Opening Note: This column from April 1 (no, really) seemed worth revisiting in light of the recent initial public offering from Robinhood, more formally known as Robinhood Markets HOOD.
Not Fully Convincing
Last summer, when I puzzled over the reasons behind the U.S. stock market's spectacular recovery--which 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:
- The U.S. government had flooded the system with cash.
- This cash had not only supported asset prices, but had also fueled investment speculation.
- 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 emphasizes rationality. It was not that investors had behaved rashly. Rather, I had failed by being too slow to recognize the impending economic recovery. Also, the rally was global, meaning that U.S.-centric explanations were not sufficient.
To that point: In the second quarter of 2020, U.S. stocks rebounded 45% from their lows, German stocks 57%, Japanese equities 46%, and U.K. stocks 32%. To be sure, when U.S. 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 found that Robinhood's clients contributed handsomely to the second-quarter 2020 U.S. 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 calculated that demand from Robinhood clients boosted the value of the overall U.S. stock market by 1.0% during the second quarter. This came after their actions had added 0.6% to U.S. stocks' first-quarter results. Those figures are high. If annualized, 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% of the aggregate market capitalization of the [smallest 20% of stocks in the U.S. market]." No doubt Robinhood's customers punch above their weight, but given that they control only roughly 0.2% of U.S. 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.)
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, Hertz Global Holdings HTZZ, Eastman Kodak KODK, and AMC Entertainment AMC, indicate that, at least with smaller companies, there's a new game afoot.
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 "Robinhoodization" 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.
- 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 favorites, 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 U.S. 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.
Closing Note: After initially stagnating, Robinhood's stock price doubled during this week's first three days, before retreating on Thursday. How much of that gain owes to individual investor enthusiasm, as opposed to to institutional activities, remains to be seen. However, if institutions have been the primary buyers, it surely is because they hope to make a quick buck by reselling the security. Appropriately, Robinhood's own stock is very much a Robinhood-era security.
Virtual investment communities are here to stay. Younger investors prefer technology to handshakes, and while many eventually will hire financial advisors, their preferences will not change. (Most of us still believe that popular music was never better than when we entered college.) And because wealth accumulates with age, their firepower will continue to grow. Consequently, social-media discussions will increasingly determine stock performances.
In other words, the SEC's task of maintaining "fair, orderly, and efficient markets" might require it to regulate Main Street's behavior, as well as that of Wall Street. To date, regulators have not shared that view, as they have expressed concerns about Robinhood's actions--in particularly, the company's payments for order flows and "gamification" of investment services--but not those of its customers. However, these are early days yet.
John Rekenthaler (firstname.lastname@example.org) 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.
The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.