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Reddit’s r/WallStreetBets Just Took Down a Hedge Fund. You’ll Love What Comes Next.

As a member of r/WallStreetBets, a popular Reddit forum, let me tell you this: It wasn’t supposed to ever happen. Our happy band of rag-tag investors was supposed to use our little corner of the internet to exchange risky stock investment ideas, not take down one of America’s most prominent hedge funds. Source: Mehaniq / Shutterstock.com Yet here we are. In the past week, traders reading WSB and other forums have pushed GameStop (NYSE:GME) and a host of other highly shorted stocks to impossibly high levels, bankrupting at least one hedge fund and causing several platforms to halt trading. So ham-handed was Wall Street’s response that Congress members Ted Cruz and Alexandria Ocasio-Cortez, long-sworn enemies, even managed a coordinated tongue-wagging (Twitter-wagging?) at the U.S. financial system. But as Citadel picks up the pieces of Melvin Capital and Reddit users find their next short-squeeze target, people are starting to ask, “what’s next?”InvestorPlace – Stock Market News, Stock Advice & Trading Tips Reddit’s r/WallStreetBets Gives Citron a Taste Let me be clear: You won’t find my posts on r/WallStreetBets. As much as I read and enjoy the platform, my work and ethics prevent me from talking about any stock I own. (Sorry, Elon Musk. I wish I were you.) Wall Street Bets has always been about having fun. Many of the posts are intentionally moronic — think out-of-the-money calls on failing retailers — and there are plenty of contributors who show screenshots of life savings going to zero. Profitable or not, it was about finding the joys and absurdities of market speculation. Back in November, GameStop was among these fun little ventures. And it all seemed quite a standard fare for the subreddit billed as “4chan finding a Bloomberg Terminal.” GameStop fans cheered on buyers while cursing out Melvin Capital for shorting the stock. All in hopes of realizing America’s favorite pastime: making a lot of money with as little effort as possible. But then Citron Research changed it all. Citron Research? Meet r/WallStreetBets On Jan. 19, respected short-seller Andrew Left managed to finally pick the wrong target. As long-time Wall Street outsider, Mr. Left made a name for himself exposing companies like Valeant Pharmaceuticals, whose executives were channel stuffing and spiking the prices of the lifesaving drugs. He would have made a great WSB contributor, if he were willing to put up with hate speech from 15 year olds. But then something happened. The day before the presidential inauguration, Mr. Left announced he would make a case why GameStop shares were worth only $20. Perhaps Mr. Left was right to target GameStop, a shrinking company that still awarded its executives $20 million. Or he could have been wrong — at $20, GameStop would still be worth less than half of Best Buy (NYSE:BBY) when adjusted for sales. But that didn’t matter one bit. Suddenly, GameStop became more than a money-making venture to Redditors. It became a way to fight back against Wall Street greed; now it was war. How Did WSB Do It? In a financial system that values a stock based on its last trade price, even tiny trades at weird prices will revalue a hedge fund’s entire holding. In other words, a few well-timed buys can cause mayhem, especially in stocks with few sellers. That’s exactly what happened with GME. Until then, short interest had remained relatively stable. Market makers, the underpinnings of the U.S. financial system, were doing their job in matching orders and sales. That all changed on Wednesday when prices jumped from $150 to $350. As market makers began to seize up, markets started going wild. That spelled problems for Robinhood. On Wednesday, Robinhood halted trading for GameStop and almost a dozen other companies. “In order to protect our firm and protect our customers,” CEO Vlad Tenev would later tell CNBC’s Andrew Ross Sorkin, “we had to limit buying in these stocks.” Can Robinhood Go Under? In the world of trading, most conservatively-run platforms don’t have trouble managing liquidity. As long as you hold enough capital and maintain disciplined margin requirements, it’s rare for your clearinghouse to force you to raise fresh capital. But when it comes to Wall Street, financial companies all seem to run into the same issue — when your customers are making so much money, it’s hard to resist the temptation to join them. Financial regulators have long known these Wall Street shenanigans. Banks from Bear Stearns to Barings all went under when they tried trading customer money as their own, leaving taxpayers and shareholders footing the bill. Many more have experimented with bare-minimum capitalization — only later to realize their disastrous mistakes. So, over the years, smart governments have occasionally found the willpower to ban such practices and enforce strict margin and capital requirements. (Often, these rules would come undone by even smarter financial lobbyists.) Today, many platforms use a loophole to lease customer securities for profit. And when GME stock can get leased out at 25% interest rates to short-sellers, there’s a great temptation for these financial firms to double-dip. Did Robinhood do that? Possibly. Despite Robinhood’s claims that its trading shutdown was proactive, the company still drew down capital lines and banned users from buying more GameStop shares — a signal that Robinhood itself might have been short on capital and shares. (Since Robinhood is a private company, we may never know the truth.) But will Robinhood get in regulatory trouble? Almost certainly. The company banned trading in a dozen stocks on Wednesday during peak investment demand — reportedly because the company needed time to raise fresh capital. So, as retail investors watched from the sidelines, hedge funds cashed out at otherwise lower prices. In a very real sense, Robinhood arguably saved institutions billions of dollars at investors’ expense. Should We Be Scared? As Wall Street picks up the remnants of Melvin Capital and the GME fallout, two things have become clear. 1) “Dumb money” isn’t so dumb after all, and 2) “smart money” is getting taken to the woodshed. First, let’s consider what Wall Street has long called “dumb money,” the retail investor. Most of these people are like you and me — investing the majority of savings in long-term stocks for retirement, while playing around with a small portion for fun. And the gleeful absurdity of r/WallStreetBets aside, most retail investors tend to know what they’re buying (even if they get the valuations wrong sometimes.) The top-100 Robinhood stocks represent a wide swatch of consumer-related companies that have grown in real-world popularity as well as stock-related fame. Second, the GME fiasco has revealed “smart money” for the absurd bets they sometimes take. While a long-short hedge fund can help investors smooth out gains, they’re often as bad as what they call “dumb money” in closing out losses. Melvin Capital, for instance, lost 30% of its net worth in the first three weeks of January. But it took another six days (after the stock had gained another 250%) for the hedge fund to finally relinquish its mammoth position. Since then, other hedge funds have stepped up to replace Melvin in this high-stakes game of “pass the hot potato,” as if trying to prove r/WallStreetBets’ point that hedge funds will always try to make more money off regular investors if they believe the odds are right. GameStop also exposed the revolving door behind hedge funds and market makers. When Ken Griffin’s Citadel LLC, a $35 billion fund, bailed out Melvin Capital, Twitter users quickly pointed out that Citadel also owns a market-making operation that services none other than Robinhood. Where to Go from Here? Investors looking to soak the financial system would do well to buy index funds and sit on them forever. You might not get the gleeful joy of seeing a hedge fund blow up, but companies like Citadel that rely on retail money will see revenues dry up. But for those looking to invest wisely, consider this. With retail investors’ newfound power, you can expect short-sellers to think twice about selling a company. Citron Research’s Andrew Left has already vowed never again to publish short-seller reports. Other hedge funds are nervously watching. That means hot stocks will move faster than ever. As Reddit users have learned this week, it doesn’t take much to influence stock prices when only the marginal trade counts. And with no one willing to short-sell stocks in the face of an angry mob, price spikes will become increasingly common. You can expect many winners and losers. The stock market, after all, is mostly a fixed-sum game. But for long-term investors, the same truth still holds: The road to consistent wealth has always been in buying a group of high-quality investments bought at a reasonable price. Practice that discipline with your core portfolio, and you’ll make plenty of merriment with joining me in reading about the trials and tribulations of others on r/WallStreetBets. On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article. Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing. More From InvestorPlace Why Everyone Is Investing in 5G All WRONG Top Stock Picker Reveals His Next 1,000% Winner It doesn’t matter if you have $500 in savings or $5 million. Do this now. The post Reddit’s r/WallStreetBets Just Took Down a Hedge Fund. You’ll Love What Comes Next. appeared first on InvestorPlace.