Blinded by Meme Stocks?

This article is an educational piece about meme stocks. For informational purposes only.

2021 was certainly not short of headlines. From the Archegos debacle to China’s technology and education crackdown – these were some of the events that shaped the year. But the one headline that definitely caught investors’ attention was the GameStop and Reddit Saga. Overnight, meme stocks were the talk of the town.

What are meme stocks?¹

Meme stocks are stocks that see dramatic increases in price, mostly fueled by social media discussions on Reddit and Twitter. Trading in these stocks is usually driven by short-term buyers and sellers. And because these stocks rarely have business fundamentals to support huge jumps in price, they tend to experience huge price swings. Many meme stocks experience huge rallies that are fueled by what is called a “short squeeze”² on Wall Street.

GameStop had been widely regarded as the first meme stock³; whose stock price rose 1625% in January 2021 alone⁴.

The GameStop Saga

As explained by its name, GameStop is an American high street store that specializes in consoles, games and other electronic devices. The chain itself is nothing to write home about as it is one of the many that offer such goods and services. In fact, due to the global circumstances of 2020 brought about by the pandemic, Gamestop was not exactly thriving.⁵

GameStop announced in early January 2021 that it was appointing 3 new directors to its board and this sparked some initial chatter on Reddit. Thanks to a legion of retail traders on Reddit as well as Elon Musk’s tweet on the stock, GameStop shares soared from $19 at the start of 2021 to an all-time high of $347 by 27 January 2021, as seen in Figure 1. Things came crashing down when a short squeeze induced huge pain on hedge funds, namely Citron Capital and Melvin Capital, who bet against the stock. It also forced several online brokers to restrict trading involving some highly volatile names, including GameStop. ⁶ The saga sparked Congressional hearings and an investigation by the Securities and Exchange Commission to ensure that financial markets are functioning properly, efficiently and that investors are protected.⁷

Figure 1: GameStop price chart from Jan to Feb 2021

Source: Bloomberg

Over the course of 2021, GameStop had rebounded but it had lost more than half its value from its peak in January 2021, as seen in Figure 2.

Figure 2: GameStop price chart from Jan to Dec 2021

Source: Bloomberg

Why meme stocks are not suitable for most investors?

The meme stock boom in 2021 could signal a fundamental change in how the stock market works, but it could also be a massive bubble. Although some investors have experienced eye-popping gains from the popular viral names, there are still several reasons to generally avoid meme stocks.

1. Different skill set – social media monitoring

As we have seen with the GameStop example, a traditional buy-and-hold strategy seems unlikely to work with meme stocks because parabolic gains can easily disappear. After soaring to $483 on 28 January 2021, GameStop plunged roughly 90% over the subsequent two weeks. They trade like lottery tickets and their intrinsic value is completely disregarded.

Meme stock trading requires a lot of social media monitoring in finding the right meme stock to bet on – a different skill set from traditional investing. At the end of the day, it may still boil down to a decent amount of luck. Many meme influencers have tried to start new stock rallies and if you tried to follow all, it is uncertain that you would make a quick buck out of it.

2. Weak fundamentals

With meme stocks, investors often need to decide if they should buy with blind faith – a stock that has no or poor earnings and what seems to be a poor outlook or stay away completely.

With the GameStop example, we have seen how meme stocks with weak fundamentals could trade at many multiples above their intrinsic values. By investing in them, investors are carrying a much higher risk of losing as much as what they have invested, and that is certainly not for the faint-hearted.

While there are risks in any type of investment, stocks with strong fundamentals are unlikely to lose half their value in a matter of a few weeks, unlike meme stocks.

For illustration, let us compare the returns between GameStop, MSCI USA Quality Index and MSCI USA Index from GameStop’s 27 January 2021 peak to the end of the year. As seen in Figure 3, an investor would have lost more than half of its value by the end of the year if he had invested in GameStop at its peak. On the contrary, he would have been up more than 20% if he were to invest in the broader indices.

Figure 3: Comparing returns from GameStop, MSCI USA Quality Index and MSCI USA Index (27 Jan 2021 – 31 Dec 2021)

3. Selling at the right time

Investing in meme stocks, especially as a short-term punt, requires you to have the skill to sell at the right time. Many meme stocks can go up 30% in a matter of a few days, but timing is particularly important for meme stocks. Will you sell it too soon? Will you able to sell it at the point that the stock had gone up 1000%? Or will you hold it for too long and end up wiping out a good portion of your fortune?

Timing the market is already challenging for ordinary stocks; what more for meme stocks? You will be at the mercy of any irrationality of social media discussions and the “right time” will always be a gamble.

Final Words

Before investing, whether it is a meme stock or even a high-quality stock, it is always important to first identify and determine your financial goals and how these investments may or may not fit into your investment strategy and risk appetite.

Sound financial planning is essential, especially if it involves your entire savings. The core of your portfolio should always be a diversified balance of long-term investments like quality stocks, bonds, or unit trusts to help achieve your financial goals. Leave meme stocks for the spare cash that you can do without because the outcome may very well be like a bad night spent in the casino. Surely, meme stocks turned some (very lucky) investors into millionaires during the pandemic, but in reality, the odds are often heavily stacked against you.

Remember, rocket ships will eventually burn out of fuel, and you certainly don’t want to be the last one buying.

References:

1. https://www.morningstar.co.uk/uk/news/215948/should-investors-buy-meme-stocks.aspx
2. A short squeeze is the result of frantic buying by traders who have bet that a stock is overpriced and will fall in price. They make these bets by essentially selling shares of stock that they don’t own in hopes of buying it at a lower price. This is commonly referred to as “short selling”. But when a stock starts to move higher, the shorts can suffer huge losses, and these traders are forced to buy the stock at higher and higher prices to exit their trades. This leads to a rally that makes a stock way overvalued based on underlying fundamentals.
However, once the upward momentum runs out and the stock starts to correct, the reverse can happen, and the stock price can plummet as those who bought on the way up scramble to unload the now overpriced shares.
3. https://www.investopedia.com/meme-stock-5206762
4. Bloomberg
5. https://www.bbc.com/news/newsbeat-55841719
6. https://abcnews.go.com/Business/gamestop-timeline-closer-saga-upended-wall-street/story?id=75617315
7. https://www.cnbc.com/2021/12/23/meme-stocks-spac-craze-and-100-million-deli-2021-marks-a-wild-year-in-the-stock-market.html

About the writer

A globetrotter at heart, Winnie did not stop being one even after becoming a mother of 2; in fact, her children are her greatest travel partners! During her free time, besides planning for her next vacation, Winnie also enjoys listening to Maroon 5 and Ed Sheeran going on quiet drives, spending time with her family and friends, and watching football. One of her biggest moments as an Arsenal fan was watching the team play from the stands at the Emirates Stadium.