After soaring 2,170% in the five-year period leading up to their peak in November 2021, shares of Etsy (ETSY -0.27%) have come crashing down. They currently trade 83% below that record from more than three years ago.

As of this writing, Etsy shares can be purchased at a dirt-cheap forward price-to-earnings (P/E) ratio of 8.9. This deal might be too difficult to pass up for those looking at a potential value opportunity in this kind of market environment.

However, don't rush in just yet. Here's one obvious risk that investors in this e-commerce stock need to know.

Etsy's red flag

I think one top characteristic that a high-quality business possesses is the ability to generate durable demand. This means customers continue to spend money on its products and services despite the economic backdrop. Companies that can perform well in robust macro environments, as well as in less upbeat scenarios, should be viewed in a favorable light by investors.

Unfortunately, it's looking more and more like Etsy doesn't belong in this category. Yes, revenue was up 2.2% in 2024. However, gross merchandise sales (GMS), perhaps the most important metric to pay attention to, which measures the dollar volume of transactions occurring on the platform, declined by 4.4%. Since hitting a peak in 2021, GMS has dropped in three straight years.

This highlights what I see as the biggest risk for Etsy, which is that the business is proving to be far more cyclical than investors might have originally thought.

This is an alarming trend. That's true when you consider what's happening in the industry. According to Grand View Research, e-commerce spending globally is slated to increase by 19% per year through the end of the decade. This type of accommodative environment should benefit a company like Etsy. However, that clearly hasn't been the case.

Josh Silverman, Etsy's CEO, blames "pressure on consumer discretionary product spending." This makes sense, given Etsy's top product categories are things like furniture, apparel, and jewelry. These are items that consumers can delay buying when inflationary pressures persist or when other adverse economic factors pop up.

It's also worth pointing out Etsy's shrinking user base. The company's active sellers and active buyers declined 10% and 1.1%, respectively, between Q4 2023 and the fourth quarter last year. It looks like the platform's value proposition is worsening.

An unexpected turn

You're forgiven if you didn't notice this cyclicality before. In the years leading up to the COVID-19 pandemic, Etsy's growth was through the roof. From 2016 to 2019, GMS and revenue surged 75% and 124%, respectively. Then, the health crisis helped supercharge expansion. But now things have taken a turn for the worse.

The retail sector broadly, and the e-commerce niche specifically, are undoubtedly very competitive. Platforms and brands are all fighting for consumer attention and wallet share. Etsy has been able to stand out among the crowd because of its differentiated offering that focuses on special, unique, vintage, and handcrafted goods.

People can buy items they can't find anywhere else. This is supported by the ability of millions of sellers across the globe to essentially make money from their hobbies. In this way, Etsy provides for an authentic transaction to take place that's much different from the experience on Amazon, for example.

However, perhaps the biggest downside of this differentiation and uniqueness might be that Etsy isn't able to drive repeat purchasing behavior. People might visit the site on that rare special occasion. Then, they might not go back to Etsy for years. This is exactly how my personal experience has been.

Etsy's habitual buyers, or those that shop on six or more days and spend at least $200 in a 12-month span, totaled 6.4 million in Q4. That's down from 8.1 million exactly three years ago. Losing these power users is clearly not an encouraging trend.

Etsy's stock trades at an extremely cheap valuation. However, investors should avoid buying shares until the company can get back to posting healthy GMS growth.