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GameStop short-sale highlights stock market problem

A West Virginia University financial expert said recent surges of traditionally undervalued stocks like GameStop, AMC Entertainment and Blackberry damage market confidence that could ultimately have a negative impact on the economy.

“All of these companies had weak financial results, low stock prices, and were heavily shorted,” said Alex Kurov, a finance professor at WVU’s John Chambers College of Business and Economics, referring to a recent coordinated effort by investors on various websites, such as Reddit, to drive up the prices of these stocks. GameStop stock, for example, increased by 1,700% since early January. It is now trading for under $70 a share, down from a 52-week high of $483 a share.

“I am not a lawyer, but this is clearly market manipulation, which is illegal,” he said. “Market manipulation is difficult to prove though because it can require showing that these traders spread false information and intend to manipulate prices. In some cases, the trading itself can be characterized as misleading, if the purpose is to create an artificial price and then sell the shares to uninformed investors.”

Short selling involves selling borrowed securities. The goal is to repurchase the stock at a lower price and make a profit, he said. The catch, however, is if the price goes up, then the short seller is forced to cover the loss, which could be thousands of dollars.

Melvin Capital Investment, a New York City hedge fund, that had invested in GameStop lost 53% of its assets and ended up being bailed out – for $2 billion – by another hedge fund, according to CNN Business.

“Short sellers have a bad rap, but they play a useful role in the market, helping to keep stock prices tethered to fundamentals like sales and earnings of the company,” Kurov said.

The impact on companies whose stock has been over-inflated is limited because the huge price increases are usually short lived.

“When such price bubbles last for a significant period of time, they allow companies (to) issue stock at inflated prices to finance their business,” he said. “This effectively gives them almost free capital. This happened in the U.S. in the case of the Dotcom stock bubble in the late 1990s. When that bubble bursts, many young unprofitable companies that had issued shares to the public had to go out of business because they were losing money and lost access to investor capital.”

Financial markets, Kurov said, are viewed by many investors as a huge casino, and what happened with GameStop has fed into that belief.

“If the GameStop bubble were an isolated incident, then there would not be much cause for concern for most investors,” he said. “However, when gambling behavior and momentum trading – buying stocks because they are going up – affects stock prices market-wide, we have a more serious problem. When prices of many stocks lose touch with fundamentals, there is a significant risk of a large market decline. To reduce this risk, investors can diversify across asset classes – stocks, bonds, commodities – and across countries.”

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