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Meme Stock Mania: 5 Lessons for Investors

The slang phrase “meme stock” refers to a stock that attains viral attention on social media platforms, but predominately Reddit. Reddit users decide on a specific security and band together to pump the price. Often, the target stock selected is highly shorted (bet against) by hedge funds and is highly speculative. By choosing a heavily shorted stock, meme stock enthusiasts believe they can cause a short squeeze and force hedge funds to cover short positions – adding fuel to the fire.

Initially, meme stock mania started with the meteoric rise of video game retailer GameStop GME. Though nothing was unique or changing about the business or its fundamentals at the time, posters on Redditt concluded that since the stock was so heavily shorted by hedge funds, if enough of the collective banded together to purchase shares, prices would squeeze higher. To say the stock squeezed would be an understatement. Shares rose by more than 5,000% off their Corona Virus lows.

Zacks Investment Research
Zacks Investment Research


Image Source: Zacks Investment Research

Pictured: GME's meteoric rise and subsequent grind lower following the pandemic.

As more and more people joined the meme stock craze and the “Wall Street Bets” message board, the buying of shares became a self-fulfilling prophecy and gave legitimacy to the strategy/scheme (depending on how you view it). However, not everyone was having fun. Hedge fund Melvin Capital was the largest hedge fund that was caught short in the stock. The fund started 2021 with more than 12 billion in assets under management and lost 50% in the month of January alone. Finally, Robinhood HOOD, the broker that many meme stock connoisseurs were using, disallowed users from buying GME stock out of concerns of lack of collateral – finally putting an end to the move. Ultimately, it was too late for Melvin, who shut its doors later that year. It was also too late for late investors who chased GME shares into the Robinhood shutdown.

Blood Bath and Beyond - the Final Chapter?

Last week, management from the troubled retailer and former meme stock darling Bed Bath and Beyond Inc BBBY announced that the company may not survive and is potentially heading toward bankruptcy. The stock is at more than 30-year lows and has fallen from $80 to $1.31 per share.

Zacks Investment Research
Zacks Investment Research


Image Source: Zacks Investment Research

Pictured: A 25 year BBBY chart shows the one time high flyer's fall from grace.

Meanwhile, other former meme stock darlings such as AMC Entertainment Holdings AMC, Virgin Galactic SPCE, and Palantir Technologies PLTR have fallen from grace. Pending a highly unexpected turn of events, the meme stock craze has come to a slow, anticlimactic end. Nevertheless, those who do not learn from history are doomed to repeat it. Below are five lessons investors can learn from the meme mania:

1.   Ultimately Fundamentals Matter: As we mentioned above, meme stock aficionados selected the next meme stock based on short interest and the potential ability to game the stock, not fundamentals. While the gamesmanship worked for a while, fundamentals drive a company’s stock in the long run. After all, shares of stock are simply just a piece of an underlying company.

Zacks Investment Research
Zacks Investment Research


Image Source: Zacks Investment Research

Pictued: BBBY quarterly EPS trend. Ultimately, fundamentals move stocks.

2.   Shorting is Not Necessarily Easy: Economist John Maynard Keynes once warned, “Markets can stay irrational longer than you can stay solvent.” Though fundamentals prevail in the long run, stocks can stay artificially inflated for a time as the “pump” remains in place. Melvin Capital learned this the hard way when shorting shares of GameStop.

3.   If you Must Trade Them - Date Them, Don’t Marry Them: If you were able to enter meme stocks (or speculative stocks of any kind) at the right time, it was best to sell into strength. While some stocks like Best Buy fell faster than others, the meme stocks eventually all succumbed to gravity.

4.   Be on the Lookout for Exhaustion Gaps:Exhaustion gaps occur when a stock has already been running up in price for days and has a large gap up (either before the market or after) in price on heavy turnover. Another clear sign of exhaustion occurs when the stock has multiple large price gaps in a short period.

Zacks Investment Research
Zacks Investment Research


Image Source: Zacks Investment Research

Pictured: BBBY had multiple "ehaustion gaps" of 40% or more before topping.

Zacks Investment Research
Zacks Investment Research


Image Source: Zacks Investment Research

Pictured: Like BBBY, SPCE had multiple exhuastion gaps prior to failing.

5.   Risk Management is Job #1: The high beta nature of speculative stocks makes them difficult to trade in a low-risk manner. Trading speculative stocks should be done with small position sizing and the expectation that the stock can move drastically in either direction.

Summary

Investors can learn lessons that will help them in the future by looking back at history. Every so often, great manias occur with no fundamental foundation. Whether it was the Tulip Mania of the 1600s, the internet bubble of the early 2000s, or the meme mania of the 2020s, investors with a clear plan and risk management framework in place ended up in the strongest position. Stay away from the madness of crowds and focus on leading stocks with sound fundamentals and strong technical price action.

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report

GameStop Corp. (GME) : Free Stock Analysis Report

Bed Bath & Beyond Inc. (BBBY) : Free Stock Analysis Report

AMC Entertainment Holdings, Inc. (AMC) : Free Stock Analysis Report

Virgin Galactic Holdings, Inc. (SPCE) : Free Stock Analysis Report

Palantir Technologies Inc. (PLTR) : Free Stock Analysis Report

Robinhood Markets, Inc. (HOOD) : Free Stock Analysis Report

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