Alexander Kurov, West Virginia University

Shares of GameStop and other companies or assets that shot up in value in recent weeks are now dropping like stones. While I feel sorry for the many investors who will likely lose a lot of money, the stocks’ return to Earth is actually a good thing – if you want to avoid financial meltdown to the long list of crises the U.S. is facing.

The reason has to do with what financial markets are – and what they are not – as well as what happens when prices of stocks and other securities become untethered from the fundamental value of the assets they’re meant to represent.

As a finance professor who does research on how markets respond to new information, I believe it is important to maintain a close link between security prices and fundamentals. When that stops happening, a market collapse may be not far behind.

Capital markets aren’t casinos

Some have portrayed GameStop as a David vs. Goliath story. According to that narrative, the big guys on Wall Street have been getting rich gambling on the stock market for years. What’s the problem when the little guy gets a chance?

The first thing to keep in mind is that markets aren’t a big casino, as some seem to believe. Their core purpose is to efficiently connect investors with companies and other organizations that will make the most productive use of their cash.

Accurate market prices, meant to reflect a company’s expected profits and overall risk level, provide an important signal to investors whether they should hand over their money and what they should get in return. Companies like Apple and Amazon simply would not exist as we know them today without access to capital markets.

The more jaundiced view of markets focuses on episodes when markets seemingly go crazy and on the speculative gambling behavior of some traders, such as hedge funds. The GameStop saga feeds into this storyline.

But GameStop also illustrates what happens when stock prices don’t reflect reality.

The GameStop bubble

GameStop fundamentals are, to put it mildly, lackluster.

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. Its revenue peaked in 2012 at US$9.55 billion and had dropped by a third as of 2019. It hasn’t earned a profit since 2017. Put simply, it is a money-losing company in a competitive and quickly changing industry.

The recent speculative frenzy, however, increased the GameStop stock price from under $20 in early January to as high as $483 in a little over two weeks, driven by retail investors on Reddit who coordinated their buying to harm hedge funds – costing the professionals billions of dollars.

It is clearly a speculative price bubble and has some characteristics of a Ponzi scheme. Many small investors who “get on the train” late and buy at the inflated prices – especially those attracted by the extreme price moves and media coverage – will be left holding the bag.

And sooner or later, the stock price will likely come back to Earth to a level that can be supported by the fundamentals of the company. Shares closed on Feb. 4 at $53.50, the lowest since Jan. 21.

The problems begin when that doesn’t happen until too late.

Bubbles are made to pop

Financial markets are made up of people. People are imperfect, and so are markets. This means market prices are not always “right” – and it’s often hard to know what the “right” price is.

That is true when it comes to the price bubbles in individual stocks like GameStop. But it’s also true on a much bigger scale, when it comes to a market as a whole.

Price bubbles and crashes are good for neither Wall Street nor Main Street. When the dot-com bubble popped in 2000 – after prices of dozens of tech stocks soared exponentially in the late 1990s – an economic recession followed soon after. The bursting of a housing bubble in 2008 triggered a global financial crisis and the Great Recession.

Too much momentum

So markets fail sometimes, and we need sensible regulation and enforcement to make such failures less likely.

Taken in isolation, the GameStop craze is unlikely to trigger a disruption to the overall stock market, especially if its price continues to fall more in line with the company’s fundamental value. Unfortunately, this was not an isolated case. Nor was GameStop the first sign of problems.

In recent days, Reddit users have also driven up the prices of silver and companies such as BlackBerry and movie theater giant AMC Entertainment. Popular trading apps like Robinhood have made trading easy, fun and basically free.

The share price of Tesla, for example, skyrocketed 720% last year, in large part when investors bought the stock because it was already rising. This is called momentum investing, a trading strategy in which investors buy securities because they are going up – selling them only when they think the price has peaked.

If this continues, it will likely lead to more financial bubbles and crashes that could make it harder for companies to raise capital, posing a threat to the already limping U.S. economic recovery. Even if the worst doesn’t happen, large price movements and allegations of price manipulation could hurt public confidence in financial markets, which would make people more reluctant to invest in retirement and other programs.

Warren Buffett once said about stock market behavior: “The light can at any time go from green to red without pausing at yellow.”

What he meant was that markets can turn on a dime and plunge. He saw these moments as opportunities to find deals in the market, but for most people they result in panic, heavy losses and economic consequences like mass unemployment – as we saw in 1929, 2000 and 2008.

There’s no particular reason it won’t happen again.

Alexander Kurov, Professor of Finance and Fred T. Tattersall Research Chair in Finance, West Virginia University

This article is republished from The Conversation under a Creative Commons license. Read the original article.