A MEME STOCK SUMMER: THE MADDEST OF CROWDS OR THE DEMOCRATISATION OF FINANCE?

A MEME STOCK SUMMER: THE
MADDEST OF CROWDS OR THE
DEMOCRATISATION OF FINANCE?
June 2021

Sam Wood, CFA & George Sugden

          “Madness is rare in the individual – but with groups, parties, peoples, and ages it is the rule.”
                                                 Friedrich Nietzche
Meme-stocks are back. The short-squeezes and co-ordinated call option buying by retail investors that
seemingly reached a peak in January have returned with a vengeance in May. The term ‘meme-stock’ has
entered the public consciousness. The PTs at my gym can talk of little else, while our hedge fund clients
have to account for the possibility of a business in secular decline in a dying industry blowing up their short
book with a double-digit daily up-move because it has a funny ticker. The implications of this phenomenon
are hard to pin down. Is it just a bubble? A pure expression of the delusion of crowds? A prime example of
human behaviour when ‘get-rich-quick’ is the ultimate end game? Yes. But that could also be too obvious a
conclusion. Robinhood, the trading app popular with the Wall Street Bets crowd, claim on their website that
they are on ‘… a mission to democratize finance for all’. As we will delve into later in this note, the new
breed of retail traders seemingly aren’t in it just to get rich. The commitment to ‘HODLing’ and ‘diamond
hands’ means that they aren’t cashing out. This new generation- already familiar with message boards, the
black humour of the internet, and the power of memes- are impacting markets in a way that professional
investors are yet to come to terms with. The stats below demonstrate just how powerful the meme-stock
movement has been:
      ▪   A basket of meme-stocks was up 95% in the 1-month May 9 – June 9 relative to the S&P 500 which
          was down -0.13%.1
      ▪   The ‘high short interest’ index, which consists of the 100 US stocks with the highest short interest,
          was up 18% in the same time period and is up 109% over the past 12-months.
      ▪   At the same time, median short interest in the S&P 500 hit its lowest point since the dotcom bubble
          at around 1.5%.
      ▪   Weekly option volumes in meme-stocks have regularly exceeded those in the S&P 500 this year.
F. Scott Fitzgerald once said that “the test of a first-rate intelligence is the ability to hold two opposed ideas
in mind at the same time and still retain the ability to function.” We won’t claim the first-rate intelligence,
but we definitely agree with the principal. Today, we find ourselves asking if two things can be true: that we
are in the midst of the craziest market since the Tech bubble, whilst also experiencing a permanent shift in
retail investor behaviour thanks to social media and trading apps- a true ‘democratisation of finance’.

CRAZY MARKETS & LESSONS FROM HISTORY
    “There is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever
                happens in the stock market today has happened before and will happen again.”
                              Jesse Livermore, Reminiscences of a Stock Operator
Let’s start with the crazy market first. How many people buying AMC or GameStop equate their actions
with buying the modern day equivalent of South Sea Company shares, or Tulip bulbs, or stock in the

1
    https://twitter.com/SoberLook/status/1402556344234917897

ARAVIS CAPITAL | A MEME STOCK SUMMER

Liverpool & Manchester Railway? How many would-be buyers of AMC or GameStop would change their
mind if they were aware of the history of bubbles of markets past? In his excellent book, The Delusions of
Crowds: Why People Go Mad in Groups, the author William Bernstein draws parallels between the belief in
popular ‘end-times’ prophecies of religious movements in the Middle Ages and the type of behaviour
exhibited in stock market bubbles. The human brain, hardwired for a world in which imitation is critical for
survival2, easily amplifies delusional beliefs. Bernstein said, “While religious and financial manias might
seem to have little in common, the underlying forces that give them rise are identical…the hardwired
propensity to imitate, to fabricate and consume compelling narratives, and to seek status.”3 Forgive me the
indulgence of quoting one of my favourite TV characters - Rust Cohle from True Detective (brilliantly
played by Matthew McConaughey) - but it allows me to run with this theme comparing medieval religious
fervour and modern day market bubbles, which is pretty irresistible. Rust, when discussing religion with his
partner Marty Hart, says, “Certain linguistic anthropologists think that religion is a language that rewrites
pathways in the brain. It dulls critical thinking.”4 It is hard not to agree with the critical thinking part when
watching scenes from the latest Bitcoin conference in Miami. You may have seen the video where Max
Keiser screams, “We’re not selling! We’re not selling! F**k Elon! F**k Elon!” to a baying crowd5. But
watching it certainly made us sympathetic to Bernstein’s theory that the same brain activity that results in
religious cults is also evident in certain investment beliefs today. This isn’t an attack on Bitcoin by the way,
we’ve written before about the prospects for its positioning in institutional portfolios, but it closes the loop
on this old-time religious link pretty nicely.

2
  For example, our ability to craft hunting tools and kayaks is not genetically hard-coded but given a large enough population,
and trial and error, someone will figure it out and the rest can accurately imitate the process.
3
  William J. Bernstein, The Delusions of Crowds: Why People Go Mad in Groups, p.5
4
  Apparently the source for this idea is Richard Dawkins, who coined the academic use of the word ‘meme’ in the 1970s.
Dawkins has drawn many parallels between viruses of the mind and religion.
5
  Preachers and their congregation?

ARAVIS CAPITAL | A MEME STOCK SUMMER

THE FALLIBILITY OF SYSTEM 1
               “We can be blind to the obvious, and we are also blind to our own blindness.”
                                              Daniel Kahneman
Many of you will be familiar with Daniel Kahneman’s book, Thinking, Fast and Slow, which formalised the
concept of the way our brains deal with uncertainty. System 1 is our effortless ‘lizard brain’ and is in control
of our intuitions and our instincts, while we engage System 2 for rational thought and effortful calculation.
When we think of the cults and manias I mention above, we use System 2 to rationally dissect the reasons
why all these people that came before us fell for obvious frauds like the original Ponzi scheme, or believed
the world was about to end because of some rogue interpretation of the Book of Revelations. It is easy to
convince ourselves bubbles and manias today happen because of more complex, non-behavioural reasons –
the direction of yields and interest rates, an excess of liquidity in the system, the need for a technology-
enabled decentralized global currency. We are cleverer and more informed than previous generations, we
live in the ‘Information Age’, and some of the smartest minds and richest individuals of our generation have
embraced these so-called bubbles in meme-stocks, SPACs, cryptocurrencies, and NFTs. But System 1 drives
our brains just like it did our ancestors brains who went bankrupt buying Tulip bulbs or South Sea Company
shares. In fact, Kahneman himself has said that his own knowledge of how our brains deal with uncertainties
has in no way improved his decision making. He believes we have an ‘unlimited ability to ignore our own
ignorance.’ No matter how ‘rational’ we believe we are, we are overwhelmingly susceptible to the opinions
of the crowd. Our minds seek patterns, conformity, and the validation of knowing we are acting in
accordance with the judgements of the group. For example, in a famous experiment, a social psychologist
called Solomon Asch uncovered results that make sense of the infectiousness of bubbles and manias. One
subject would be shown twelve cards like the ones below and be asked which lines were closest to the same
length. When they tested alone they would score 95% or above. Then they would be placed in a group of 6-
the five other participants being Asch’s assistants. When they were tested last in the group, after the ringer
assistants had deliberately given wrong answers, the subjects’ performances plummeted. Incredibly, only
25% of subjects would still provide correct answers, and some 5% of subjects would answer all twelve cards
incorrectly if the group did. Before considering how you would do, remember our amazing ability to deceive
ourselves about our own ignorance.

ARAVIS CAPITAL | A MEME STOCK SUMMER

CLEVER-TICKERS, MEME-STOCKS AND THE IMPLICATIONS OF
‘HODL’
    “The concept of diversity is essential...When we have diversity we tend to have efficient markets, and Mr.
    Market’s idea of value is plausible. When we lose diversity, the wisdom of crowds flips to the madness of
                                     crowds…and prices depart from value.”
                                                   Michael Mauboussin
So, is there anything that distinguishes the current market action in meme-stocks from bubbles of the past or
the incompetence of our own brains to the art of investing wisely? On an individual basis, maybe not. But in
aggregate there are clues that suggest we might be experiencing a shift in the structure of the US equity
market and its participants, as well as questions around whether this bubble will truly ‘burst’ as so many
have in the past. Usually, bubbles burst as everyone rushes to sell at the same time. But how does the
Robinhood and WSB crowd’s cult-like adherence to ‘never-sell’ and ‘HODL’ change that dynamic? Clearly,
when the marginal buyer disappears the risk of a significant drawdown is still present- there have been some
major corrections in meme-stocks. But those corrections haven’t necessarily played out like previous
manias. After rising from $17 per share on January 4th to $347 in late Janaury, GameStop reached a low of
$40 in March – still nearly 2.5x the price before the initial short-squeeze. The median closing price for
GME in 2021 is $1606, nearly 10x its price at the start of the year. Is there an argument to be made that the
never-sell approach of the investor base has prevented these stocks trading back down in-line with their
fundamentals? As Mauboussin would say, does a breakdown in the diversity of opinions in the shareholders
of meme-stocks, i.e. they are all willing to hold regardless of fundamentals or price-action, lead to a
permanent quasi-madness in the stock price? How realistic it is that this could be the case, not just for GME
but for an index of retail favourites more broadly, also depends on the reversal of a theme that has been
persistent since the 1960s- the amount of the US equity market that individual investors control. US
household’s equity ownership is approaching highs last seen in the dotcom era. Will mobile trading apps,
commision-free trades, cheap leverage, and fractional shares mean that retail investors wield more power for
longer than their dotcom era counterparts when trades cost $15 a pop over dial-up modems? In other words,
will the madness of crowds more permanently contend with the wisdom of crowds? To provide some real-
world evidence that this isn’t perhaps as fanciful as it sounds, the chart below shows the relative
performance of a portfolio filled with ‘clever’ tickers vs. the broader stock market over 14 years:7

6
  As of June 11th, 2021.
7
  We know, good stocks might just have clever tickers. Composition of the clever-ticker portfolio and the market outlined here:
http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.1085.3881&rep=rep1&type=pdf and here http://economics-
files.pomona.edu/GarySmith/Econ190/Econ190%202019/Baer,%20Barry%20Final%20Thesis%20vf.pdf

ARAVIS CAPITAL | A MEME STOCK SUMMER

CONCLUSION
                         “The stock market is a giant distraction from the business of investing.”
                                                                     John C. Bogle
It is generally accepted that the purpose of capital markets is to direct investment towards companies that
will use that capital most productively and provide investors with the highest return, and away from those
that won’t. How long the meme-stock phenomenon can alter that equilibrium remains to be seen.
Furthermore, for the ‘never-sell’ philosophy to continue to provide a high floor for the prices of meme-
stocks, we have to rely on retail investors committing to that dogma permanently. Isn’t it more likely that the
cultish adherence to            is symptomatic of the age and pop culture of 2020/2021, rather than an
enduring trend? To actually get rich and convert paper gains to real gains, retail investors will have to cash-
out at some point. It feels probable that a few months down the line we may well be writing about how the
meme-stock summer was the next ‘big-short’ and the opportunity of a lifetime for those hedge funds that
survived January and May. This is certainly the belief of our partners Cramer Rosenthal McGlynn, who in a
webinar we hosted on May 26th, reiterated that the pipeline in the short book of their UCITS L/S Fund had
never been so rich. On the other hand, if trading apps become as ubiquitous on smartphones as dating apps
and ride-hailing apps, then the participation of retail investors in the US equity market will surely continue
to increase. In that case, we may also see new lows in aggregate short-interest levels in US stocks, as short-
sellers decide there is more to life than battling on-line mobs that believe you are evil.
The consequences of such dynamics on the so-called efficiency of markets could be subtle but notable. The
belief that, in the long-run, ‘good companies go up and bad companies go down’, could be impaired. We are
already seeing the executive management teams of meme-stocks embrace the popularity of their stock with
retail investors, so how long before we see high short-interest in their stock mentioned as a performance
driver in the Investor Relations materials? For professional investors today, markets must feel like playing
poker when the rest of the table is repeatedly going all-in pre-flop without looking at their cards. That
numerous studies8 have proven the aggregate performance of day-traders is negative, most quit within two
years, and that only 1% of day-traders are profitable over time, will have been little consolation for the
professionals during January and May this year. Ultimately, we think increased retail participation in equity
markets via trading apps will be a net negative for consumers and, in the not-too-distant future, will likely be
an exploitable lay-up for hedge funds and professional investors. There will be no grand democratization of
finance, which we believe is the marketing language of an app largely designed to exploit the uninitiated.
But the gamification of investing and a new generation of smartphone investors means that outlier events,
like GME, AMC and the clever-ticker portfolio, could well become an enduring feature of equity markets
and a permanent thorn in the side of professional investors.
Aravis Capital work with a number of high-quality funds that offer portfolio solutions for all
environments. For more information, please contact your Aravis sales representative, or the Aravis
Research team (george.sugden@aravis-capital.com).
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8
 https://faculty.haas.berkeley.edu/odean/papers/Day%20Traders/Day%20Trading%20and%20Learning%20110217.pdf ,
https://faculty.haas.berkeley.edu/odean/papers%20current%20versions/individual_investor_performance_final.pdf