Meme stocks: are investors being tempted to take riskier shots?

The Covid-19 pandemic brought about some of the greatest volatility in stock market history. However, since the middle of 2020, measures of volatility have fallen while global equities have continued to march higher.

US stocks now trade at all-time highs, which has reduced the potential returns that investors can expect to receive over the medium term.

Recent greater-than-average returns have distorted people’s expectations. Indeed, over the last ten years to 31 October 2021, the S&P 500 index has returned +18% per year.

The table below shows the importance of starting at the beginning. Over the ten years to October 2011, investors received returns of just +2.9% per year (in GBP terms).

Figure 1: Total returns for 10-year periods (GBP terms)

^{Source: Refinitiv, IG}

While many analysts remain upbeat on the outlook for equities, the oversized returns investors have achieved recently are unlikely to continue.

Over the last 100 years, stocks have returned a nominal 7% (before inflation). BlackRock, the world’s largest asset manager, expects US stocks to average +5.2% annual return over the next five years. While this would still be positive for investors, if inflation averages around 2.5% per year, real annual returns will average under 3%.

These dynamics have increased the temptation for investors to search in areas of the market for higher potential returns. And there is certainly evidence of irrational exuberance, from the rapidly growing cryptocurrency market to the popularity of special purpose acquisition companies (SPACs).

Meme stocks: a 50 or a duck?

One market trend which has captured the imagination of millions across the world is the well-documented cluster of ‘meme stocks’.

Demand for shares in these popular stocks is often orchestrated through social platforms such as Reddit, where like-minded investors join together to attempt to squeeze the share price of these companies higher.

GameStop, one of the initial meme stocks, has experienced huge fluctuations over the last year, rising by over 135% in a single day and declining by almost 90% over a ten-day period after its share price peaked on 27 January 2021. Trading in meme stocks comes with high risk due to volatility and therefore traders should take the time to understand the risks before making any decision.

The excitement surrounding these types of stocks has inevitably led to fund issuers launching their own products to allow investors to invest in a collection of meme companies within a single fund.

VanEck Social Sentiment ETF (BUZZ) is an US-listed fund which invests in 75 of the most mentioned stocks on social media.

Top holdings in the portfolio currently include the likes of Tesla, GameStop, AMC, and Palantir.

Wide ranging returns amongst the funds’ individual holdings have translated into elevated levels of volatility compared to the broader US stock market, as measured by the S&P 500 index.

And while the share price of some meme stocks remain above their start of year values, the chart below shows that investors in BUZZ have seen remarkably similar returns to the S&P 500 index so far this year. This means that investors in BUZZ have not been sufficiently compensated for taking on additional investment risk.

Figure 2: Year-to-date returns for Meme stocks and S&P 500 index (total returns, in GBP terms)

Interest in meme stocks waning?

There is also growing evidence that enthusiasm for meme stock investing is waning.

Alternative data platform, Quiver Quantitative, have been tracking the number of comments on Reddit’s WallStBets forum which shows that engagement in the trend has been in decline since January, with average daily comments dropping from around 70,000 to 10,000 since the start of the calendar year.

This should concern investors that are currently holding these meme stocks given that the increase in their prices have been mostly based on unfounded optimism rather than any increase in fundamental value.

Social media platforms such as Reddit have allowed smaller investors to band together to act as a single large trader and create a squeeze on a company’s shares. With fewer numbers, the ability to maintain this upwards pressure on a company’s share price is reduced.

Put simply, while the meme stock movement may have enabled some investors to profit from large share price fluctuations, the longer-term returns for these types of stocks is far more likely to be negative.

Valuations matter eventually

Valuations matter. The chart below looks at the average price to book and price to sales ratios for the current top ten holdings in BUZZ compared to the wider US stock market (S&P 500 index). The elevated multiples for these socially hyped stocks imply that they trade at prices well above their fundamental value.

Over time, one should expect these to decline back to more normal levels.

Figure 3: Meme stocks are trading on far greater multiples to sales and book value compared to the wider market

Conclusion

Overall, we believe meme stock investing is like a batter who is fixated with hitting sixes each ball they face.

It may have worked well so far, but the greater risk-taking leaves you exposed to being bowled clean at some point in the future.

Those seeking to grow their wealth over time would be wise to look past the meme stock mania and instead invest like a steady opening bat. This involves building a portfolio which should provide greater stability, like a traditional Test match hundred.

Many expect to receive higher returns when taking on additional investment risk. This does not always materialise. Investors should always scrutinise a company’s fundamentals and question the current risk-reward trade-off when investing in meme stocks.

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Your capital is at risk. The value of shares, ETFs and ETCs can fall as well as rise, which could mean getting back less than you originally put in.