Updated on May 15, 2024

First Published on August 8, 2023

GameStop (GME) and AMC Theatres (AMC) have surged 198.9% and 114.7% respectively in the past five days.

This rally is attributed to a social media post by Roaring Kitty, the key figure in the 2021 meme stock frenzy. His renewed activity has sparked speculation of a comeback.

Roaring Kitty is famous for leading retail investors on Reddit to cause a short squeeze GME in 2021 and has been inactive since.

What are Meme stocks? How do they get hyped? Are they worth investing in? How long will the craze last? This article explores these questions.

What are MEME stocks?

Meme stocks are top-rated among retail investors on social media platforms like Reddit, StockTwits, Twitter, and Facebook.

These stocks often share some common themes:

• Weak company fundamentals

• Significant short interest from hedge funds

• Potential turnaround stories

Retail investors use social media to create a buzz around these companies, leading to surges in their stock prices and trading activity.

With strong support from online communities and high short interest, meme stocks experience incredibly high trading volumes and demand. As a result, their share prices often skyrocket far beyond their actual value based on fundamental analysis.

Common characteristics of a meme stock include:

• Popularity among younger retail investors.

• Dramatic price spikes and extreme volatility over a short period

• Being significantly overpriced than what fundamental analysis would indicate.

Examples of MEME stocks

Let's look at a famous example of a meme stock: GameStop (NYSE: GME).

GameStop, a struggling brick-and-mortar video game retailer, had all the ingredients to become a meme stock:

• The rise of online retail and the impact of the pandemic weakened the company's fundamentals and dragged down its stock price.

• Hedge funds heavily shorted its stock due to its prolonged underperformance.

• A turnaround story emerged when Ryan Cohen, a billionaire investor and founder of Chewy, an online pet supplies retailer, announced his investment in GameStop and joined its board.

In August 2020, a YouTube influencer named RoaringKitty (also known as Keith Gill) said GameStop's stock price could rise from $5 to $50 due to a potential short squeeze.

On January 12th, 2021, Cohen joined GameStop's board, triggering a stock rally. GameStop's stock price skyrocketed from around $20 to nearly $500 in a few weeks, causing significant losses for short-sellers.

However, the stock's rapid rise made it significantly overvalued, and it quickly dropped back to $50 within a month.

Besides GameStop, several other meme stock examples have emerged, capturing the attention of retail investors.

How does a Meme stock work?

A Reddit user summarized the typical pattern of a MEME stock cycle:

1. Early Adopter Phase: Some investors spot an undervalued company and start buying its shares at the current price, leading to stability or a slight increase in stock price.

2. Middle Phase: The stock experiences its first surge in price with high daily trading volume, attracting more interested investors.

3. Late/FOMO Phase: The stock goes viral on social media, and individual investors rush to buy in fear of missing out (FOMO), pushing the price higher.

4. Profit-Taking Phase: As the stock reaches its peak, early buyers cash in their profits. Investors who joined during the middle phase see smart investors selling and follow suit, causing a chain reaction of selling as everyone fears potential losses.

Since this cycle can complete itself in a matter of days, effective risk management and market timing are essential when making investment decisions.

Risks of Meme stocks

While MEME stocks can offer the potential for high returns in a short period, investing in them also comes with significant risks. Here are some key risks to consider:

1. Decoupling stock price with its fundamentals: MEME stock prices often don't align with the company's fundamentals, leading to wild price swings and making it hard to know future trends.

2. Sensitive to short-term supply and demand: MEME stock prices are heavily influenced by short-term buying and selling, causing unpredictable movements.

3. Susceptible to social media sentiment: MEME stocks are strongly influenced by social media hype. If investors shift their focus to other stocks, previously popular MEME stocks can drop suddenly.

Because of these risks, some consider MEME stock investing more like speculation than traditional long-term investment.

So, should investors avoid MEME stocks altogether?

Jeremy Siegel, a longtime professor of finance at the University of Pennsylvania’s Wharton School, suggests it's okay to invest in MEME stocks, but investors should be careful.

He advises allocating only 10% to 15% of your portfolio to MEME stocks and putting the rest (85%) into stable, long-term index funds. This approach keeps your investments more sensible and secure.

Siegel emphasizes not investing a significant portion of one's portfolio in MEME stocks unless investors have extra funds and can handle significant losses.

How to identify a meme stock

If you're interested in investing in MEME stocks but not sure how to spot promising ones, here are five things to consider:

1. Check Social Media Buzz

MEME stocks are all the rage on social media. Websites like SwaggyStocks can help track trending stocks. Here's a list of hot stocks as of August 2, 2023:

2. Watch Short Interest

MEME stocks are often heavily shorted.

Look at the short-interest ratio, and if it's above 40%, it may mean a large portion of the investors are hoping the shares will go down in value.

For example, the used-car company CVNA had a short interest ratio over 52.47% in January 2023, and it remained above 40% for several months.

This means that if the stock price rises sharply, it may cause a short squeeze, which will push the stock price to increase even more.

3. Look for Turnaround Stories

Retail investors love MEME stocks with turnaround stories.

For instance, CVNA's recent rebound in 2023 caught investors' attention after announcing positive earnings results earlier this year, according to The Motley Fool.

4. Understand Price Lifecycle

MEME stock prices are super volatile. If a stock is in the profit-taking stage, it might be overvalued, posing risks to new buyers.

Summary

• MEME stocks are those that gain popularity on social media platforms.

• Their main characteristics are high volatility, potential for short-term gains, high risks due to their detachment from company fundamentals, and susceptibility to social media sentiment.

• Investing in MEME stocks can be an option, but it's essential to do so moderately and with a rational approach.

• Methods for identifying potential MEME stocks include observing social media buzz and short interest, looking for turnaround stories, and understanding price trends.