Modern communication infrastructure can facilitate swift simultaneous action by a large number of people. If used to coordinate a surprise attack, an organized mob can overcome a store or even the capitol building. Is Wall Street the next target?

GameStop is a brick-and-mortar retail chain that was losing money even before the pandemic. Yet the price of its stock increased 1,900% in January on the basis of no particular improvement in fundamentals. The rocketing price seems to be a classic short squeeze, with a new twist: the grip of the squeeze came not from a deep-pocketed individual but by the internet-coordinated action of a large number of small investors.

GME price, Feb 5, 2016 to Jan 29, 2021. Source: Google Finance.

To understand what a short squeeze is all about, let’s start with a simple example in which the issues will hopefully be very clear. Suppose there is a company that you are convinced is going to be able to make one more dividend payment of $1 to each shareholder before it goes out of business next year. Even though the company is headed for bankruptcy, the stock has some intrinsic value, namely the $1 that each owner of a share will receive as dividend. If the stock sells for $2, it would be overpriced, and you might try to profit by selling the stock short.

To do that, you could try to borrow a share from a dealer so that you can sell a share for $2. You would have to put up funds (known as margin or collateral) to prove that you are able to cover the $1 dividend payment and capable of buying the stock outright if you were forced to. If after your short sale other market participants start buying a lot of shares and drive the price up, you’ll have to put up more funds to prove to the lender that you still are able to buy back at the higher price to fulfill your original sell. If you can’t do that, the dealer who originally lent to you will use your collateral to buy the shares outright and close out your position. The buy orders from the closed-out shorts can then add to the buy orders from the rest of the market to drive the price skyward.

In the case of GameStop, the buy orders that drove the squeeze came from large numbers of people getting information from financial news discussion sites.

So do the squeezers profit at the expense of the shorts? Let’s follow our hypothetical example one step further. Suppose that the shorts had it exactly right — the hypothetical company is about to go out of business. Next year the squeezers who bought the stock get their $1 dividend, but that’s all they’ll get. And they paid much more than a dollar to buy each share, for their buy orders were what originally drove the price up. They can only make a profit if before the company goes bankrupt they sell the stock to somebody else who’s willing to pay more than a dollar for it.

And to whom do they sell the stock? As Shakespeare might say, aye, there’s the rub. If they sell to the original shorts, there’s no squeeze — the whole operation only works if the shorts can’t find anybody to sell to them. So where will the squeezers find the person who’s willing to pay more than $1 for the security? Another chat room, perhaps?

In our hypothetical example, every buy order in the original squeeze paid more than $1 to acquire something whose value, if held to maturity, was only $1. The mob as a whole therefore had to lose money. The shorts whose positions were closed out certainly also lost money. So who gained?

The answer is, the people who bought into the squeeze early and then sold their positions to the gullible parties farther back in the mob. The mechanics are basically those of a chain letter. The original buyers may make some handsome profits, but only if they sell in time. The followers, on whose participation the whole process depends, must lose big. A profitable squeeze requires some gullible victims who end up absorbing the losses that are a necessary component of the strategy.

The feature that makes this hypothetical example crystal clear was the assumption that the company would be out of business in a year. That allowed us to see unambiguously that, as events turned out, the stock had an indisputable fundamental value, namely one dollar per share. But the math works out exactly the same for a company that’s going to pay dividends for two years and then go out of business. In that case, the fundamental value is the discounted value of those two dividends, no more and no less. It’s also the same math for a company that’s going to pay dividends for five years and then be bought out by some other company. The fundamental value is the discounted value of the five dividends plus the discounted liquidation value. Real-world examples may have lots of details and lots of contingencies. But the underlying principle is still the same. Any asset has an intrinsic fundamental value, which is the discounted value of cash flows that accrue to the owner of the asset. If you pay more than this, squeeze or no, you paid too much, and are counting on selling it to somebody else who is even more gullible than you.

The moral is, you can get hurt trying to stand in the way of a crowd, and you can get hurt trying to join a crowd. Personally I prefer to take long positions all by myself based on fundamental values.

And I for sure am not buying GameStop.