That seems to be the talk of the town lately, doesn’t it? What is the latest “meme” stock? How high is it going? Should I buy these meme stocks?
It’s quite fascinating watching behavioral economics unfold in full fashion when it comes to these meme stocks that have become ever so popular in 2021. Stocks that really have limited, shrinking, or little underlying fundamental value are suddenly seeing absurd increases in stock price driven by retail investor sentiment, increased popularity and activism through various Reddit channels as a way to “Stick it to Wall Street” and short sellers alike. As much as an emotional and feel good taunt this retail investor movement might be, market makers do have a lot of power on wall street to influence price in a certain direction (especially around options expiry to ensure max pain), and to influence regulatory action around such price movements around these particular meme stocks. More importantly, as price trends become exponential, there becomes a smaller pool of investors willing to purchase the stock at such high market prices. Thus, open interest and volume becomes soft near these peaks, and the stock begins to fall as investors begin taking profits and unloading their shares onto unsuspecting and inexperienced retail investors looking to make a quick buck.
There’s an emotional draw to the potential of making huge returns on these stocks, and a lot of these amateur retail investors fail to realise or simply understand the real risks involved when putting money into the market, especially into these extremely volatile equity holdings. I’ve talked at length about various facets of behavioral finance in Lesson 32 and Lesson 50. Investor emotions are tough to predict, and irrational behavior can cause unwarranted volatility in any particular stock over the short term.
I can sit here and beleaguer the point about how these extreme prices do not reflect fundamental value of these meme stocks, but the real short term risk that many investors forget is the power of regression. I would say this is more relevant to mature companies, as growing companies are more volatile in nature, but the power of regression and the moving average of a stock’s price and valuation are meaningful regardless, and extreme movements in either direction away from these averages should trigger caution for an investor.
According to the Cambridge Dictionary of Statistics, regression to the mean is defined as the “phenomenon that arises if a sample point of a random variable is extreme, a future point is likely to be closer to the mean or average”. It centers around the premise that an extreme value point is just one occurrence, and the expectation that future data points will also be at these extremes is very unlikely. Extreme value points are typically outliers in a data set that arise from short term or abrupt events. This is why a large sample size is preferred when developing statistics to represent a population. Computing the average age of a population is much more meaningful when taking the average age across 50 people as opposed to 5. Those first 5 people may all be aged 60, whereas the next 45 people are aged between 20 to 30.
The same holds true in finance. Moving averages is one of the underlying principals for technical analysis. A lot of technical analysis is built around movement away from moving averages to trigger overbought and oversold levels. For example, 13 day moving averages (MA), 50 MA, and 200 MA are the three basic moving averages that technical traders look at to determine whether stock prices are in an uptrend or downtrend. Any extreme movement away from these averages will increase the probability of a retracement back to the average. This is true for both an uptrend and a downtrend of a stock. The same holds true when looking at fundamental averages, which to me is more valuable and meaningful long term than technical analysis. For example, if a stock has exhibited a 10 year average Price-Earnings Ratio of 15, and the stock price currently trades at a Price-Earnings ratio of 25, there is a high probability that the stock is currently overvalued and will trend downwards to reflect a PE ratio closer to it’s long term average. If a meme stock moves upward 300% in 3 weeks yet nothing fundamentally about the business has changed, what warrants the stock to stay at these elevated levels, especially if retail investor activism and sentiment is so short term before it moves on to the next meme stock? The answer is absolutely nothing. It does provide a perfect opportunity for insiders and executive management to sell their shares at absurd levels though!
To each their own, but trying to throw money at these meme stocks to make a quick buck may work the first time, heck it may even work the second time, but by no means does it suffice as a maintainable long term investing strategy. Glorified gambling is all it really is, and as long as a retail investor knows this and understands their risks with putting money into such volatile equities, AND can manage their risk properly with their overall portfolio, then by all means throw some money into it. Other than that, it’s a very small area of the market that can easily be avoided without any negative consequence in doing so. Maintaining a portfolio of long-term holdings in consistently profitable and growing companies will perform in line with the markets over the longer term. Afterall, we all should be striving to achieve the AVERAGE compounded returns of the S&P500,at the very least anyway.
S&P500 90-Year Historical Price Trend