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Wharton: How a New Wave of Retail Investors Is Redefining Stock Pricing

Small investors are reacting to both positive and negative earnings surprises by lifting stock prices, a Wharton study of Robinhood trades reveals.

Published with permission from Knowledge @ Wharton, Wharton's online business journal.

Traditionally, large institutional investors — not individual retail investors — have a profound impact on stock prices because they execute large trades. But recent Wharton research shows that a new wave of retail traders is making its presence known in the market.

Retail investors are buying stocks with earnings surprises that are positive or negative, thus pushing up their prices, according to a recent paper titled “Retail Investor Trade and the Pricing of Earnings” by Wharton accounting professor Jeremy Michels. (An “earnings surprise” is when reported earnings per share –EPS — are more or less the median analyst forecast.) Those prices continue to stay elevated even beyond the earnings announcement window, suggesting that retail investors can influence the speed with which stock prices reflect accounting performance.

Michels used aggregated trading data from fintech firm Robinhood as a proxy to conclude that retail investors react to the earnings announcement itself and not necessarily to the news contained in the announcement, such as a positive or negative financial performance. Activity by these traders alters the association between earnings and returns, especially in stocks of small companies or companies that are expensive to sell short. The study covered trades between May 2018 and August 2020.

Changes in the pricing of earnings associated with the increasing prevalence of retail traders has potentially far-reaching implications, the paper stated. For instance, “efficient prices protect otherwise uninformed investors from paying an unfair price for a given security,” it added. “Frictions that mitigate price discovery or introduce excessive volatility can limit this protection.”

The paper shows how changes in Robinhood users’ holdings are associated with the release of earnings news by firms, and how that earnings news is priced depending upon how active these Robinhood traders are. The research found that when those Robinhood traders are more active in buying a firm’s shares around earnings announcement events, they drive up returns.

“When Robinhood traders are more active in purchasing firms’ shares around the earnings announcement event, it tends to drive returns up, and it tends to result in more positive returns, even if the earnings news was relatively negative,” Michels said in an interview on the Wharton Business Daily show that airs on SiriusXM. The influence online platforms potentially have in such pricing of stocks is more pronounced among smaller firms, particularly where their shares are relatively costly to borrow or sell short, he added.

The study of the Robinhood sample defied conventional market wisdom on how stock prices adjust after an initial reaction to earnings announcements. “Typically, we might think that prices will immediately and completely reflect the earnings news that’s released on the earnings announcement date,” he said. “But sometimes this initial market response can be somewhat incomplete, and traditionally we might see returns continuing to drift upward for positive events and drifting downward for more negative events.”

In contrast to that, the study found that irrespective of whether a firm reports “a very positive surprise in earnings or a very negative surprise in earnings,” the momentum of the initial price increase persists beyond the earnings announcement window. “Overall, my results suggest greater retail trading activity can disrupt the price-earnings relation in the immediate earnings announcement window,” Michels wrote in his paper.

Changing Trading Environment

Several factors are at play in feeding the new wave of retail investors, notably commission-free trading apps and the recent economic stimulus payments, according to Michels. The paper noted that competition among retail-oriented brokerages has pushed trading commissions to zero, reducing frictions that might otherwise impede retail trade. Technology and mobile app-based trading platforms have further increased the ease and accessibility of trading, it added. “A corresponding surge in retail investor trade has the potential to upend existing relations between accounting earnings and market returns,” it stated.

Historically, large institutional investors with their sophisticated pricing models have dictated stock prices. Smaller and less sophisticated retail investors have had little or no influence on stock prices. “We’ve known for a while that retail investors perhaps disregard accounting information or at least fail to fully appreciate the valuation implications of it,” said Michels. “But what we’re seeing now more than ever is how this can move stock prices and move markets. You might think that in many cases the larger traders influence market prices. But the rise of the retail trader, and those trades coordinated through social media platforms, can really shift market prices.”

According to Michels, the paper could offer pointers to regulators on how they could better protect retail investors in a changing environment characterized by social media-driven herd instincts that drive prices of meme stocks such as AMC and GameStop, seemingly unmindful of their underlying fundamentals. “Understanding the extent to which retail investor trade alters the association between accounting earnings and price is a first step in understanding how the recent increase in retail investor trade may impact price efficiency and investor welfare,” the paper stated.

“In several well-publicized instances, surges in retail investor trade have corresponded to wild fluctuations in firms’ stock prices – fluctuations seemingly divorced from fundamental firm performance,” Michels wrote in his paper, citing the GameStop price rallies. “These anecdotes highlight the potential for more engaged retail investors to alter how markets price accounting information.”

Pointers for Regulators

The SEC has long restricted ostensibly less sophisticated investors (non-accredited investors) from participating in less transparent or less liquid markets, Michels noted in his paper. “Arguably, this is at the expense of fairness, as these investors are restricted from a set of investment opportunities,” he added. The SEC recently updated its definition of an accredited investor to allow individuals to qualify based on professional certifications and credentials, as opposed to only net worth or income.

Taking off from the study, Michels said he would track changes in retail investors’ sophistication in processing earnings announcements and how regulators weigh their options. “It will be interesting to see whether there will be a learning by retail traders or a change in their level of education or sophistication as we see more and more of them getting into the market,” he said. “Or whether there will be [new] regulation to adjust to how easily [retail investors] can move in and out of these positions, or maybe regulation that can help make prices more efficient, so that we don’t see these inflated prices associated with more coordinated retail purchasing.”

Michels said he would like to focus his future research in this space on finding how the trading patterns of retail investors evolve. “Is it the case that they get into the market, and they start learning and becoming more sophisticated consumers of accounting information, and ‘meme stocks’ are their gateway drug, in a sense, to a broader investing experience?” However, finding the right data for such work is a challenge, he added.