The frustrating illogic in the rise of the meme stocks
Twenty years ago this month, I graduated from the University of Chicago’s Booth School of Business, the spiritual home of the efficient-markets hypothesis. Since then, I have mostly held to the faith.
But then came the meme stocks, such as GameStop and AMC Entertainment, which have soared beyond all reason after attracting attention from Reddit stock-pickers. I used to think this was just a pandemic-induced hysteria, but it’s still going on — most recently with a health insurer. Forcing me to ask: In what sense is any of this efficient?
The efficient-markets hypothesis has gotten a bad rap from followers of other faiths, who tended to assume that saying “markets are efficient” meant something like “market prices represent the true and complete and eternal value of financial assets.” Even the theory’s most zealous adherents do not actually believe that markets can accurately predict the future.
There are multiple denominations of the hypothesis, but all of them allow that a stock’s price is likely more or less than buyers would be willing to pay if they knew everything that was going to happen to that company until the end of time. It’s just that people can’t reliably predict whether the current price is too high or too low — or how much higher or lower it ought to be.
All three understand that sometimes there is surprising information that affects a company, as when an exciting new cancer drug appears to cause spontaneous remission of hard-to-kill melanomas or, alternatively, when an exciting new cancer drug kills cancer cells really well but also kills the patients.
If the news is bad, then normally the stock price goes down. People who were willing to buy at the old price have second thoughts, while people who had been happy to own shares become eager to sell. The price adjusts accordingly, often helped along by short-sellers, who sell shares they don’t yet own in the hopes that the price will fall still further and that they can buy shares at a lower price before they have to deliver them, pocketing the difference as profit.
But in some cases, short-selling attracts attention, including from the Reddit horde. And sometimes the group decides to try to “squeeze” the short-sellers by driving up the stock’s price.
Some of the Reddit traders might think the short-sellers have it wrong and hope to make a bunch of money proving that. Some hope they can make a quick profit on the bubble by timing their exit a bit better than others have. This is basically normal market behavior — unwise, maybe, but normal. Possibly some are nefarious characters using the boards to “pump and dump” stocks — which is immoral, and possibly illegal, but sadly also normal among some thinly traded stocks.
But a lot of these Redditors apparently just hate short sellers, or like belonging to the gang, or maybe think this is all hilarious. And because there are so many of them, they’ve been able to drive a series of strange cycles: A bunch of them pile in, the stock price leaps skyward, immense paper fortunes are made, and the lucky company gets to raise some much-needed capital. Eventually the joke stops being funny, the stock price regresses, a bunch of Redditors lose their shirts and the cycle starts over, often with the same stocks.
Months ago, it was possible to chalk this up to a stir-crazy public flush with pandemic relief checks and desperate for distraction. But with GameStop and AMC once again gyrating wildly, I’m struggling to believe that these markets are still efficient.
It turns out my faith depended on a hidden assumption that, in a broad sense, prices had something to do with a stock’s prospects as an investment vehicle. That is, an expectation that everyone who was trading in the market, and helping to set a stock price, was trying to make money one way or another.
After all, for what other purpose do most people buy stocks?
They’re not pretty, they don’t taste good, and they won’t keep rain off your head. But if, for whatever reason, that assumption breaks, markets get very weird. Option-pricing models are also fracturing under the pressure.
I could argue that in some sense the market is still efficient — now it’s just pricing in the fact that random people on internet message boards enjoy watching stock prices fluctuate for the sheer hell of it. But this means losing other kinds of information, such as some relationship to the firm’s underlying business potential.
This is unlikely to ever be a problem for the largest stocks — it’s hard to see how Redditors could scrape up the cash to affect the price of Apple, which has $2 trillion worth of stock outstanding. But at the margins, market prices make less sense to me than they used to. And, frankly, so do people.