest short burn you’ll see in history.”
Day traders congregated on the forum, encouraging each other to buy the stock, essentially pushing the share price higher. The higher the share price climbed, the more painful short positions became, and eventually big institutional players and hedge funds were forced to liquidate their positions as margin calls were triggered and short sellers were forced to cover their losses.
According to The Wall Street Journal, one of the biggest “victims” of this “short squeeze” was hedge fund Melvin Capital, who had lost almost 30% of its $12.5 billion assets under management (AUM) through Friday last week and needed a $2.75 billion bail out from Citadel and Point72. (See GME stock analysis on TipRanks)
Telsey Advisory analyst Joe Feldman downgraded the stock three days ago to a Sell and set his price target at $33. This implies downside potential of around 91% from the most recent close.
Telsey believes that “the current share price and valuation levels are not sustainable, and we expect the shares to return to a more normal/fair valuation driven by the fundamentals.”
Meanwhile, other analysts on the Street agree that the share price is severely overvalued, with an average price target of $11, which suggests downside potential of 97% over the next 12 months.