How the GameStop short squeeze may be connected to the stock market’s plunge

The S&P 500 and Dow both closed deep in the red on Wednesday, down 2.6% and 2.1% respectively, after trading slightly lower this week. Though analysts point to a variety of plausible catalysts for the selloff, some suggest it’s possible that the profit-taking in large cap indexes is in part to raise money to cover short bets made on stocks like GameStop.

“When people are getting run over and they have to raise cash, I wouldn’t be surprised if there’s a little bit of that going on right now, because God knows more than one hedge fund was short GameStop,” Russell Rhoads, head of research and consulting at EQDerivatives, tells Fortune.

Shorts on GameStop are currently down over $23 billion year-to-date in 2021, according to S3 Partners data.

Those kinds of losses may be prompting managers to sell some of their positions in other securities. “Even a hedge fund with substantial financial assets can’t stay short forever on a stock that goes up ten fold, so there will be some who have to raise capital without a doubt,” Randy Frederick, vice president of trading and derivatives at Charles Schwab, tells Fortune.

Indeed, Ihor Dusaniwsky, a managing director at S3 Partners, explains “hedge funds use stock as collateral for their leverage” to be able to borrow cash or securities for transactions from a prime broker. And for those who are short “Reddit names” like GameStop or AMC, “There are probably a bunch of hedge funds that are looking at their … longs and shorts, and saying, ‘I have to change the makeup of my portfolio because I have a handful of stocks that are costing me tremendous amounts of money for using the prime broker’s balance sheet’,” he tells Fortune.

“That is a scenario that I think is starting to happen on the Street which is probably showing up in some of the sales of some of these mega cap names,” Dusaniwksy adds.

Meanwhile, some hedge funds may also owe redemptions to their investors at the end of the month (this Friday, for markets), which means they’d have to have cash for the payouts, notes Rhoads. Though some like Frederick wager that’s likely not a huge factor in the market moves, Rhoads argues he “would not be the least bit surprised if that’s part of what’s going on.”

Retail mania

But what’s more, some analysts suspect the markets overall might be on edge in light of the frothy retail-fueled trades.

For some strategists, the “craziness” might be a sign that a pullback isn’t too far off. The movement in stocks like GameStop is “just an example of the type of craziness you tend to see when you get toward market tops,” Frederick suggests.

And these days, retail investors have more power than they used to. Goldman Sachs estimates individual investors own more than one-third (36%) of the $57 trillion U.S. equities market. That number is only going to grow thanks to the rise of cheap, app-based trading platforms such as Robinhood.

“Our data analysis shows us there is something new in the markets that’s being almost entirely driven by retail investors—what we call, ‘viral stocks.’ Just like there are viral tweets, there are viral stocks,” says Ivan Ćosović, founder of Dusseldorf-based Breakout Point GmbH, a data analytics firm that tracks retail investors and activist shorts.

In analyzing popular internet message boards and investor forums like Reddit’s WallStreetBets, Break Point has seen chatter around a number of small-fry stocks—penny stocks like OcuGen and Zomedica, but also BlackBerry, Nokia and Tootsie Roll—grow from a few comments to a torrent. Shortly after, many of these chatted-up shares make the jump to Robinhood’s “100 Most Popular” list.

And since retail investors have become a “formidable force,” says Schwab’s Frederick, “It’s probably the first time we’ve ever seen where the institutional investors really need to be wary.”

Indeed, some on the Street argue what’s happening with GameStop and these other retail favorites is giving them flashbacks to the Internet Bubble.

“I do think some old timers in the markets are looking at this and seeing some equivalence to what happened in 1999—Overvalued market, and just silly, non-fundamental moves on stocks like this GameStop thing,” EQDerivatives’ Rhoads argues.

That’s not to say the 2021 market is doomed to follow 1999’s path—in fact, many analysts argue stocks are likely to stay in a long-term bull market and end the year higher. But those like Rhoads suggest “If we see stocks break out and then turn right around, that could be a precursor to something a little bit nastier in the overall stock market.”