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(THE CONVERSATION) GameStop and other company stocks or assets that have risen in value over the past few weeks are falling like stones. While I feel sorry for the many investors who are likely to lose a lot of money, the return of stocks to earth is actually a good thing – if you want to avoid financial meltdown due to the long list of crises the US is facing.
The reason has to do with what financial markets are – and what aren’t – and what happens when the prices of stocks and other securities are separated from the basic value of the assets they are intended to represent.
As a finance professor who studies how markets react to new information, I think it’s important to maintain a close link between security prices and fundamentals. If this stops, a market slump can’t be far behind.
Capital markets are not casinos
Some have portrayed GameStop as a David vs. Goliath story. According to the narrative, the great people on Wall Street have been gambling richly in the stock market for years. What’s the problem when the little guy gets a chance?
The first thing to note is that markets are not a big casino as some seem to believe. Their main purpose is to efficiently connect investors with companies and other organizations that are most productive of their money.
Accurate market prices, which are intended to reflect the expected profit and overall risk of a company, give investors an important signal as to whether they should give up their money and what they should get in return. Companies like Apple and Amazon simply would not exist without access to the capital markets as we know them today.
The more jaundiced view of markets focuses on episodes in which markets appear to go crazy and the speculative gambling behavior of some traders such as hedge funds. The GameStop saga feeds into this plot.
But GameStop also shows what happens when stock prices don’t reflect reality.
The GameStop bubble
GameStop’s basics are flawed to say the least.
The company is a brick and mortar chain of video game stores. Most video game sales now take place as digital downloads. GameStop has been slow to adapt to this new reality. Sales peaked at $ 9.55 billion in 2012 and had declined by a third from 2019. The company has not made a profit since 2017. Simply put, it’s a money-losing company in a competitive and rapidly changing industry.
However, the recent speculative frenzy raised GameStop’s stock price from under $ 20 in early January to $ 483 in just over two weeks, driven by retail investors on Reddit coordinating their purchase to harm hedge funds – causing the pros to billions cost dollars.
It is clearly a speculative price bubble that has some of the characteristics of a Ponzi scheme. Many retail investors who get on the train late and buy at inflated prices – especially those attracted by the extreme price movements and media coverage – will be holding their bags.
And sooner or later, the stock price is likely to return to levels that can be supported by company fundamentals. On February 3, shares were trading at around $ 92.
The problems start when it happens too late.
Bubbles are burst
Financial markets are made up of people. People are imperfect and so are markets. This means that market prices are not always “right” – and it is often difficult to find the “right” price.
This also applies to the price bubbles in individual stocks such as GameStop. But it also applies on a much larger scale when it comes to a market as a whole.
Price bubbles and crashes are not good for Wall Street or Main Street. When the dot-com bubble burst in 2000 – after the prices of dozen of technology stocks rose exponentially in the late 1990s – an economic recession soon followed. The bursting of a real estate bubble in 2008 sparked a global financial crisis and the great recession.
Too much momentum
Hence, markets fail sometimes, and we need good regulation and enforcement to make such failures less likely.
On its own, the GameStop craze is unlikely to cause disruption to the entire stock market, especially if its price continues to fall more in line with the company’s core value. Unfortunately, this was not an isolated incident. GameStop wasn’t the first sign of trouble either.
In the past few days, Reddit users have also seen silver prices skyrocket, and companies like BlackBerry and cinema giant AMC Entertainment have skyrocketed. Popular trading apps like Robinhood have made trading easy, fun, and basically free.
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For example, Tesla’s stock price rose 720% last year, in large part when investors bought the stock because it was already rising. This is known as momentum investing, a trading strategy where investors buy stocks because they go up – and only sell them when they believe the price has peaked.
If this continues, there is likely to be more financial bubbles and crashes that could make it harder for companies to raise capital, posing a threat to the already fading recovery in the US economy. Even if the worst does not happen, large price movements and allegations of price manipulation could damage public confidence in financial markets, making people more reluctant to invest in retirement plans and other programs.
Warren Buffett once said of stock market behavior: “The light can change from green to red at any time without pausing at yellow.”
What he meant was that the markets can turn a dime and dive in. He saw these moments as opportunities to find business in the market, but for most people they lead to panic, severe losses, and economic consequences like mass unemployment – as we saw in 1929, 2000, and 2008.
There’s no particular reason why it won’t happen again.
This article is republished by The Conversation under a Creative Commons license. Read the original article here: https://theconversation.com/wall-street-isnt-just-a-casino-where-traders-can-bet-on-gamestop-and-other-stocks-its-essential-to- keep capitalism from falling 154 154.