The year isn't halfway over yet, but 2021 will go down as the year of the meme stock.
Previously ignored consumer stocks like GameStop (GME -6.39%) and AMC Entertainment Holdings (AMC -9.69%) have skyrocketed this year. Hordes of traders on social media platforms like Reddit are using techniques like short squeezes, viral memes, and hashtags to pump up the stocks and attract new investors. AMC shares are up 2,500% year to date, while GameStop stock has surged 4,000% over the last year.
Cryptocurrency Dogecoin (DOGE -3.38%) has also joined the meme party, racking up gains of as much as 12,000% this year, giving investors returns of more than 100 times for a brief period.
The meme stock boom, which has included a wide range of stocks at various moments, could signal a fundamental change in how the stock market works, but it could also be a massive bubble. Even as some investors have experienced eye-popping gains from the popular viral names, there are a number of reasons to avoid meme stocks. Here are three of them.
1. You'll never know when to sell
Deciding when to sell an ordinary stock is hard enough. It's nearly impossible to time the market, and assessing a stock based on other factors like valuation, growth prospects, and broader market conditions is tricky. But with meme stocks, it's essentially impossible to determine when to sell because the fundamental factors that apply to most other stocks don't apply here.
Similarly, a traditional buy-and-hold strategy seems unlikely to work with these stocks despite the "to the moon" cries from their fan base. That's because sudden parabolic gains can easily disappear, as we've already seen. In January, GameStop suddenly surged to $483 a share before plunging roughly 90% over the subsequent weeks. It's recouped some of those losses since then, but its trajectory shows how easy it can be with meme stocks to feel like you sold too soon or you held on for too long.
2. You could lose a lot of money
Most stocks trade at prices that represent a fair estimation of the business' underlying value. If a company is valued at, say, $10 billion, that price is based on the company's profits, growth prospects, assets, or some other component that has intrinsic value.
That's not the case with meme stocks, which trade more like lottery tickets. Their price could soar one day on an insignificant piece of news or a groundswell of support on social media, and crash the next as interest shifts and the news changes.
At this stage, with prices on these stocks already many multiples above their intrinsic values, buying meme stocks carries a risk of losing much of what you've invested. The recent volatility in the sector shows how quickly this can happen. If you bought GameStop at its peak on Jan. 28, you would have been down 90% in less than two weeks. Similarly, Dogecoin peaked at $0.74 ahead of Elon Musk's appearance on Saturday Night Live, but has fallen by more than 70% since then. Other meme stocks have also flown too close the sun. Koss, for instance, crashed as much as 85% in just a few days after its peak in January.
While there's risk in owning any stock, most tickers won't lose half their value in just a few weeks, and the average one is much more stable than the typical meme stock.
3. They are simply overpriced
A stock isn't just a bet, it's ownership in a business, and the price of that stock generally represents the performance of that business over time. With meme stocks, that umbilical connection is severed, and valuations and prices skyrocket, divorced from the fundamental value of the company. The chart below shows the market caps of GameStop and AMC, the two most closely followed meme stocks.
As you can see, the stocks' valuations are wildly higher than they've been at any point in the last 10 years before the meme stock boom, even though the fundamentals of both businesses have worsened during the pandemic. AMC saw attendance and revenue crash during the crisis, and faces a difficult path to recovery as most of its studio partners now have their own streaming services, allowing them to take new content directly to subscribers at home. GameStop, meanwhile, faces disruption from gaming systems going to all-digital platforms and broader pressure on brick-and-mortar stores. Other meme stocks like BlackBerry, Koss, and Express also look fundamentally weak.
Meme investors have favored consumer stocks with high short interest, and though that strategy has been effective to quickly pump up share prices, it now means that the prices of these stocks have little relationships of the values of the companies they represent.
That's one more reason to believe that any of these meme stocks could crash at any time without warning.