2021 has become an interesting year for the stock market. As the world begins to recover from the COVID-19 pandemic, and stimulus spurs economic growth, stock prices are skyrocketing in one of the biggest recoveries the market has ever seen.
However, that’s not the only thing that’s new and interesting about the market in 2021. A whole new class of stocks has begun to emerge.
These stocks are known as meme stocks. But what are they, and should you consider adding them to your investment portfolio?
What Are Meme Stocks?
Meme stock is a relatively new term used to describe stocks that are benefiting from social media hype.
The vast majority of these stocks have experienced heavy short interest from institutional investors, resulting in their prices facing downward pressure.
However, retail investors have shown the investing community that when they band together, they have the ability to outweigh the pressure put on stocks by short sellers, leading to dramatic gains in stock prices.
Where Did the Term “Meme Stock” Come From?
The term “meme stock” started to circulate on the Internet after retail traders on a subreddit known as WallStreetBets worked together to wage war with hedge funds that were shorting the video game retailer GameStop.
Before the social-based action on the stock, GameStop was trending in the downward direction, and for good reason. The pandemic hit the retailer exceptionally hard, forcing the company to close various locations and leading to much lower levels of foot traffic in its stores, resulting in significant reductions in revenue and earnings.
As a result, institutional investors saw an opportunity and decided to short the stock, meaning they borrowed shares from investors who owned the stock and sold them immediately into the open market in hopes of buying shares back at a lower price later. The short sellers hoped to take home the difference between the two prices as profit.
That didn’t work out so well for the big-money investors who sold GameStop short in early 2021.
Many retail investors didn’t like the idea that big-money players were borrowing their shares, only to sell them and drive prices lower. So, the group on WallStreetBets decided to take their concerns to the public and urge everyone reading to buy the stock to hand losses to the hedge funds and other institutions driving prices down.
Why did the institutions lose so much money?
When you short a stock, you borrow shares in order to sell them at today’s price. And, like anything else that’s borrowed, these shares must be returned.
When a shorted stock rises from the price at which it was sold into the market, the investor loses money because they have to buy back the borrowed shares at a higher price.
Sometimes, when the price of a stock starts to rise, short sellers may buy shares to return before they get too much more expensive, accepting their losses and pushing the price even higher in what’s known as a short squeeze.
As the retail investors took the upper hand, memes started appearing all over social media surrounding the event, and the term “meme stock” was coined.
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Examples of Meme Stocks
Although GameStop was the first stock in this category that experienced a wave of short squeezes that drove share prices to record highs, it’s not the only player in this game. Other popular stocks in the category include:
AMC Entertainment Holdings (NYSE: AMC)
AMC Entertainment, the popular movie theater chain, is arguably the second most popular stock in the category. Like many other companies, the coronavirus outbreak led to significant hardship for AMC. Theaters pack large crowds of people into small rooms, which becomes a playground for communicable diseases, like COVID-19.
During the pandemic, the company was forced to close its doors entirely for an extended period. However, while it was unable to earn revenue, the bills kept piling up. This led to the company burning through billions of dollars in cash and financially crippling what was once a thriving business.
The sharks began circling and hedge funds started making big short bets.
On the other side, retail investors argue that theaters have opened back up and vaccination counts are climbing. Not to mention, after being cooped up at home for a year, consumers are seriously yearning for the opportunity to go out — say for dinner and a movie. They believe the company is primed for a comeback.
The social buzz started to become electrifying, creating a magnet that drew retail investors in. The stock climbed from about $2 at the start of 2021 to nearly $20 per share by the end of January. Later, in June, another short squeeze took place, driving the stock from around $12 per share to over $62 per share.
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Bed Bath & Beyond (NASDAQ: BBBY)
Bed Bath & Beyond is another retailer that fell on painful times as a result of the COVID-19 pandemic. As with other businesses that were deemed “nonessential,” the company was forced to close its doors for an extended period to prevent the continued spread of the virus.
The company found itself in the crosshairs of short-selling hedge funds.
As with many other meme stocks, Bed Bath & Beyond is a beloved company among consumers. With the reopening of stores, many are expecting the company to see significant growth as consumers look for ways to get out of the house.
As social media started to buzz, a short squeeze ensued, driving the price of the stock from around $18 to nearly $53 per share.
Tesla & Dogecoin (NASDAQ: TSLA)
Tesla isn’t your average stock in the meme category, but it’s worth mentioning.
For some time, there’s been a strong argument that Tesla is overvalued. The company barely started to turn profits in 2020, and there aren’t any major increases in profitability expected in the near future — certainly not enough to justify a price-to-earnings (P/E) ratio that has ranged from 550 in June 2020 to a high of around 1,400 in January 2021. While that figure has tapered down a bit, now sitting at around 400, the overvaluation remains clear.
However, Tesla and its CEO are popular social media stars and a fan favorite among retail investors.
In fact, Elon Musk doesn’t just influence the price of his own company; a simple tweet from the famed billionaire has the potential to send his favorite cryptocurrency, Dogecoin, through the roof, as was demonstrated in the spring of 2021.
With Musk being such an influential figure in social media, there’s little question that the hype online has quite a bit to do with the company’s valuation.
Why Are Meme Stocks So Popular?
These stocks are popular for multiple reasons.
First and foremost, investors in meme stocks are looking to make money.
The GameStop short squeeze brought the price of the stock from under $20 per share to nearly $350 per share in a matter of weeks. There’s nothing like making a 1,750% gain in a few weeks on an investment to get you fired up.
Emotion often drives moves in the stock market, and a heady mix of excitement and greed is one of the biggest drivers of popularity in these stocks.
2. Supporting the Underdog
There’s something that makes us feel good when we stand behind the underdog. For some reason, people love to see a person, company, or sports team that’s been counted out gain the upper hand.
The vast majority of stocks in the meme stock category are heavily shorted, meaning the brightest minds on Wall Street bet against them because they see danger ahead. Many of these companies have experienced declining revenue and an extended lack of profitability as a result of the pandemic, and some could face bankruptcy if things don’t change for them soon.
These are definitely underdogs, but they’re also well-known companies, giving investors the feeling that they’re fighting to keep a struggling brand they love above water.
3. The Thrill of the Fight
Investors are also in a pretty thrilling battle. For some time now, hedge funds have made massive amounts of money from short positions, betting against companies and profiting from their declines.
Some retail investors are tired of this activity and see it as an unethical practice, especially when big-money funds unleash massive short positions and drive a stock’s price down in an attempt to profit from losses for the little guy.
Recently, retail investors realized that when they work together, they have the power to hand these massive hedge funds huge losses. There’s a certain thrill to the battle — and to the fact that everyday investors have scored some wins with massive gains in GameStop, AMC, and other targets they’ve pushed hedge funds out of.
The Risks of Investing in Meme Stocks
Trading in stocks that have a social media buzz around them can be fun, and if you place buy and sell orders at the right time, it can be incredibly lucrative.
However, there’s significant risk involved with most of these stocks as well. Before diving in, think about the following:
1. High Volatility
With so many people talking about these stocks online and the potential for one statement to cause massive moves in one direction or another, there’s quite a bit of volatility, which poses a significant risk.
High volatility is exciting on the way up, but it also means that a stock has the potential to fall quickly. If you’re not able to respond to the declines in time, you can suffer significant losses in a single trading session.
2. Something’s Probably Wrong
Most of the stocks in this category are so popular because retail investors know the names of the brands, and hedge funds are betting against them.
However, hedge funds aren’t in the business of losing money, and they pour millions of dollars into research every year to stay on top of their game.
Usually, if a big hedge fund is betting against a publicly traded company, it’s because there’s something seriously wrong with the company’s operations, finances, or a combination of the two. And if multiple hedge funds have come to the same conclusion, you can bet the company is in some trouble.
3. Emotional Investing
Many retail investors want to “stick it to the man,” make a massive short-term profit, or stand up for the little guy. Those desires often overshadow the most probable path toward winning trades: research.
Emotional trading is dangerous and can come with significant repercussions.
Should These Stocks Be Part of Your Investment Portfolio?
Considering the risks, investing in meme stocks is not for everyone.
If you decide to invest in them, they should be included in the highest risk allocation of your investment portfolio, taking up only a small portion of your total assets, because many are heavily overvalued.
Moreover, investors with a low risk tolerance should avoid meme stocks altogether. The same goes for traders who aren’t willing to do extensive research or aren’t capable of doing the detailed technical analysis involved in making successful trades in this highly volatile corner of the stock market.
However, there is one way to gain access to the meme category with significantly lower risk and far less time spent on research.
If you want exposure to the sector and don’t want to do the work involved in picking individual stocks, an exchange-traded fund (ETF) known as the FOMO ETF is one to consider.
This ETF, managed by Tuttle Capital Management, invests in meme stocks as well as special-purpose acquisition corporations (SPACs), both of which come with significant risk but have the potential to generate significant reward.
Keep in mind that while risk is reduced through diversification, this ETF is a high-risk, high-reward investment. This means there is potential for painful declines, which should be considered instead of letting excitement surrounding potentially significant gains lead your decision-making process.
The meme category is exciting. It’s an example of how popular and powerful social media has truly become. Moreover, it’s a testament to the fact that when retail investors band together, they have the strength to move Wall Street itself.
As exciting as this may be, investors who take part in the massive movements are also taking on significant risks. Every short squeeze listed above resulted in steep declines shortly after the peak prices were reached, and traders who got in too late or waited too long to sell were left holding the bag.
If you’re going to trade in the meme category, make sure you understand what you’re buying and the patterns you’re seeing on the stock chart. Research is the key to success in the stock market and many other areas of life; meme stocks are no exception.