By Mark Hulbert

Meme stocks and other "lottery stocks" are likely to soar if inflation heats up in coming months, but after that underperform the market.

Lottery stocks have what statisticians call a long right-hand tail. That means their past returns don't fall within a normal bell-shaped distribution, as most stocks largely do. Instead, the right side of their distribution -- representing potential large gains -- extends further to the right than normal.

Their skewed distributions mean they have a small chance of producing spectacular returns, as in a lottery, and therefore attract individuals whose stock strategies are more akin to gambling than investing.

A new study has found that this gambling-like behavior increases markedly when inflation rises, causing lottery stocks to soar. This tendency helps to explain the meme stock craze that took the market by storm in 2021.

The new study, which just began circulating in academic circles, is entitled " The Inflation Gamble." Its authors are Alok Kumar and George Korniotis of the University of Miami, c, and Yosef Bonaparte of the University of Colorado Denver.

The professors' finding runs counter to conventional wisdom, which holds that higher inflation causes investors to become more conservative. But the researchers discovered that inflation actually increases investors' willingness to incur risks as "they attempt to mitigate inflation-induced loss in purchasing power," and that this willingness shows up as a preference for lottery stocks.

To document this, the professors constructed a hypothetical portfolio of stocks that previously had been most sensitive to inflation and whose prior returns were most skewed to the right-hand side of their distributions. This portfolio of inflation-sensitive lottery stocks proceeded to perform spectacularly when inflation spiked upward, and underperform the rest of the time.

For example, in the 10% of months between 2000 and 2022 when inflation was the highest, Vosse said via email, this portfolio rose at an average annual pace of 27.6%. In the months immediately following those in this highest-inflation decile, the portfolio fell at average annual pace of minus 25.0%.

A graphic illustration is provided by the performance of GameStop, the paradigmatic lottery stock. As you can see, its performance over the past five years has been closely correlated with changes in the annual inflation rate. That puts GameStop's spectacular spike in early 2021 in an entirely new perspective, since the standard account up until now has been that it was caused by a social-media frenzy among small retail investors and an ensuing short squeeze. This new research suggests that this social-media frenzy didn't take place out of the blue, but took off from a foundation of rapidly accelerating inflation.

The professors are well aware that correlation is not causation, however, and therefore their empirical findings don't prove that higher inflation is the cause of investors' gambling behavior. But they found strong circumstantial evidence that inflation is the culprit. For example, they found that "per capita state-level lottery revenue is higher in U.S. states with higher inflation levels." Furthermore, they find that interest in "gambling activities such as sports betting, as revealed through Google Trends search intensity, is higher during periods of high inflation." These and other findings "provide direct support for our conjecture that higher levels of inflation encourage more risk-taking and gambling among individuals."

Several important investment implications emerge from this new study. One is the need for each of us to be aware that our risk-reward calculus changes when inflation rises. Probably unconsciously when inflation is high, we let the potential lottery type gains of certain stocks outweigh the risks of huge losses. The professors write that "recognizing and understanding this behavioral shift is crucial for financial advisors."

Another investment implication is that we should sit on our hands during social-media frenzies that propel lottery stocks to previously unthinkable levels. Almost certainly those huge gains will be short-lived and the stocks will proceed to be long-term losers. We shouldn't forget the disastrous performance of the Roundhill MEME exchange-traded fund, which was created to invest in an index of meme stocks. This ETF was launched in late 2021, in the wake of the explosion of interest in meme stocks earlier in that year. From its launch until December 2023, when the ETF was closed, it lost more than half its value.

Nimble traders may be able to exploit this new research by shorting the lottery stocks that spike upward when inflation worsens. The study's authors produced a list of such stocks for Barron's. The 15 listed below are those that, since 2010, have been most sensitive to changes in the inflation rate and whose return distributions were most skewed to the right.

Kumar said via email that if and when inflation next spikes upward, these and other stocks like them "will earn a high return and then in the subsequent months perform poorly."

Mark Hulbert is a regular contributor to Barron's. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com .

Write to editors@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

January 28, 2025 03:00 ET (08:00 GMT)

Copyright (c) 2025 Dow Jones & Company, Inc.