In November of 2021, the Board of Governors of the Federal Reserve (the “Fed”) issued its Federal Reserve Financial Stability Report, a biannual report focused on potential risks to the financial system. In this issue, the Fed highlighted the role of social media and retail investors in equity market volatility.
The Fed was concerned that social media and retail investors had been at the center of volatility in equity markets. According to the Fed report, in January 2021, social media posts related to specific stocks spiked, coinciding with a sharp increase in intraday volatility in shares of stock: the standard deviation of one-minute price changes jumped more than ten-fold from 0.25% to greater than 2.5%.
The report found that these “meme stock” social media posts target the growing share of young investors, who are increasingly becoming a larger percentage of the market. The Fed stated that these investors are generally more willing to take risk and use leverage to try to generate higher returns and typically also have more debt. The report concluded that this appetite for risk and leverage leaves those investors, the market, and the companies they invest in more vulnerable to large swings in stock prices. Additional implications for financial stability that the Fed recognizes are:
- the future unpredictability of this heightened risk appetite with the interaction between social media and retail investors, and
- a concern that risk-management systems of financial institutions might not be calibrated for the increased risk associated with this trend.
The report found that driving this trend is trading app technology that has lowered the barriers to entry for retail investors, and has made it easier for investors to act on impulses after reading something on social media. Instead of making a telephone call to an investment professional and having a discussion, or even needing to wait to be on a computer, investments are a swipe and a tap away on a phones. Consumers have easy access to markets, but that access is also potentially dangerous for less informed and less experienced investors–and for the companies that these investors are influenced to purchase via social media posts.
Compared to a strategic long-term financial plan, investors influenced by social media (“meme investors”) are more likely to be swayed to purchase investments that might not meet their risk tolerance, in the amounts that they are purchasing. The Fed was concerned that, in some cases, investors would learn about and execute trades for complex derivative strategies that cause the consumers’ positions to become even riskier.
Companies that are targeted by meme investors face risks of their own. A wild fluctuation in share price has a direct impact on the capital structures of these companies. The same company that issued shares when the price was high could potentially find itself addressing debt/equity covenants triggered in credit agreements if/when their stock price collapse. Thus far, meme stock strategies have been focused on creating short squeezes in stocks where large institutional traders were driving the price down. The strategy drives the share price up, but it is inherently a short-term tactical trade. Unlike investments based on traditional valuation-based on growth and dividends, the additional capital brought in by a meme can end just as quickly as it began. Furthermore, companies should consider the risk of other types of trades that investment meme creators might try to market on social media.
Finally, the brokerages and banks that employ investment professionals should also be concerned about meme stocks, and what their employees say and do on social media. There is a concern that employees may be giving unsolicited and inappropriate advice to unqualified investors. Sharing a meme or liking a post might also be construed as an endorsement or solicitation of an investment opportunity or strategy. Their use of a personal account, or creating a ghost account, would not necessarily absolve them of their fiduciary and ethical duties to their existing clients and other market participants.
The Fed recognized that the impact of meme investors on market volatility has been minimal so far, but cautioned: “More frequent episodes of higher volatility may require further steps to ensure the resilience of the financial system.”
Thanks to Paul Guirguis for his assistance in drafting this post.