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How the era of the everyday investor is changing stock-markets

John Rekenthaler  |  07 Apr 2021Text size  Decrease  Increase  |  
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I recently puzzled over the reasons behind the US stock market’s spectacular recovery. It struck me as premature given that the economy was in a deep recession with no signs that the covid-19 virus would be eradicated anytime soon. Several readers proposed the following:

  1. The United States government had flooded the system with cash.
  2. This cash had not only supported asset prices, but had also fueled investment speculation.
  3. This speculation came from retail investors, who were feeling flush, because they had cut their spending while maintaining their income. In addition, some had received $1,200 checks courtesy of the Cares Act.

I was dubious. For the most part, I adhere to conventional finance theory, which emphasises rationality. It was not that investors had behaved rashly. Rather, I had failed, by being too slow to recognise the impending economic recovery. Also, the rally was global, meaning that US-centric explanations were not sufficient.

To that point: In the second quarter of 2020, US stocks rebounded 45 per cent from their lows, German stocks 57 per cent, Japanese equities 46 per cent, and UK stocks 32 per cent. To be sure, when US stocks sneeze other bourses reach for their handkerchiefs, thereby spreading the effect of American policies, but one cannot explain the S&P 500’s rise by pointing solely, or even predominantly, to domestic actions.

A kernel of truth

That said, the readers had a point; the significance of today’s retail investors should not be dismissed. As demonstrated by the GameStop (GME) saga, they don’t necessarily operate according to academic rules, and their clout is increasing. This makes for a different stock market environment, with corresponding lessons.

Recently, two researchers for the Swiss Finance Institute, Philippe van der Beck and Coralie Jaunin, supported this contention. In “The Equity Market Implications of the Retail Investment Boom,” the duo finds that Robinhood’s clients contributed handsomely to the second-quarter 2020 US rally, especially for smaller-company shares.

The authors used a (now-dormant) website called Robintrack to measure the activity of Robinhood’s customers. The site provided the number of Robinhood accounts that held each stock, updated several times daily, throughout the second quarter of 2020. Although Robintrack did not provide the account sizes, the authors roughly knew the amount of assets that Robinhood controlled, and thus were able to “reverse-engineer” (better translated as “guesstimate”) how demand from Robinhood’s customers increased for each stock during the second quarter.

(In addition to tracking the activities of Robinhood investors, the authors cataloged various institutional shareholders, such as hedge funds, banks, pension funds, investment advisors, and insurance companies. They used such information to derive an estimate of each stock’s price elasticity, which, in turn, affected their estimate of how Robinhood’s trades affected that stock’s price.)

A skeptic’s reaction

It is an imprecise process, in many ways, which leads me to discount the authors’ estimates. They calculate that demand from Robinhood clients boosted the value of the overall US stock market by 1 per cent during the second quarter. This came after their actions had added 0.6 per cent to US stocks’ first-quarter results. Those figures are high. If annualised, they imply that Robinhood’s trades contributed 3 percentage points to the Wilshire 5000 Index’s total return in 2020. That seems … optimistic.

So, too, does the authors’ claim that “Robinhood demand accounted for 20 per cent of the aggregate market capitalisation of the [smallest 20 per cent of stocks in the US market].” No doubt Robinhood’s customers punch above their weight, but given that they control only roughly 0.2 per cent of US equity assets, it’s hard to believe they exert that much influence over one fifth of the nation’s publicly listed stocks.

(Then again, Robintrack omitted Robinhood’s options transactions, which also affect stock prices. In that respect, the authors’ estimates are conservative.)

Trading etfs

But such quibbles belong elsewhere. The point is that, however cautiously one treats the authors’ estimates, something remains. Both their research and the anecdotal evidence, such as the surprising performances of Robinhood favorites GameStop (GME), Hertz Global Holdings, Eastman Kodak (KODK), and AMC Entertainment (AMC), indicate that, at least with smaller companies, there’s a new game afoot.

Looking ahead

This trend figures to extend. Small-company index funds continue to gain market share from their actively run rivals, meaning that fewer small-company shares are held by active investment professionals. It therefore seems that individual buyers and not portfolio managers will increasingly be tasked with pricing small-company stocks. The “Robinhoodisation” of secondary stocks looks to be in its early stage.

One should not exaggerate the current effect, but the phenomenon must be taken into consideration. The expanding influence of retail stock investors induces behavior that confounds traditional expectations, and it doesn’t appear to be going away anytime soon.

Implications

  • Small-company stocks will act ever more erratically.

Perhaps "erratically" is pejorative, but the adverb strikes me as accurate. I don’t know how else to describe the performance of Robinhood favourites, which frequently experience dramatic price changes without corresponding corporate news. Small stocks will march ever more loudly to their own drummer.

  • Small-company stocks will be better portfolio diversifiers.

Different behavior means lower correlations. From 2015 through 2019, the performance of Vanguard Total Stock Market Index (VTSAX), which represents the overall US stock market, never diverged by as much as 5 percentage points in a calendar quarter from that of Vanguard Small Cap Index (VSMAX). Last year, the two funds deviated by 9 percentage points in the second quarter and 13 percentage points during the fourth.

  • Regulatory scrutiny will increase.

Over the past three decades, regulators have targeted institutions and not retail shareholders. For example, the SEC’s 2000 rule, Selective Disclosure and Insider Trading, sought to protect the interests of everyday investors by restricting the ability of companies to “whisper” advance news to their institutional followers. The Commission’s focus has long been on Wall Street, not Main Street.

But what if retail investors are colluding on message boards, pooling their resources with the express purpose of altering security prices? The SEC will not and should not ignore those activities. What is good for the goose will be good for the gander. Along with greater investor power will come the call for greater investor responsibility.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

is vice president of research for Morningstar.

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