The economics of meme stocks

If you want to understand one aspect of markets today, you should forget Benjamin Graham and recall another mid-20th century US economist, Thomas Schelling.

I say so because of the phenomenon of meme stocks – shares such as GameStop or AMC which soar as small investors pile in only to plunge later.

To see how such shares emerge, imagine you have arranged to meet a friend in Leicester but your phone has died so you can’t tell him where you are. What happens? If your friend knows you’re coming by train, he’ll meet you at the station. Otherwise, you’ll meet at the clock tower, because traditionally people do meet there. It is what Schelling in his 1960 book The Strategy of Conflict called a focal point – a place where people’s expectations converge without them having to communicate.

Meme stocks emerge at first because they are focal points. What makes them so is salience. Just as the clock tower is the most obvious place in Leicester, so meme stocks gain salience from a mixture of memories of people visiting the companies, their modest size, and the fact that hedge funds are big shorters of them: these provide points at which expectations can converge. You might think these are a slender basis for buying. You’d be right. But as Avinash Dixit and Barry Nalebuff pointed out in The Art of Strategy, focal points “can easily be determined by whim or fad”.

Meme stocks thus become meme stocks because of self-fulfilling expectations.

There’s nothing new here. Schelling pointed out in his other classic book Micromotives and Macrobehaviour that bank runs, of the sort we saw at Northern Rock in 2007, are also examples of self-fulfilling expectations: if people fear a bank will become insolvent (or fear that others will fear so) they’ll rush to withdraw their money and so cause the collapse they feared. Run-ups in meme stocks are like bank runs, only in reverse.

Maynard Keynes anticipated meme stocks when he likened stock picking to a competition in which people had to guess which face other people would think prettiest. The prize goes to the one who best predicts others’ tastes. The reality of who is really prettiest is irrelevant. What matters is opinion about opinion. That’s a long way from the world of Ben Graham, in which investors profit by discovering hard facts which Mr Market is ignoring.

Of course, it’s not just in investing that focal points matter. Columbia University’s Moshe Adler has shown that they also help explain celebrity culture. Some people achieve a little prominence by chance and because people want to discuss the same things, this accidental advantage, he says, can “snowball into superstardom.” Leicester’s clock tower, meme stocks and Piers Morgan are similar phenomena.

Focal points, however, only give birth to meme stocks. It is something else that makes them grow – something too familiar to us. There’s a reason why we say that a popular meme has “gone viral”. It’s because as Christian Bauckhage at the University of Bonn has shown, memes do spread exactly like diseases. Some people get an idea as they get a disease and spread the infection to others. In his book Narrative Economics the Nobel laureate Robert Shiller shows how the same mathematical model used to describe the spread of disease also describes the spread of economic stories. Whether these stories are true or not doesn’t much matter. What matters is how infectious they are.

But of course, pandemics eventually die out: once enough people have developed antibodies, while others aren’t susceptible anyway, the virus has no where to go. In the same way, bubbles in meme stocks burst when there are too few potential buyers.

Here, though, the analogy between meme stocks and viruses breaks down. We’ve seen not just one bubble in GameStop but three – so far.

What we’re seeing here is something else described by Schelling – of how expectations sometimes lead not to a stable equilibrium but to cyclical behaviour. He gives the examples of measles. A single outbreak ends as parents rush to get their children vaccinated, but a period without an outbreak breeds complacency and fewer vaccinations – until so few are vaccinated that another outbreak occurs.

We’ve long known that this happens in financial markets. The late Hyman Minsky described how financial stability encourages speculation and so generates a cycle of stability-boom-bust-stability and so on.

Meme stocks accelerate this process. What used to happen over years now takes place within weeks.

But we see analogues to this all the time. A man who promises when hung over never to drink again is soon back out on the lash, and the woman who bins off her no-good man returns to him.

In all cases, what’s going on is a combination of wishful thinking, weakness of will and lottery-type preferences triumphing over experience. Meme stocks could treble your money in a few weeks, but better stocks won’t, and that’s a powerful lure.

Here, though, we must remember the advice of the great political scientist Jon Elster – that sometimes we can explain without being able to predict (and vice versa, but that’s another story). Just because we can explain the cycle of emergence, boom and bust and re-emergence in meme stocks does not mean we can predict such cycles sufficiently accurately to profit from them. Some things are better as purely spectator sports.