Motivated by profit and the opportunity to inflict financial pain on mega-wealthy hedge fund managers, retail traders – armed with a few thousand dollars in their Robinhood accounts – ganged up to drive the prices of heavily shorted companies like GameStop (ticker: GME) from about $9 in October to well over $300 per share by the end of January. The move heavily scarred the likes of Gabe Plotkin’s Melvin Capital Management, which suffered a 53 per cent plunge in January. Melvin was forced to seek a $3 billion capital infusion from Ken Griffin’s Citadel and Steve Cohen’s Point72 to stay afloat, according to CNBC.

Any sudden stock, bond or asset class gyrations have the potential to create market dislocations at least and, at worst, systemic malfunctions. Regulators have been forced to periodically intervene when market dislocations have threated the financial system. In 1998, Long-Term Capital Management LP (LTCM) lost $4.6 billion due to a one-two punch of bad bets related to the 1997 Asian financial crisis and the 1998 Russian financial crisis. The impending implosion was so massive and the fund’s financial tentacles so deep that regulators feared a wider systemic collapse. The Federal Reserve orchestrated a coordinated $3.6 billion recapitalization of LTCM by fourteen leading financial institutions. Regulators intervened again in 2008 during the height of the financial crisis caused by the housing bust, bailing out General Motors and conducting a few shotgun weddings, including JP Morgan’s purchase of Bear Stearns. Last year’s pandemic selloff prompted the Fed to inject trillions of dollars into the financial system to stem the possibility of a systemic breakdown. While Robinhood trading didn’t threaten the financial system, it did invoke circuit breakers among clearing firms.

Robinhood was a Silicon Valley startup launched with the promise of disrupting Wall Street by giving better market access to the little guy. The new-age firm introduced zero-cost trading and the ability to transact in fractional shares, particularly useful for micro-sized portfolios. As its popularity soared, the Menlo Park brokerage firm found itself at the mercy of an industry it had hoped to disrupt. Frenetic one-sided bets prompted Robinhood to halt trading in a handful of popular names, including GME, as clearing firms forced the brokerage house to post additional capital to ensure orderly settlement activity and avoid cracks in the market’s structure. Robinhood quickly drew down on its $500 million bank line of credit and took in an emergency infusion of more than $1 billion from its existing investors. While the move raised hackles among its customers and a couple of legislators, trading resumed the following day.

Robinhood’s trading halt infuriated its Main Street customers, who fumed that institutional investors were able to trade in GME while they couldn’t. The public rancor raised the awareness of several lawmakers, including New York’s Alexandria Ocasio-Cortez and Texas’ Ted Cruz, who never agree on anything, who asserted that Wall Street is stacked against the little guy. It was also revealed that Robinhood routes nearly half of its trading volume through Citadel Securities, run by hedge fund giant Ken Griffin, whose flagship hedge fund, as we mentioned above, is an investor in Melvin Capital. Robinhood generated $271 million from all order-flow payments in H1/20, according to a Washington Post report. The move only reaffirmed progressives’ beliefs that financial institutions need to be reined in. Massachusetts Senator Elizabeth Warren, a long-time Wall Street critic, argued for an SEC investigation. A congressional review could lead to tighter regulatory oversight of the financial markets, particularly if an investigation concludes that certain hedge funds engaged in “naked shorting” of GameStop shares. Outlawed in 2008, naked shorting occurs when investors sell shorts associated with shares that they do not possess and have not confirmed their ability to possess. Given that short interested accounted for well over 100 per cent of GME shares in circulation, it’s apparent that a share of the short interest was indeed naked.

The investment establishment will be forced to adjust to this new reality. Populist capitalism will not go away, particularly if it remains profitable for its participants. That means that hedge funds and their mega-wealthy portfolio managers could be forced to rethink their business models. A substantial share of hedge fund strategies involves shorting: whether it’s market neutral or long-short strategies, short interest represents much of the “hedge” in hedge funds. The risk of a short squeeze turns the risk dynamic of maintaining short positions upside down. Hedge fund managers will need to reconsider their approach. After being targeted for his GME short position, Citron Research’s Andrew Left announced that after 20 years in business he will no longer publish short research. Several other hedge fund managers are revising their short strategies as well. Even though selling stocks in companies whose share prices overstate their fundamental reality makes sense in the long run, hedge fund managers must remember one of my favorite John Maynard Keynes quotes: “The markets can remain irrational longer than you can remain solvent.”

While last week’s events were eye popping for hedge fund investors, populist capitalism carries implications for long-only, buy-and-hold investors as well. Last week’s selling was likely short-lived, promulgated by hedge funds selling to raise liquidity. However, any wider perception that the stock market is rigged could have longer-term, deleterious effects. Moreover, we will be watching for any lasting impact of new regulations on the hedge fund industry as a result of targeted buying.

Many Americans and their lawmakers expostulated last year’s bull market against a backdrop of widespread unemployment. We worry that recent trends could promulgate populist-driven policies – promoted on the Biden campaign trail – that could raise tax rates on wealthy Americans and wipe out the carried interest tax treatment for investment partnerships. For now, President Biden and Congress need to focus their attention on infections, vaccines and economic relief. Forcing the one-percenters to “pay their fair share” could eventually move to the front burner once the pandemic dust settles. Even though President Biden’s agenda is full in addressing the COVID-19 infection and vaccine distribution, the vituperative criticism of Wall Street will not be as easily eradicated.