Even with the unexpected profit reported earlier this week, the odds are stacked against GameStop.
That is because GameStop GME, at its now much-higher stock price, is just as overvalued as it was before. Its share price has been pushed higher in no small part by speculators who are attracted to the stock's lottery-type trading characteristics. On average, stocks with similar characteristics tend to underperform the market.
I refer to its past returns when I labeled GameStop a lottery type stock. A long right-hand tail is what statisticians call the stock, representing the small chance of winning big, like a lottery. Its average daily percentage change over that period was a loss of 0.7%, with no daily return greater than 5.1%. The stock went up 35.2% in the trading session after the earnings report.
As you can see from the accompanying chart, speculators piled into the stock in a big way. The volume went up to more than 65 million on the day after the earnings report, compared to the average daily trading volume of 4.6 million shares in the previous six months.
Many of the speculators who propelled GameStop's stock higher have no interest in the company's long-term turnaround prospects. They piled into the stock in hopes of winning big on a short-term trade. The stock price will be higher than is justified by the company's fundamentals and will therefore be overvalued. According to a recent study by the National Bureau of Economic Research, lottery-type stocks tend to underperform the market, on average.
This tendency may have begun with GameStop. The stock was trading for 5% less than its volume-weighted average price during the day's trading on the same day in after-hours trading the same day.
The NBER study, entitled Attention, Social Interaction, and Investor Attraction to Lottery Stocks, was conducted by Turan Bali of Georgetown University, David Hirshleifer of the University of Southern California, Lin Peng of Baruch College and Yi Tang of Fordham University. The researchers found that a stock acquires lottery-like characteristics because of a feedback loop that involves its volatility, investor attention, and social interactions via channels such as social media.
A stock with relatively dull day-to-day trading will suddenly come to life. Its huge one-day gain will draw the attention of speculative traders looking for more, pushing the stock even higher - at least temporarily. Social media causes the stock to become more volatile and attract more attention, and causes it to become even more volatile. This feedback loop does not have any correlation with a stock's underlying net worth.
There is evidence of this feedback loop that is provided by the jumps in other meme stocks in the immediate aftermath of GameStop's unexpected profit. AMC Entertainment AMC, and Bed Bath Beyond BBBY, soared in concert, for example. GameStop's surprisingly good earnings have nothing to do with the prospects for either of these two other companies. Their stocks rallied along with GameStop because they are lottery-type stocks and speculators are interested in a quick profit.
As opposed to gamblers, investors should be on their guard.
Mark Hulbert is a regular contributor to MarketWatch. He can be reached at mark hulbertratings.com
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