Ahhh, retail investors. The “dumb” money.
Or I guess, the “smart” money depending on the extent to which they were cognizant of their own role in perpetuating what Howard Marks last summer dubbed “a perpetual motion machine”, characterized by a self-feeding loop that allowed a handful of high-flying names to rise inexorably higher, leading directly to their inclusion in a variety of “strategic” funds, flows into which only serve to perpetuate the situation in a never-ending, virtuous loop. Here’s Marks:
Importantly, organizers wanting their “smart” products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks. For example, having Apple in your ETF allows it to get really big. Thus Apple is included today in ETFs emphasizing tech, growth, value, momentum, large-caps, high quality, low volatility, dividends, and leverage.
And when I say “never-ending”, bear in mind that nothing lasts forever. Cue Mark again:
The large positions occupied by the top recent performers – with their swollen market caps – mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise. Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced.
Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever. If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold. It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch. In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual.
The note those excerpts are taken from elicited jeers and tomato throwing from the peanut gallery, despite the fact that he was stating incontrovertible facts. He would later attempt to pacify the irritated masses in a September note. A followup in January found him bemoaning what he clearly believed was a mischaracterization of his previous piece.
The seemingly unstoppable rise of benchmarks put active management in a real pinch considering it’s pretty damn hard to outperform when benchmarks only go up, especially when you’re starting from behind by virtue of charging comparatively enormous fees (anything looks “enormous” compared to 9bp or whatever the hell these passive ETFs are charging these days).
That, according to Wells Fargo, created a veritable “sellers’ strike” from active managers, a situation which prompted the bank to liken passive investing to a “black hole” or, “QE for U.S. stocks”.
Well since Marks’ January memo, flows into and out of some of the more popular retail equity ETFs (and there’s certainly a flows story in FI ETFs as well, but that’s more complicated, so we’ll leave it aside for our purposes here) have indeed begun to approximate “hot money“, suggesting these “passive” products are increasingly being used as liquidity conduits, hedging vehicles or otherwise employed for the purposes of day trading.
As I’ve been at pains to explain to those who would accuse me of being some kind of fearmonger or click-chaser, those observations need not be seen as an effort to cast aspersions. If popular ETFs are being used for the purposes mentioned above, that’s not necessarily a bad thing, but it does seem to fly in the face of what they are ostensibly designed to do. Indeed, there’s something a bit paradoxical about the notion that ETFs are helpful for “long-term investors” when one of the selling points for ETFs is “intraday liquidity.”
Why would Joe The Plumber, buy-and-hold investor interested in growing his wealth by participating in the presumed long-term prosperity of the U.S. corporate sector, need “intraday liquidity”? He wouldn’t. Sorry, but he just wouldn’t. That doesn’t make any sense and it never will. In fact, there’s a very solid argument to be made that allowing Joe The Plumber, buy-and-hold investor, to access intraday liquidity is a recipe for disaster because by virtue of being a plumber, Joe doesn’t have a goddamn clue about when he should be buying and selling.
Anyway, January was characterized by more than a few folks as the pinnacle of retail euphoria as an avalanche of inflows into U.S. equity funds stemming at least in part from optimism around the Trump tax cuts drove stocks to new all-time highs in one final glorious melt-up prior to the February meltdown.
We documented the signs of retail euphoria extensively in these not-so-hallowed pages in a series of posts including “It Is Great News That Millennials Are Opening ETrade Accounts To Trade Crypto And Weed Stocks” and “Lured By Yacht Promise, ETraders Opened 64,581 New Brokerage Accounts In January“.
In that latter post, we noted that in FYQ1, TD reported a near 50% YoY increase in client activity:
We also flagged what, at the time, was the latest monthly activity update from E*Trade, which showed everyone’s favorite discount brokerage added 64,581 gross new brokerage accounts in January, the most for a single month since September of 2016:
And then there was this amusing bit of anecdotal evidence:
You get the idea. Motherfuckers were excited about some stocks and that was at least partially attributable to Trump’s incessant Dow tweets.
The market’s recent stumbles (on fundamental concerns tied to trade jitters, tech regulatory woes and geopolitical issues), have raised intermittent questions about who is to “blame”. Is it retail investors whose status as the “marginal buyer” is in flux? Or is it the institutional crowd that stubbornly refuses to re-risk? After all, the February selloff was attributable to a combination of technical factors including the annihilation of the Seth Golden crowd and forced de-risking by systematic strats, so now that that’s out of the way and with earnings painting a positive picture, shouldn’t equities have the (figurative and literal) “green” light?
About the only bid that hasn’t been in question is the corporate bid, which showed up “bigly” in February (according to Goldman’s buyback desk) and is expected to provide real-life “plunge protection” in the amount of $800 billion in 2018 (if you buy JPMorgan’s estimate).
Ok, so that brings us to a new piece from Goldman which amounts to a kind of meandering trip through the evolution of the retail bid. “Retail investors appear to have driven much of the US equity market turbulence in late March and April,” the bank notes, before explaining as follows:
The performance of a group of stocks popular with retail investors showed little stress during the initial market correction in February, but underperformed sharply as the equity market dipped for the second time in late March. Retail investors apparently reduced positions in their favorite stocks as well as broad equity market exposure; the popular stocks underperformed at the same time as US equity mutual funds and ETFs experienced large-scale outflows. During the last two weeks, retail favorites have partially recovered alongside a rebound in retail investor sentiment and equity fund inflows.
Next, Goldman reminds you that while retail has always been a bulwark of stock ownership, their trading activity has picked materially of late.
[Aside: Hilariously, FinTwit has decided that out of this entire Goldman piece, the most important chart is the one below in the left pane, despite that fact that it’s a standard chart that everyone has seen a thousand times].
Retail trading, as measured by daily customer activity data from Ameritrade, Schwab, and E*TRADE, rose steadily through 2016 and 2017. In early 2018 it leapt to the highest levels in at least a decade, both in absolute terms and scaled relative to total NYSE trading activity.
The bank goes on to observe that households’ allocation to stocks came into the new year at its highest since the tech bubble (the old tech bubble, not the “just buy the damn robots” bubble, which is the current incarnation), before reminding you that “US margin debt has risen to the highest levels on record”:
Goldman attempts to build on previous research in which the bank attempted to divine something about who was HODL-ing (to borrow a crypto meme) and who was selling (i.e., retail versus hedge funds) during the February plunge. The gist of the new piece is this:
Ahead of the 1Q earnings season, plunging retail sentiment weighed on the broad market and the favorite stocks of retail traders. At the same time, hedge fund and mutual fund managers reduced “beta” equity exposure but kept “alpha” positions relatively stable. Most of the way through the earnings season, retail investor sentiment has rebounded alongside strong earnings results. However, hedge fund favorite stocks have underperformed sharply.
But from where I’m sitting, the takeaway seems to be that January might have marked something akin to “peak retail.”
Recall that just before things fell apart, a record percentage of Americans expected stocks to rise in the coming year, according to the Conference Board survey which goes back more than three decades:
Here’s what that chart looks like now:
Goldman uses the AAII spread, noting that “the difference between shares of bullish and bearish respondents to the American Association of Individual Investors survey reached 44 pp on January 3, the largest spread since December 2010 [before] turning net bearish in late March” and then partially bouncing back. Currently, the spread between bullish and bearish respondents sits at -2, just below the 10-year average.
When I think about all of the above in conjunction with the dramatic plunge in Bitcoin that likely wiped out a sizable number of newly-minted “investors” and the fact that we are unlikely to see a return to the low vol. regime (which was both a cause and an effect of the ebullient sentiment that prevailed last year during the reign of “Goldilocks), I can’t help but wonder whether JPMorgan was right a couple of months ago to suggest that we can no longer depend on retail as the “marginal equity buyer”.
For now, I’ll leave you with a quote from a recent BofAML note on the (possible) death of BTFD:
Importantly, even if US equities do end up recovering to set new highs in 2018, perhaps on the back of a strong earnings season, simply breaking the trend of rapid recoveries (and the Pavlov BTD mentality), should prevent a return to the 2017 bubble lows in volatility.