--Amanda Vaught, firstname.lastname@example.org
Over the course of the past year, during the Covid lockdowns and into the re-opening phase, we’ve seen a few key themes play out in the markets. One theme is what we refer to as “Shiny Objects.” Some of the shiny objects that siphoned a lot of funds and attention this past year were cryptocurrencies, meme stocks, NFTs (non-fungible tokens) and SPACs (Special Purpose Acquisition Company).
Here I’ll focus on the bigger ones – crypto and meme stocks. First, I’ll cover some background to provide some context into how we think about these shiny objects.
Background: Efficient Markets Hypothesis vs. Behavioral Markets
The Efficient Markets Hypothesis posits that stocks always trade at their fair value. Under this rubric, an investor can’t make gains by purchasing undervalued stocks. She achieves bigger gains by investing in riskier assets.
Image via Investopedia.com https://www.investopedia.com/articles/investing/041213
Using Fundamental analysis, an investor can examine the financial balance sheet of a company and determine whether the stock is undervalued or overvalued compared to its price trading on the stock market.
Another method to determine price movements on the stock market is with technical analysis. Under this approach, investors use trends on price (such as 50-day moving average vs 200-day moving average), trading volumes, or other metrics, to guide when they buy or sell a stock.
Another lens to use for investing is behavioral finance. This approach incorporates the personal history of market participants as an explanation for investing decisions. For example, many piled into the meme stock craze earlier this year for fear of missing out on making easy money – this is investing behavior based on emotion rather than on an analytical analysis.
Recent Factors at Play in the Stock Market
Source: Charles Schwab, Bloomberg, as of 6/11/2021. Past performance is no guarantee of future results.
Different approaches to stock market analysis rely on different types of factors. The above chart (via Charles Schwab) illustrates several of them along with how each factor performed over the past week, month, year-to-date, and year.
In general, riskier factors will show higher returns (or larger losses). That trend is evident when looking at the factors for volatility (11%) or trade activity (9.3%).
What’s interesting from this data over the past year is that profitability as a factor gave a negative return. If you believe in fundamental analysis, one would think that a more profitable company would have better stock returns. This proved not to be the case, at least over the last year. In a year of unprecedented returns, if you relied on profitability alone, you would have missed out over the last 12 months of gains in the stock market. Using fundamental analysis over the past year has not been paying off.
In general this past year has been an anomaly for the profitability factor. If you look at the profitability factor over the long term, you can see in the chart below, as of Aug. 18, 2021, that it returns 9.7%
Chart via Liz Ann Sonders on Twitter, https://twitter.com/LizAnnSonders/status/1427961773555134465
Past performance is no guarantee of future returns.
Another factor to highlight from the above chart: Value stocks were negative for the first part of the year, and then shot up for the first half of 2021. If you were discouraged from owning value stocks due to their negative performance, you would have missed out on these large gains. As of August 2021, this trend has cooled, and growth stocks have been surpassing value returns again. A properly allocated investment portfolio helps investors capture these back and forth gains between value and growth stocks as well as other areas of the market.
Cryptocurrencies use blockchain technology to verify and record transactions in a decentralized system. Bitcoin, Ethereum, and Dogecoin are examples of some of the most popular cryptocurrencies.
Crypto enthusiasts across social media have modified their profile pictures to include laser eyes – as Amanda demonstrates here.
Like any asset, cryptocurrencies have pros and cons. We’ll go through a number of highlights here.
On the pro side for cryptocurrencies are their privacy benefits. Currently, there is no digital cash. If you want to give someone money electronically, you must run the transaction through a bank. In the crypto world, the owners hold their crypto, and perform 1-to-1 exchanges with others. No third-party bank or other financial institution is privy to the transaction. While this does facilitate illicit transfers, it also works as a force for good in human rights. For example, many protestors in Hong Kong would use cryptocurrencies, so that the Chinese government couldn’t track their activity. (More on the human rights benefits of cryptocurrencies is discussed on this episode of the Odd Lots podcast: A Human Rights Activist Explains Why Bitcoin Is So Important to His Work).
Another pro for crypto is the blockchain technology behind it. Blockchain operates as a ledger to facilitate the process of recording a transaction (i.e. transferring ownership of one crypto-coin from one person to another). As the crypto universe evolves, so does the technology underlying it. Many experts predict new applications of blockchain and the rise of new business models to come from this evolution.
No matter what your opinion on cryptocurrencies, the crypto-sphere reached a $2 Trillion market cap in the spring of 2021. With this much money at play, it definitely makes its mark as something deserving of attention.
Finally, the money movement into cryptocurrencies may act as a speculative siphon, drawing gambling-type behavior away from the stock market and into the cryptocurrency markets.
Many retail investors were taken in by the incredible rise of the stock market from the March 23, 2020, bottom. The year 2020 saw an increase in social media accounts advocating for various options trading strategies, meme stocks captured the attention of millions, and new, less-seasoned, traders bought into the stock market while stuck at home during Covid lockdowns. This increased investing in the stock market also led to increased speculation. When the prices of cryptocurrencies began to rise, this grabbed the attention of many speculators and the stock market saw a reduced volatility. The below graph shows how the number of bitcoin transactions per day died off as the bitcoin price fell in June 2021.
On the con side of cryptocurrencies is their price volatility. Bitcoin and Ethereum, two of the major cryptocurrencies, have experienced significant prices swings in 2021. The below chart shows the price swings of Bitcoin and Ethereum from 7/31/2020 through 7/31/2021.
When an asset is this volatile, it does not operate as a store of a value. In general, true currencies (or fiat) retain a store of value, meaning they are a predictable form of exchange that can be stored and retrieved at a later date without losing their value. Crypto “currencies” do not have that feature.
Another side of the crypto market that makes it highly risky for investors is fraud. Currently, there are more than 6,000 different cryptocurrencies that one can buy. Many of them are fraudulent. The FTC recently reported that people lost more than $80 Million in cryptocurrency scams since October 2020. https://www.ftc.gov/news-events/blogs/data-spotlight/2021/05/cryptocurrency-buzz-drives-record-investment-scam-losses
Cryptocurrencies also carry significant regulatory risk. The SEC does not regulate the cryptocurrency market, but many anticipate they will in the near future. New rules and regulations could have a major impact on the operations of crypto-markets.
Be savvy around marketing
Much of the hubbub around cryptocurrencies is driven by people with a vested interest in selling you cryptocurrency.
For example, as a financial professional, what I say and do regarding investments is regulated by FINRA, the SEC, and various state laws and regulations. That means that, in this current blog post, I cannot tell you to buy X stock. The reasons for that are:
- That would count as investment advice when I don’t know anything about you. I am a sworn fiduciary who will help select investments for you based on your individual situation. I can’t advise you on what to buy when I don’t know you.
- I could own a position in X stock and persuading you to buy it would increase the value of my X stock.
In contrast, people promoting cryptocurrencies on social media are not required to disclose their own positions in cryptocurrencies. And they are not acting as fiduciaries to you as they don’t know anything about you.
For the record, I own zero cryptocurrencies.
Crypto proponents try to sell cryptocurrencies as a hedge against inflation of the US dollar.
At the beginning of 2021, many suspected that inflation was on the horizon. Some crypto-enthusiasts touted cryptocurrency as an asset to use to protect against this impending inflation. In general, this hedge theory of cryptocurrency has not played out.
Gold bugs have used a similar argument to sell gold, but research over the past 50 years has shown that gold does not work as an inflation hedge either. (“Gold as an Inflation Hedge: What the Past 50 Years Teaches Us”)
The below chart shows how the price of Bitcoin changed over the past year (purple line) compared to the U.S CPI month-over-month change. As inflation increased over the summer of 2021, the prince of Bitcoin fell off.
Bitcoin provided no protection against inflation either.
Google trends show January 2021 is when meme stocks started to get popular.
Google Trends chart showing the popularity of the search term “meme stocks” 1/1/21 through 6/19/21.
The prices of GameStop and AMC stocks were a phenomenon. The general media narrative was that day traders made a lot of money, while hedge funds lost big. Large dollar amounts and media attention contributions to a FOMO (“fear of missing out”) feeling once these types of activities get a lot of news coverage. Should you start to get a twinge of FOMO when reading these headlines, remind yourself that once it’s in the major news networks, the money-marking opportunity has already passed.
In early June 2021, coinciding with the fall-off of crypto prices, Google trends show that people are back to searching for meme stocks.
The share of the trading volume by retail and day traders has increased significantly this past decade.
As show in the above chart, the trading volume from individual investors increased from 10% to 24% of all trades. This trend started before Covid-19 lockdowns with the growth of the Robinhood app, and many major brokerages implementing no-fee trades. No-fee trading lowers the barriers to entry for many who want to participate in the stock market. But then this trend accelerated during the Covid lockdowns. Now retail trading comprises a significant share of the trading we see in the market today – it’s more than hedge funds, mutual funds and banks.
According to a recent Betterment survey (shown above), retail traders rely on social media, news websites, and conversations with friends in order to make investing decisions. That is, these traders are generally not considering financial factors and fundamental analysis when deciding which stocks to buy and sell. These traders are highly criticized by financial professionals for this reason. Some of the criticism is warranted, as day trading can be a very dangerous game to play. Day traders are more likely than not to lose large sums of money.
This new trend was well summed up by Alain Bokobza, head of global asset allocation at Société Générale:
“Powerful waves of passive and systematic investment long made retail investors largely irrelevant when framing market forecasts … until now. Rather than criticizing retail investors and their behavioral patterns, it is better to slot them into the money equation.”
This trend may be here to stay. We recognize that it may cause more volatility in the stock market, and financial fundamentals won’t drive the price of a stock like they used to.
Day trading, whether in meme stocks or not, brings tax consequences. Many nonprofessional traders fail to appreciate the tax implications of their trading activity. Without this knowledge, a day trader is not prepared for the financial consequences once tax day comes. Tax can be a significant expense of short-term buying and selling in the stock market.
Here is one egregious example of a day trader who did not understand the wash sale rules:
The IRS also expects tax payments on any cryptocurrency gains. (See this recent piece in the Wall Street Journal: “The IRS Is Coming for Crypto Investors Who Haven’t Paid Their Taxes”.) Please consult your tax advisor for details on your specific situation.
In conclusion, with markets and investing it can be hard to discern the valuable information from the noise. Shiny objects come and go, and there will always be get-rich-quick schemes. Investing can feel like a losing game, but sometimes the key to winning is to simply not lose. Stick with tried-and-true methods. Set up automatic deposits to your brokerage, Roth and/or 401(k) and invest with a fee-aware, well-diversified portfolio.