Editor’s note: This article was updated on Oct. 18 to correct free cash flow and stock split data.
In July, GameStop (NYSE:GME) launched its NFT marketplace to a relatively muted reception. NFT trades had already fallen three-quarters since January, and traders assumed the game retailer had missed yet another party. Shares would eventually drop another 25%.
Investor pessimism, however, has quietly turned GME stock into a short-squeeze candidate. Sagging trading volume means that it would take traders almost 17 days to cover their short positions, up from three days in July. And with 30% of GameStop shares now directly held by transfer agents, the Texas-based firm has become a trap for short sellers who didn’t get the memo the first time around.
The Risks of Short Selling
In 2014, I shorted shares of watchmaker Movado (NYSE:MOV) as a bet on rival Apple’s (NASDAQ:AAPL) newly launched smartwatch. Shares of Movado would slide from $45 to $25 before I closed the position at a significant profit.
The emotional toll, however, was immense. Monitoring shares of the legacy firm was agonizing; every day brought new fears of unlimited losses. And had I stayed in the position, the volatile short sale would have cratered my client’s portfolio when shares jumped to $50 several years later. Unlike buying stocks, shorting them involves selling more when stocks go down and raises the risks of a wipeout.
Movado would become my last negative bet, ever.
Nevertheless, many institutional investors fail to remember the lessons of unhedged short-selling. Memories of meme stock blowups from early 2021 are fading. And falling markets are tempting short-sellers back into firms from Bed, Bath & Beyond (NASDAQ:BBBY) to electric charging station EVgo (NASDAQ:EVGO).
GameStop Stock’s Hidden Short Squeeze Risk
Nowhere is this clearer than at GameStop, a firm once short-squeezed by Reddit’s r/WallStreetBets to devastating effect.
Since July, daily volatility of the video game retailer has declined by around half. On a per-day basis, GME stock now moves only as much as tech firms like Etsy (NASDAQ:ETSY) and Snap (NYSE:SNAP), lulling short sellers into a sense of false security. Short interest now sits at 51.1 million shares, a 63% increase from this time last year. The put-call also ratio remains bearish; 1.52 puts now exist for every January 2023 call outstanding.
Meanwhile, liquidity in GameStop shares has steadily decreased. At least 71.3 million GME shares are now directly registered with GameStop’s transfer agent, according to its latest quarterly filing, up from 50.8 million in the prior quarter after adjusting for stock splits. Its free float today is likely less than 150 million once factoring in other closely held shares. Add in a declining stock price, and the dollar amount of daily-traded GameStop shares has fallen from over $400 million last year to $90 million today.
Much like the process of assembling a Super Smash Bros team, these diverse factors are setting the stage for a blowout fight. Rising prices force short sellers to buy back their stakes and offset losing positions. Narrow markets magnify upward price pressure, causing more short sellers to buy shares, and so on. The resulting short squeeze can bankrupt even the largest of hedge funds, as Melvin Capital realized in 2021 after losing around $7 billion that year in bearish meme stock bets. In other words, GameStop has once again become a short squeeze waiting to happen.
Will GME Stock Get Short Squeezed This Year?
Timing a squeeze is risky at best.
GameStop’s shorted shares as a percentage of float remain well below the 2021 peak; its recent squeeze potential stems from lower liquidity rather than more short selling. And prices of GME stock remain far above their 2021 values. Today, they trade at 1.2X price-to-sales (P/S), compared to a 0.25X ratio before the first short squeeze.
Finally, GameStop’s business outlook is in arguably worse shape today than when activist investor Ryan Cohen first stepped in. The gaming retailer has failed to find its way into e-commerce and can no longer rely on shrinking its inventory to maintain cash flow as it did in 2020 and 2021. The company could bleed as much as $600 million in free cash flow next year, earning it a lackluster B- in my quantitative Profit & Protection stock-picking system. From a purely probabilistic standpoint, such money pits underperform the market over 12-month time horizons.
Nevertheless, retail traders have ignored such warnings. To them, it matters little that the company scores poorly on a proven stock grading system or that Wall Street analysts have a $16 price target on GME.
Instead, they’re interested in stocks that can rise 2X… 5X… 10X and stick it to bearish hedge funds at the same time.
So, if short sellers want to avoid the sleepless nights like I once had with Movado, they should consider quietly tip-toeing out of their increasingly risky GameStop bets. Because if Reddit’s r/WallStreetBets has it their way, GameStop will get short-squeezed again soon.
Tom Yeung is a market analyst and portfolio manager of the Omnia Portfolio, the highest-tier subscription at InvestorPlace. He is the former editor of Tom Yeung’s Profit & Protection, a free e-letter about investing to profit in good times and protecting gains during the bad.