The Fed Fires a Warning Shot Over ‘Meme’ Stocks Amidst Industry Volatility

Casual observers, traditional retail stock traders, and financing industry professionals alike were off-guard as “meme stocks,” securities that experienced rapid volatility stemming from social media, surged in value after blocks of retail investors eschewed traditional notions of investing in favor of fun. Meme stocks took their place in the cultural zeitgeist after thousands of investors poured support into struggling companies such as Gamestop (GME) and AMC Entertainment Holdings (AMC). Though these stocks were expected to return to their “real” value, meme-flated prices have left an impact, and a November 2021 Federal Reserve report cautions that the rise of meme stocks could pose risks to future financial stability.

Traditionally, stock prices are expected to reflect the value of the company and its future cash flows. This was certainly true for GME and AMC. These publicly traded companies were on thin ice even before the pandemic, amid the decline of brick and mortar and the rise of streaming services. The pandemic caused even sharper losses. Accordingly, bearish hedge funds bet against GME and AMC using options because their share values were low, and their core businesses were still struggling. However, these funds recoiled when Gamestop and AMC’s stock prices surged 1,700% and 840%, respectively, late this past January.

AMC and GME shot up due to social media chatter, most notably in the subreddit r/WallStreetBets. The popular forum provides communication channels for novice stock traders to collectively get behind in certain stocks, regardless of public factors indicating a lack of profitability. While many expected meme stocks to be only a fad, that has not been the case. Now, the Fed is paying attention – and warning investors.

The Federal Reserve’s biannual financial stability report published earlier this month directly addressed this trend. The report noted the impact on the markets has been minimal thus far. However, it also highlighted that the GME and AMC short squeezes indicated several trends that could create “broad financial instability.”

First, meme stocks could pose risks to vulnerable investors. While the rise in meme stocks has been driven by young and social media-savvy trading novices, younger investors may wind up bearing the bulk of the negative consequences. The Fed’s report noted that investors with greater debt (including a high percentage of younger investors) are left more vulnerable by large swings. The increased use of “options,” whereby investors can bet on the value of a stock at cost, tends to amplify losses. This leaves younger investors particularly susceptible to sizable swings caused by their peers’ erratic social media chatter.

Second, the Fed likewise warned that elevated risk appetite among retail investors could lead to wider trepidation if the relationship between traditional retail investors and social media continues to become more unpredictable. No one wants to be the next Melvin Capital (a hedge fund that bet against Gamestop during its meme-fueled rise and experienced a 46% loss in the first half of the year). Social media investors’ lack of predictability may incentivize traditional retail investors away from taking risks, driving prudent investors out of the market.

Third, the Fed warned that risk management systems lacked calibration for such episodes, noting how this sharp volatility “may require further steps to ensure the resilience of the financial system.”

Despite the Fed’s warning, the market’s reaction has been to try to ride the meme-stock wave rather than to quell it. Undaunted by the seemingly unpredictable nature of social media stock surges, some have to quantify and forecast social media “hype.” In March, Buzz Holdings created an exchange-traded fund called the VanEck Social Sentiment ETF (BUZZ) that tracks the performance of stocks receiving social media hype. The index uses language algorithms monitoring broad social media sources to examine whether comments are positive, negative, or neutral and ranks the stocks based on sentiment and prominence in discussion. BUZZ has not yet proven to be a crystal ball for the next meme stock. Nevertheless, the project demonstrates the industry’s awareness of the potency of meme stocks and its early attempts to predict social media discourse and its effects on share prices.

The Fed’s report confirms that market watchers and financial institutions will likely be on the lookout for market volatility due to social media attention. The industry’s reaction demonstrates that, despite the Fed’s warnings, it wants to capture the value in that volatility. Predicting the next Gamestop may prove elusive – but doing so could be the name of the game.