In the past, I’ve often said that nothing is certain in the stock market.
I realize now that I was wrong.
The coming collapse in shares of GameStop (NYSE: GME), AMC Entertainment (NYSE: AMC) and other so-called meme stocks – that have experienced astronomical run-ups this year – is absolutely, completely, 100% guaranteed.
In fact, I discuss these stocks in my latest market update video on YouTube. Click here to watch.
That doesn’t mean you should run out and short them or buy puts on them.
Indeed, many traders – including big hedge funds – have already lost substantial sums doing exactly that.
Why is it certain that these stocks will eventually crater, regardless of how they perform in the short term?
The answer to that question is something every serious investor should understand.
So let’s take a closer look…
Under ordinary circumstances, stocks move on corporate fundamentals.
If a company’s earnings are better than expected – and the outlook keeps improving – the share price will rise.
If a company’s earnings are worse than expected – and the outlook remains negative – the share price will fall.
That’s what happens with 99% of publicly traded companies 99% of the time.
However, there have always been corners of the market – including penny stocks and other thinly traded issues – ripe for manipulation.
For decades, bucket shops and even unscrupulous newsletter editors promoted these stocks – bidding them to unjustified and unsustainable levels – so that insiders could bail out, leaving unsuspecting punters holding the bag.
That’s not exactly the case with today’s meme traders…
For starters, the promotions are more spontaneous and fanned by social media users egging each other on with inane comments like “To the moon!” or “Hold forever. Sell never.”
Moreover, these high-flying stocks represent real (if struggling) companies, and their market caps are often in the billions or even tens of billions of dollars.
Yet meme stocks tend to have one thing in common: They are caught up in a classic short squeeze.
Let me pause for a moment to point out that there is nothing inherently wrong with short selling.
Short sellers provide liquidity, narrow spreads and help keep inflated stock prices in check.
But betting against a stock where most of the outstanding shares have been sold short – as some hedge funds did this year – is a classic example of asymmetrical risk.
Lots of downside. Very little upside. (After all, the most a stock can fall is 100%. There is no limit to how high a stock can go.)
Early meme traders realized that as short sellers were forced to “buy to cover” – to cut losses and/or meet margin calls – it would drive these stocks higher.
However, as share prices reached ever-greater levels of absurdity, new short sellers came in to replace the old ones. And the cycle started all over again.
That is how a stock goes from “extremely overvalued” to laugh-out-loud ridiculous.
Like a Ponzi scheme, this can only go on for so long before the whole thing collapses.
When the downturn comes, it is likely to be sudden and violent, as it was earlier this year when GameStop plunged more than 90% from January 28 to February 19.
The lesson here?
It’s foolish to bet against a heavily shorted stock that is already scraping the floor.
But it’s also silly to plow real money into insanely priced shares that have recently skyrocketed in value.
I often hear meme stock traders in the media say they are “just having fun.”
Making money in the stock market – especially in the short run – is fun.
But, as millions will soon learn, taking a beating isn’t.
True, these meme stocks are riding a wave of momentum. And that may continue awhile.
But the upward trend is not supported by corporate measures of health and profitability.
I feel qualified to speak on this subject, incidentally.
I’ve traded momentum stocks myself, with more than a little success, for over 35 years.
I also write a highly regarded trading service, The Momentum Alert, that has locked in steady double- and triple-digit gains for two decades now.
(In fact, my team just released a special report on a hidden part of the market called “Dark Trades.” These secretive trades give big Wall Street firms an unfair advantage over the little guy… But I track this activity in my Momentum Alert service and show you how you can use it to gain an edge in the market. You can view the presentation here.)
Warren Buffett’s mentor Benjamin Graham famously said that the market is a voting machine in the short term and a weighing machine in the long term.
And what it weighs is corporate profits… or earnings.
GameStop, AMC and many other meme stocks have momentum. But they don’t have any earnings to weigh. Nor will they have some anytime soon.
That means there is a great reckoning ahead, one that will occur when the voting stops and the weighing begins.
No one can predict how long irrational behavior will last… or when all this foolish meme trading will end.
But end it will. As these things always do… in tears.