Meme stock trading: Just assume everyone else is mad, or drunk, or both
By Tim Worstall
11:22, 21 July 2022
So how should we trade Revlon (NYSE: REV) then? The company announced bankruptcy and the stock jumped 300% which is simply not rational behaviour at all. OK, it was Chapter 11, not a full on liquidation but still, whut? The answer being that this is a meme stock now and we've got to alter our mindset to deal with those.
It's got to be said that meme stocks are fun. AMC (NYSE: AMC) was a cinema chain busted by lockdown but meme stock status made it so flush with capital it's now investing in gold mines like Hycroft Mining (NASDAQ: HYMC) which itself has had its time in the speculative sun. The Grandaddy of these is GameStop (NYSE: GME), a one time likely-to-be-bust physical retailer of video games. Well, likely to be bust until some noted that the short position was not just more than 100% of the free float but apparently more than 100% of issuance. At which point a social media organised short squeeze occurred, the stock soared and GameStop could refinance. The business is still, well, a bit umm, but the share price is well up. We can also take joy that a hedge fund that was shorting it lost 50% of its money and had to sell itself, an online broker near went bust and had to emergency sell a piece of itself. These are indeed funny, Har Har, events. Then there was Hertz (NASDAQ: HTZ) which we'll come to.
The standard economic analysis of prices in financial markets is that the next, immediate, price move at the smallest level – say, the pip – is a random walk. As with atoms in gas and Brownian motion, any one can go any way. But clearly gases do flow in actual directions despite that chaos at the individual bit level – so too with financial markets. There are real trends, real influences at the larger scale. So, random by the fraction of a second, run by proper economic basics in the long term.
The bit in the middle, the bit that interests us as traders, that's a bit more difficult. That's when the behaviour of all us other traders with our opinions – not basic economic facts – determines prices. It should be obvious that not all humans believe the right things all the time, there'd be no explanation for Simon Cowell if all did that. So in this middle part, the medium term, it's the opinions of everyone else that needs to be calculated to see which way prices are going to go.
What is your sentiment on GME?
Meme stock basics: Everyone else is mad, or drunk, or both
A useful definition of a meme stock is when everyone else is mad, or drunk, or both. Which could be why Revlon jumped on bankruptcy. For by any objective measure it's not going to come back from this. To work out what equity is worth in Chapter 11 the usual information source is bond prices. The law says that secured creditors get paid first, then unsecured, only then equity. If the bond prices are saying that the junior (ie, unsecured) bonds are worth less than 100% then they're not going to get paid in full. So, equity will get nothing. Even if the firm gets cleaned up a debt for equity swap will still leave the old stockholders with no – or a painfully titchy – part of the new one. If the majority shareholder, Ron Perelman (with 87%) had wanted to put more equity in then he would have done. There's no logical or likely way that the remaining 13% of the equity is going to stump up enough new equity to solve the capital/debt problem.
So, why's the stock jumping? Why isn't it worth zero at Revlon? Which is where Hertz comes in. Or even, perhaps, just the meme stock idea. Hertz went bust because it borrowed money, using bonds, to buy the car fleet. Lockdown, those used cars are worth less, Hertz must put up more security that it didn't have against those bonds – busteroonie. Hertz should now be worth nothing, or at least the equity should. But that's not what happened, the memers piled in, Hertz was even able to issue new stock (for $billions fer the Lord's sake) in bankruptcy which is unheard of.
But then something else happened, The car manufacturers screwed up their response to lockdown, cut their chip orders. As reopening happens they can't make new cars – no computer chips. Used cars – of which Hertz has a lot, their original problem – become worth more than new. Hertz is still bankrupt, but it's bankrupt worth more than its debts – the equity now has value.
The reason Hertz worked is not because it became a meme stock but because the used car values soared. The meme is simply coincident with that – or, of course, we could believe that folk were prescient.
Revlon, Inc. - REV CFD
Of all of these Hertz is the one and only that any rational investor – thinking of the long term – would even take a gamble on. But clearly they've produced vast profits for those trading the right way. Which is where we come to this middle time period in trading and or investing. In the long term those economic realities will out, in the short term we're in a random world. In that in between – in trading timescales – we're in trying to work out what it is that everyone else is doing, believing. Whether GameStop is stonks or not doesn't really matter on the day or week timescale, what does is what do the other players in the market think?
And the truth here is that some significant portion of our fellow traders could – possibly should – be regarded as mad, drunk or possibly even both. What we need to be doing is predicting what they are going to do, not what the underlying economics is telling us will out in that long term.
This could all be thought of as woefully depressing. There are no – or at least in certain corners of the markets there aren't – rigid and set rules that will determine prices. This is what so upsets the anal retentives who oppose market economies and want to plan everything. You mean, but, what, it all depends upon just what folk think at any one time? Yep, it does. Prices in markets are what people think prices in markets should be and nothing else.
The depressing part would be that this means we've got to read other people in order to see where prices are going to go. But why would that be depressing? We humans are good at reading people. The reason we are is that we're all the descendants of those who read people for a few hundred thousand years. Who to bonk, who to attack, who to eat and so on. Sitting in our own heads is that hundreds of thousands of years of being successful at this stuff – sure, they might all be drunk or mad but we can read them. For that's what we do, that's being human.
Meme stocks are the most human part of the financial markets exactly because the only thing that drives them is human nature and the oddities to which that is prone. Which is great, because we humans are good at working out what other humans are going to do. None of us would ever get laid if that weren't true and there are millions upon millions of kiddies out there to show that at least some of us do. At least, before the kids arrive.