A trash rally: Guess who’s back?

January was a strong start to the year for equity markets. In fact, the Nasdaq is off to its best start since 1991. Given that lenders (banks) are building reserves to prepare for a recession, and the money printers (central banks) are trying to cool the economy, the strength of equity markets seems to defy logic. It’s as if financial markets are completely ignoring the recession nipping at our heels. What’s driving this?

You guessed it: much of the January returns were powered by a trash rally. We’re talking about low-quality, high volatility stocks driven up by retail investors and internet frenzy.

What defines a trash rally?

Remember the GameStop phenomenon of January 2021? This is a textbook example of a trash rally. A near-bankrupt company saw its stock skyrocket thanks to a bizarre retail trading frenzy and a rash of internet jokes and memes. This resulted in a significant and illogical increase in stock price (trash rally) and the origins of the term “meme stock.”

Meme stocks are defined by several key characteristics:

• low ROE
• negative earnings
• high leverage
• low market cap
• high short interest
• weak leadership

The current trash rally is being fueled by a resurgent risk appetite among some investors. We’re seeing explosive growth in a variety of meme stocks this month after a crushing year for equities, although many analysts are skeptical the most recent moves will last.

A closer look at the data

According to JP Morgan, retail market orders reached 23% on Jan 23, 2023. To put things in perspective, when the original GameStop saga began, retail trading peaked at 22%. The result of this euphoria can be seen below with the year-to-date performance of these high beta stocks including some indexes that replicate low-quality stocks.

How has the performance been since January 2022

Source: Global Alpha Capital Management and Bloomberg

How are those meme stocks doing since January 2022?

Two years ago, we were all stuck at home, feeling bored, and getting a false sense of financial security from stimulus checks. With sports events and gambling closed, retail investors made the stock market their casino. While some retail investors made a fortune, unfortunately, many lost a lot. The above charts (blue bars) show how most of the names have been cut in half, if not more.

Management teams of many meme stocks took advantage of the inflated stock prices to issue more equity and improve their finances. According to the Financial Times, meme stocks have raised over $4.7 billion from the hype.

AMC, a poster child for meme stocks, raised $2.8 billion from sales of equity and new debt. Fundamentally their business has not improved with current sales below 2018 revenue, and EBITDA is expected to be half of what they did in 2018. This is despite the fact that Avatar: The Way of Water is close to collecting $2 billion in global box office ($623.5 million in the U.S.).

Here we go again

All signs point to another meme stock rally. Take troubled retailer Bed Bath & Beyond, for example. They missed interest payments on bonds on Jan 29, which may lead to bankruptcy, and yet the stock price appreciated by 129% in just over a week. Carvana, the debt-strapped online used-car retailer is up 143% year-to-date. A meme stock favourite, Carvana was trading at $11.55 at the point of writing, way below its peak of $370 set in August 2021. Despite being down almost 98% from its peak, more than 266,000 call contracts changed hands on January 30, 2023 according to Bloomberg.

Is this just a U.S. Phenomenon?

The Bonusetu (a Finnish Casino) research team combed through Google trends for each European country to find the most Googled stock for each country. Tesla took the top spot in a whopping 28 countries and AMC is most popular in five countries. Below is a screenshot or performance of some other names in the group.

While we understand Google trend data does not necessarily mean Europeans participated in the trades, it’s difficult to imagine an alternative explanation. Was everybody in the UK, Germany, Ireland, and Croatia just purchasing tickets to watch Avatar at an AMC theatre? Or booking their next vacation on Icelandic Air or Virgin Galactic? It seems far more likely they were getting seduced by meme stocks.

Will history repeat itself?

Once again euphoria has set in and everyone is having a good time, gleefully ignoring the well-documented consequences of excessive indulgence. We’ve seen this story play out several times over the last few decades. Think back to 2001. That year, Nasdaq was up 12% in January but fell over 30% in the following 11 months when the dot-com bubble burst. In our February 11, 2021, weekly called The Canary in the Coal Mine we compared the meme stock situation to the tech bubble as well as the 2008 financial crisis.

Portfolio Impact

Popular media is once again helping stir up the meme stock frenzy. As we see a repeat of the same movie (no pun intended, AMC) this may have an unfortunate impact on higher-quality names that could get mispriced lower. The good news? For long-term investors in quality companies, this provides an amazing opportunity to buy quality companies at attractive valuations.

Our ability to be highly selective and nimble in our portfolio holdings leaves us well-positioned to enter a period of great opportunity for fundamental stock pickers. Our focus on high-quality companies with defensible business models and strong balance sheets should help outperform our small-cap benchmark. As we reflect on the state of markets and the fundamentals of our target companies, we are excited about the current environment and future growth opportunities.