US stock market - Main Street, Its Merry Men – On The Edge

Fri 21 Aug 2020

By Brian Dennehy

Access Level | public

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If a stock market bubble can be defined purely by a notable historical overvaluation, the next stage, an out-and-out mania, needs the additional evidence of behavioural excess by investors e.g. buying products they don’t understand, whether stocks or funds or derivatives, borrowing to invest despite limited prior experience, or buying into a new “get rich quick” fad.

I originally explored the issue of a bubble in the United States in this blog back in July 2017.  There were signs of extreme behaviour by investors then in their large scale buying of ETFs and index trackers, with no regard for the bubble valuations.

Now we have entered a phase of a completely different level of insanity, the mania phase. I looked at this in more detail in the recent blog “Anatomy of a Mania”.

“Rip-roaring investment manias are quite rare, and the last one was the tech bubble from 1998-2000. They never end well and are very dangerous for investors who are overcommitted to markets.”

The average age of someone with a Robinhood account is 31, and in more than 50% of cases this is the first investment account which they have opened. Although this app is dominated by younger people, particularly those who have become thoroughly bored during the lockdown, they are not alone.

For example, the Wall Street Journal recently told the story of William, a 67-year-old who was trying to make up the lost ground from the falls of 2008 and 2009. He was doing quite well for a while, then became over-confident.  He started investing into vastly riskier ETF/ETNs with leverage or gearing. This meant that if the stock market went up by £1, he might gain £5 or £10, depending on the contract. However, the reverse was also the case – but when you are a novice, even at age 67, and are feeling overconfident, figuring the risks is just not on your agenda.

Within two weeks of deciding to become more adventurous, William lost all his money, $800,000. He had worked all his life to have an enjoyable retirement date, and now it was all gone because of that most damaging of investment biases – over-confidence. But not just any over-confidence, overconfidence based on financial literacy. A horribly dangerous combination.

What are the implications of this for the wider market and the outlook?  Is Robinhood and similar easily available apps the reason for the mammoth jump in the US stock market since the middle of March?  And, it is worth adding, a jump in a scale not matched by any other Western stock markets, and despite the fact that the US has ongoing and serious issues with the coronavirus in a large number of states, as well as the considerable political risks either side of the Presidential election on November 3rd.

This was explored in a recent paper from Allianz, entitled “When Main Street makes it to Wall Street”.

Allianz believe there were two main factors driving the market upwards, the first being a Pavlovian response to the central bank saying it would intervene to support markets, and the second being what I call the Robinhoodies, the new retail investors.

The expectations of the new retail investors are formed in a completely different place to those of more traditional retail investors or professional investors. They do not get their insights or education from mainstream, and fairly conservative, financial media but rather from social media, lifestyle networks, which are fed by alarm and drama, and haunted by snake oil salesmen.  As a result, novice investors have developed a worrying preparedness to take risks, not least by the extensive use of derivatives or geared funds.

The other factor driving the US market is the persistent support of markets by the Federal Reserve at the first sign of a lurch downwards.  The result is that the response time between the Fed announcement and the stock market rally has become shorter and shorter. This trend has been going on for a very very long time, where some believe it started in 2008, but the foundation was in 1987, as I explored in this previous blog.

Investors no longer need evidence that the profits of companies may improve for one reason or another - they just act in a Pavlovian manner, because they believe that the Fed has their back.

Paradoxically, the longer this persists the greater is the vulnerability of increasingly disconnected and over-valued markets.  But markets cannot grow to the sky without regard to the underlying valuations and profitability of the stock market and health of the wider economy. One day this will come to an ugly end.

A similar observation was made by Allianz in respect of corporate bonds, as well as the stock market, when the Fed announced it was prepared to buy corporate bonds – again a Pavlovian and instantaneous buying of such bonds, irrespective of the impact of the virus and the mountains of very poor quality debt. 

While institutional investors bought corporate bonds, in tandem they have strongly increased their money market funds, effectively cash, since the beginning of the year, cash that would otherwise have been committed to the stock market.  This again highlights that the stock market has not been driven by these institutional investors with the big chequebooks.

Of the domestic holders of the US stock market, US households have 34%, and that is certainly enough critical mass to move the markets.

In the past those US households tended to be buy-and-hold investors, in other words they were quite conservative, and perhaps accepted their limitations. In addition, when they did get notably more involved in the market, such as in the late 1990s as the technology bubble was just about to burst, it was more often than not a sign that the rally was about to end.

What has changed such that those US households are not just Johnny-come-latelys, but are also dominant in driving the market? What is key is that brokers like Robinhood have lowered the entry barrier, and they have also expanded the range of products, making high risk products available to retail investors for the first time and making them sexy.

As Allianz put it, these new brokers have brought the toolbox of Wall Street to Main Street.

Almost overnight these novice investors have become significant players in very complex derivatives markets. For example, there are days when the mini-options contracts available on Robinhood account for 20 to 30% of the total options market activity, for example, in Alphabet or Amazon or Tesla. In quarter one of 2020, 66% of Robinhood payments were from options trading.

If you look into chat rooms you not only observe the widespread ignorance of the RobinHoodies but also the hysteria, driven by FOMO, Fear Of Missing Out.

Allianz believe these obvious problems will eventually result in the regulators taking action to limit the sale of these new high-risk products, although probably not until after a few more get cleaned out.  (How many suicides do they need to get that they need to do something?).  When this does occur, it will trigger a wave of selling by the new retail investors, and the momentum since March will be reversed sharply. 

In conclusion, the fragile condition of the US stock market is now even more so as a key driver in recent months has been novice investors with scant understanding of risk or the complexity of the products in which they are trading. 





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