Forbes India 15th Anniversary Special

Meme stocks: A cautionary tale

Think twice before jumping on the investing hype train, writes professor Eric Kirzner. It's likely just a bubble waiting to burst

Published: May 24, 2024 12:22:57 PM IST
Updated: May 24, 2024 12:33:15 PM IST

Meme stocks: A cautionary taleHerd behavior can have both positive and negative effects, depending on the situation. Image: Shutterstock

Mob mentality. Groupthink. Pack behaviour. General strikes. Sports events. All are forms of ‘herd behaviour’, which occurs whenever a large number of unconnected people act in the same way at the same time—sometimes with direction from others, sometimes not.  Fuelled by fear, greed or a desire to be part of a particular group, individual judgment and opinion-forming processes shut down as people automatically follow the group's behaviour.

Herd behavior can have both positive and negative effects, depending on the situation. For example, it can lead to increased efficiency and safety in a group. But it can also cause people to make irrational or dangerous decisions. In the realm of investing, herding results when investors copy the behavior of other investors. And like many forms of herd behaviour, the results can be catastrophic.

This behavioural phenomenon underlies some of the biggest stock and property bubbles in history—including some very recent ones.

The bubble metaphor stands for assets—real or financial—that  are based on nothing but air, and subject to sudden bubble bursts.  A bubble is when specific asset prices (such as stocks, or real estate or precious metals) far exceed their intrinsic value.  Bubbles are often perpetrated by scoundrels exaggerating or lying about the real value of the investments, although sometimes the bubble is created through irrational exuberance of the Crowd itself.     

For those interested, you can read about some of the early bubbles, beautifully documented by Charles Mackay in Extraordinary Popular Delusions and the Madness of Crowds.  In it, he describes the Dutch Tulip Mania of the 1640s; the  South Sea Company bubble of 1711–1720; and John Law and the Mississippi Company of 1719–1720.  

Modern day financial bubbles include the 1982-1989 Japan stock and real asset crash, the 1999-2001 dot-com bubble, the 2007-08 teaser-mortgage-created global financial crisis and various cryptocurrency bubbles including the one that occurred in May, 2022.  But a relatively new form of micro, isolated bubbles has emerged:  meme stocks.

But first, a look at how this all began. The growth of the Internet has fostered a whole new wave of investing and disseminating investment advice—and hype.  Online chat and discussion rooms developed in the 1990s, and a favourite topic was the dot.com stocks which were leading the 1990s disinflation market rally.  The activity of chat room traders was a contributing factor in fueling the dot.com price explosion of the 1990-2001 period.

Chat rooms have since morphed into modern-day social network chat rooms.  Users—many of whom are small, often inexperienced  investors—post messages about their investment ideas, their recent stock purchases and in some cases, exhort others to join them.  It is very easy to trade small quantities today using on-line services, direct trading accounts (with $10 or less commissions,) and investing apps, some of which have ‘free’ trading accounts.

One of the most popular platforms is r/WallStreetBets (WSB) on Reddit, a social news network, where a large group of users, some organized and some independent, share stock tips, make predictions, engage in contests and share trading experiences.  The WSB group isn’t new; it started about a decade ago and now has millions of users. If you go to the site you will see thousands of messages about purchases and trade opportunities—and  plenty of bragging about trade successes. Some of the ideas are logical and some are pretty wild.  It’s pretty much a wild west trading show, although in in fairness they do have posted rules. Some of the rules and guidelines are (please excuse Reddit’s colourful language):

  • Your gains and losses must be realized if you want to talk about them;
  • Avoid pump and dumps, short squeezes and market manipulation;
  • No bullshitting: only comment if you know what you're talking about.  Don't make shit up, and be responsible when giving and taking advice. This includes talking about things you don't know about. You should listen, not talk. Nobody wants an ill-informed opinion
  • Paper trades don't count as real trades and are forbidden as standalone posts. Nobody gives a shit about your preschool's trading competition, don't ask us for help; and
  • No advertisements, self-promotion, fundraising or begging.

So-called ‘meme stocks’ are favourites of the chat room crowds.   A meme stock refers to the shares of a company that have gained online attraction and popularity on social media platforms.  These online communities can focus huge attention resources toward a particular stock. The meme stock movement unofficially started in the summer of 2020 when most people were stuck at home during the first few months of the pandemic. Looking for something to do and a way to turn some of that extra free time into money, many people turned to the stock market and social media for ideas.

Also read: How to break free from herd mentality

Last year in this publication, I wrote about what was then the poster child of meme stocks: GameStop.  I explained how GameStop (GME)—the  world’s largest video game seller, but an unprofitable company—went from $15 a share in 2020 to $483 a share in January 2021 due to a short-squeeze perpetrated by chat room traders.  WSB and others were not only buying GME, they were buying and talking up some other companies with large short positions, including AMC Entertainment and BlackBerry.  GME traded as high $483 a share at one point giving the company a market value about $24 billion—about 80 times greater than its closing 2019 value.  In the short run, the WSB group won, hands down.

The hedge funds were caught in a classic ‘rising price short squeeze.’
For those who aren’t familiar with the term, this is an unusual condition that triggers rapidly rising prices in a stock or other tradeable security. It occurs when a security has a significant amount of short sellers, meaning lots of investors are betting on its price falling. The short squeeze begins when the price jumps higher unexpectedly and gains momentum as a significant measure of the short sellers decide to cut losses and exit their positions.

With enormous losses piling up, huge margin calls and no stock to deliver, Melvin Capital and Citron Capital (and possibly others) gave up, covered their shorts, and took their enormous losses.  It all came to an end as the reality of the company’s real value finally took hold.  The buying momentum ended with a whimper.  With the shorts now out of the market, buying in GME dried up, the bubble burst and the stock sunk.

In 2023 Gamestock was priced at $19.00, close to where it was when this all started, and it’s almost like nothing ever happened.  But not quite: the mayhem is not forgotten.  An entertaining TV series called Eat the Rich: The Game Stop Saga and a movietitled Dumb Money came out, starring Seth Rogen as hedge fund manager Gabe Plotkin.

The latest chapter in the meme stock saga is AMTD Digital, and it tops GameStop in sheer audacity. AMTD Digital (ticker: HKD) went public on the New York Stock Exchange in July 2022, priced at $7.80 a share.  Based on the earnings per share, sales revenue, other metrics and current prospects, the IPO was probably fairly valued.

Here is how the company described itself in its prospectus:
Our mission is to act as fusion reactor for the best entrepreneurs and innovative ideas fusing synergistically all elements within the AMTD Spidernet ecosystem using digital means, harnessing and magnifying the power from each partner to create a force with meaningful and influential social, technological and economic impact.

An ambitious vision, to say the least. So, what happened next?

The  IPO literally exploded out of the blocks and within a few weeks in early August, the stock rose to $2,225 per share during the day on August 2.  Undoubtedly this was some type of record for aftermarket trading for an IPO.  Its $360 billion market cap made it at that time one of the most valuable companies in the world based on market capitalization: worth more than Coca-Cola, Shell, Facebook and Costco.  The ticker HKD was the most popular mention on the WSB chat room, but WSB users denied being involved.  CNBC called HKD “The $300 billion meme stock that makes GameStop look like child’s play.”

As is always the case, gravity quickly took hold and the stock came back to earth.  It then fell steadily into 2023.  But the meme traders didn’t forget about it.  On January 5, it traded over 40 million shares and hit $37.72 after closing at $10 the day before. That petered out quickly and lo and behold, at press time it is back to $6.75—very close to its IPO price. Thus concludes—at least for now—one of the great bubbles in stock history.
 
To date, no person or group has taken credit for the bubble.  Certainly not the company. In August 2022 it stated: “To our knowledge, there are no material circumstances, events nor other matters relating to our company’s business and operating activities since the IPO date.”

Meme traders remain very active, gravitating to companies with large short positions. They seem to particularly like companies that have announced bankruptcy such as Revlon and Bed Bath and Beyond. To top it off there is a meme stock exchange-traded fund (ETF.)  The Roundhill Meme ETF tracks a meme index of companies that exhibit a combination of elevated social media activity and high short interest, both of which are indicators of market sentiment.  Under normal circumstances, at least 80 per cent of the fund’s net assets will be invested in meme stocks and it will invest in all component securities of the index in approximately the same proportions as in the index.

All in all, meme stocks and meme bubble trades appear to be here to stay.  And while they represent a tiny portion of the overall investment landscape, the ethical and regulatory challenges posed by both are formidable.

A final note.  After he initially made some money, Sir Isaac Newton apparently lost virtually all of his life savings in 1720 by buying back into the South Sea Co. His famous quote at the time: “I can calculate the motion of heavenly bodies, but not the madness of people.”

Oh, the irony. Of all people, you would think that the discoverer of the law of gravity would have recognized that what goes up comes down—and usually faster.

Eric Kirzner is a Professor Emeritus of Finance and the John H. Watson Chair Emeritus in Value Investing at the Rotman School of Management. 

[This article has been reprinted, with permission, from Rotman Management, the magazine of the University of Toronto's Rotman School of Management]