The Top Reddit Stocks (And Dogecoin) Are Creating Bubbles. What to Do?

What two things do electric vehicle (EV) and marijuana stocks have in common? One, both industries became retail-investor darlings last year. Many companies in these sectors became known as “top Reddit stocks” for their prominence on the freewheeling r/WallStreetBets subreddit.

The second similarity is less obvious: Both were “Top Reddit Stock” bubbles that have burst this year. Regular investors might have missed that the average top-10 stock in each industry is down 60% from its peak. Analysts expect more losses to come.

Yet, the Reddit stock bubble is unlike anything we’ve quite seen before. Rather than sending investors panicking, these bubble bursts have spawned more manias in their wake. This week, Dogecoin (CCC:DOGE-USD) briefly became the fifth-largest cryptocurrency despite having no clear ambitions for real-world use; investors who bought $10,000 DOGE in January could have sold out for almost $1 million last week.

Meanwhile, traditional investors have started worrying about missing out. Once off-limit investments like Tesla (NASDAQ:TSLA) and Bitcoin (CCC:BTC-USD) have gone mainstream as institutional investors reach for returns.

“Institutions are buying up more bitcoin per month than the ones that are being mined,” said Alessandro Andreotti, an over-the-counter (OTC) Bitcoin broker. “There just isn’t enough for everybody.” Even riskier bets have happened since.

As Wall Street tries to beat Reddit investors at their own game, they will inadvertently create opportunities for smaller investors to win. That’s because when it comes to investing in bubbles, speed is often the only thing that separates the winners from the losers.

Top Reddit Stocks of 2021: One Bubble After Another

Tell any longtime Reddit investor that their bubble has just burst, and you can expect a blank stare in response. Top Reddit stocks from GameStop (NYSE:GME) to Marathon Patent Group (NASDAQ:MARA) are still up thousands of percent from early 2020.

Ask a Wall Street investor, however, and a different truth emerges. Many of these investors have lost billions from entering late in the game. Tesla stock owners saw $250 billion in value melt away earlier this year. Top investment banks found themselves losing billions after holding the bag on high-beta bets.

What happened?

The simple explanation is that Wall Street overestimated valuations. In January, Tesla’s $840 billion market capitalization made it as large as the next 10 legacy automakers combined. Viacom (NASDAQ:VIAC) and Discovery (NASDAQ:DISCA) — firms in turnaround mode — had forward price-to-earnings (P/E) ratios that put them in the same league as Apple (NASDAQ:AAPL) and Facebook (NASDAQ:FB). High-beta stocks were bound for a correction.

There is, however, a deeper fundamental reason. In a quest for immediate returns, slower-moving institutional investors have started mimicking retail-investor appetites for risky bets. A new bubble economy was the only logical outcome.

Reaching for Yield, Reddit Style

In the world of fixed income, bond traders refer to this risk-seeking behavior as “reaching for yield.”

Here’s how it works.

In good times, conservative bond buyers will often start inching toward riskier issues in hopes of earning higher yields. That bumps people with average risk tolerances into higher-volatility assets, and so on. It’s a strategy that works marvelously, until it suddenly doesn’t. (The collateralized mortgage obligations of the 2008 financial crisis were among these “reaching for yield” assets.)

Today, a similar effect has taken hold in stock investing. As hot money has flowed into the stock market, active funds have seen their styles drift toward the risky. According to data from Thompson Reuters, Tesla now makes up 6% of the Growth Fund of America (MUTF:AGTHX), one of the largest actively managed funds in the world. (In 2019, the fund had just a 0.5% position.)

Cathie Wood’s ARK Innovation ETF (NYSEARCA:ARKK) has seen a more extreme shift. Last year, its top-10 holdings had a median price-to-sales-to-growth ratio (a PEG ratio for high-growth companies) of just 0.15. Today, that figure is 0.5. In other words, Ms. Wood’s fund is risking far more money for less growth potential.

Collectively, these Wall Street funds have pushed valuations of retail-heavy stocks to unimaginable levels. The total value of firms with price-to-sales ratios greater than 20 now stands at $5.7 trillion, up tenfold from last year. Cryptocurrencies have seen a similar gain.

Meanwhile, Main Street investors have moved on from these mainstream bets. Interest in finding “The Next Bitcoin” has never been higher.

The strategy has rewarded retail investors handsomely. An investment of $10,000 in Dogecoin back in January 2020 would be worth $1.4 million today. Similar gains in GameStop and other “meme stocks” have turned lucky shareholders into multi-millionaires.

The Party Keeps Going

The investment game of cat-and-mouse has only gotten faster.

Consider Dogecoin.

No sooner had #DogeDay ended on Tuesday, than SafeMoon (CCC:SAFEMOON-USD), a one-month-old currency, replaced DOGE as the most searched-for cryptocurrency in the world. The new coin purportedly penalizes sellers with a 10% fee. Other meme coins like Pirate Chain (CCC:ARRR-USD) saw prices triple within days.

The late-to-the-party investors once again found themselves holding the bag. Dogecoin prices collapsed from $0.40 to $0.20 just as institutional investors were starting to buy in. It seemed as if Reddit investors were always one step ahead.

How Investors Can Profit from Top Reddit Stocks

To profit from this new bubble economy, investors need to follow two essential rules:

1. Speed. Investors need to move faster than institutional money to avoid becoming marks themselves.
2. Profit-taking. Even hot stocks will sink back to earth if their intrinsic value remains low.

Today’s bubble economy isn’t the first time asset bubbles have formed among broader market optimism. In 2014, investors became fascinated with 3D printing, sending profitless firms like 3D Systems (NYSE:DDD) to multi-billion-dollar valuations. Cryptocurrencies, rare earth metals and Chinese stocks have also seen rises and falls.

Asset bubbles, however, are now happening far more frequently. One possible explanation is that many retail investors have learned to take profits from high-flying investments instead of riding them down to zero. The rise of zero-commission options trading on Robinhood has also limited the time horizon investors can take. And social media has made it easier for like-minded investors to swarm in on investments.

Regardless of why, regular investors can profit by being one of the first people in the door and then leaving the party before things end. You might not ever sell at the top, but it’s far better than getting stuck with the Wall Street crowd on the way down.

Where Do Top Reddit Stocks Go From Here?

Last November, veteran auto industry expert Ben Foldy assessed electric vehicle stocks competing with Tesla. “There will be winners. And losers.”

Fast forward to today, and the winners have yet to emerge. Several are on bankruptcy’s doorstep. Some drops are warranted; firms like Lordstown (NASDAQ:RIDE) purportedly faked orders for months and hid major accidents from shareholders. Shareholder lawsuits are piling up.

But the individual stories mask the more remarkable change that investors have seen in the past 18 months. With the rise of zero-cost investing and social media, quick-thinking retail investors have suddenly found the tools to outsmart Wall Street. If you’re willing to place your wagers, you too can make sense of this fascinating new world.

On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.

Note: Top-10 electric vehicle stocks include Tesla, Churchill Capital (NYSE:CCIV), Lordstown Motors, Nikola (NASDAQ:NKLA), Fisker (NYSE:FSR), Canoo (NASDAQ:GOEV), Nio (NYSE:NIO), LI Auto (NASDAQ:LI), XPeng (NYSE:XPEV) and Workhorse (NASDAQ:WKHS). Top-10 marijuana stocks are Aurora Cannabis (NYSE:ACB), Hexo (NYSE:HEXO), Canopy Growth (NASDAQ:CGC), Cronos (NASDAQ:CRON), Tilray (NASDAQ:TLRY), OGI (NASDAQ:OGI), Aphria (NASDAQ:APHA), Sundial (NASDAQ:SNDL), Medmen (OTCMKTS:MMNFF) and Green Thumb Industries (OTCMKTS:GTBIF).