Meme Stocks Ride Again, But Caution Is the Word

Meme stocks partied like it's 2021 this week, but investors might want to take note and proceed cautiously before jumping into the frenzy.

Shares of small or little-known companies climbed double-digits for no fundamental reason, summoning memories of the 2021 "meme" craze. Back then, shares of companies like GameStop (GME) and AMC Entertainment (AMC) enjoyed spikes fueled in part by historically low yields and investor exuberance as the pandemic waned, including online coordination by certain investors.

Treasury yields are much higher now, but stocks like Kohl's (KSS), Krispy Kreme (DNUT), Opendoor (OPEN), 1-800-FLOWERS (FLWS), and GoPro (GPRO) surged this week. The rallies didn't reflect a sudden national craving for donuts or Mother's Day bouquets. As Bloomberg noted, many of these stocks aren't doing well fundamentally.

"Instead, the rallies may reflect the outsized influence of social media posters on heavily shorted stocks," noted Joe Mazzola, head trading and derivatives strategist at Schwab. Online influencers sometimes try to generate so-called short squeezes on certain company names, driving meme activity. The current "call heavy" options market and low volatility might also favor this sort of trading.

A short squeeze can happen if the price of a stock is rising, prompting short sellers to head for the exits. As the short sellers scramble to buy back and cover losses, upward momentum builds upon itself, and the stock can move sharply higher.

Kohl's nearly doubled after the open on Tuesday, and Krispy Kreme rose 60% in two days.

Sometimes, though not always, this sort of "meme mania"—as Bloomberg termed it—can signal a last gasp for a rally.

"This type of behavior can crop up when stocks are near highs and sentiment is heavily bullish," said Nathan Peterson, director of derivatives analysis at the Schwab Center for Financial Research.

Investors may harbor bad memories of how meme mania in 2021 preceded a U.S. bear market in 2022. Though it's impossible to predict when a bear market might roar, the meme craze isn't necessarily a warning sign.

"It's tough to say for certain that this suggests we're near a market top," Peterson said. The fundamental backdrop remains positive, he added, especially with so much traction from secular growth stories like AI, power demand, and robotics.

Still, meme mania isn't the only recent activity that raises concerns among market participants worried about a near-term top. There's also been exuberance in recent initial public offerings (IPOs), especially those related to cryptocurrency.

None of this means the market is about to crest, however. Even if there's no way to predict it, there are things to track that might give hints.

When monitoring for signs of a near-term top, Peterson typically looks for some of the following trends:

• Stocks selling off on good news.
• Stocks start closing near the lows of the day rather than the day's highs.
• Momentum names begin punishing chasers rather than rewarding them with more gains.
• Technically, markets begin to move up in parabolic fashion and then encounter a sharp reversal.

"These signs are nuanced and are really for traders who have a near-term trading perspective, not necessarily for a long-term investor," Peterson said.

Meanwhile, anyone watching the big swings and wondering whether to participate should be extra careful. Shares of GameStop spiked above $120 intraday in early 2021, surged again several times to above $80 later that year, and now trade below $25. The AMC story is similar and even more dramatic. Shares hit an intraday high of $726 in late May 2021 and now trade below $4.

In other words, these aren't stocks that necessarily promise rewards for long-term holders, and trying to time meme-fueled rallies and sell-offs isn't something most investors can do successfully.

"Traders should approach these highly volatile names with caution," Peterson added. "They often move up on no fundamental news and can reverse just as swiftly without warning, so a high level of risk tolerance is needed for these meme stocks."

That doesn't mean no one should trade meme stocks. Just understand the risk and volatility they can bring.

"If you are thinking about trading these stocks, be mindful of both overnight and intraday volatility," said Schwab's Mazzola. "You could find your profit and loss swinging dramatically from positive to negative and back and forth. Keep the share size smaller, the stops tight, and stay nimble."