Market Extra: Individual investors are back — here’s what it means for the stock market

Stocks saw the strongest bull market in history following the 2008 financial crisis “without any prominent retail interest in it,” said Chris Konstantinos, chief investment strategist at RiverFront Investment Group, in an interview.

He noted that total bond fund flows have outpaced stock flows by nearly $3 trillion since 2007. In fact, individual investors appeared interested in almost anything else, from real estate to cryptocurrencies, Konstantinos said.

A shift got under way last year as the coronavirus pandemic took hold. Sequential growth in accounts at brokers such as Charles Schwab Corp. SCHW, +0.98% that cater to individual investors “was remarkable” at the end of the second quarter of 2020 and was followed by a major surge in growth in the following quarter, said Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, in a Feb. 2 note.

At the same time Google searches for “day trading” were also on the rise, she noted (see charts below).

Calvasina and others acknowledged that a combination of lockdown-related boredom and stimulus checks from the U.S. government likely played a role in the uptick in individual investing interest.

The jury is out on whether the uptick in retail trading interest will endure, said Ed Clissold, chief U.S. strategist at Ned Davis Research Group, in an interview. It’s unclear how much of the pickup in retail trading merely reflects individuals throwing extra money via stimulus checks at the market, he said.

That sort of trading feels more like gambling than investing, he said, noting that “frothy” market action tends to fade quickly away.

But others argued that individual investors are likely to stick around.

‘Structural change’

Calvasina said RBC suspects a “structural change may be afoot and that retail investors are likely to remain bigger players in the U.S. equity market going forward.”

If so, that will require an attitude adjustment by Wall Street pros, who got used to paying little attention to individual investors.

After all, powerful waves of passive and systematic investment had rendered individual investors largely irrelevant to analysts cooking up market forecasts, wrote strategists at Société Générale, in a Thursday note.

But the market volatility created by the GameStop situation served as a wake-up call, the analysts said.

While GameStop and other heavily shorted names soared, hedge funds and other investors were seen liquidating long positions elsewhere, to take profits and cover losses, putting pressure on equities markets. Major benchmarks ended January on a sour note, with the Dow Jones Industrial Average DJIA, +0.30%, S&P 500 SPX, +0.39% and Nasdaq Composite COMP, +0.57% logging their largest weekly declines since October.

See: ‘My family won’t let me go hungry’: Two young traders reveal the perils of trying to surf GameStop’s epic wave

U.S. stocks roared back in the past week, however, with the S&P 500 and Nasdaq scoring all-time highs as GameStop tumbled more than 80%.

Need to Know: GameStop’s meteoric gains have almost entirely disappeared — here’s advice for those who didn’t get out in time

The SocGen analysts couched the phenomenon as part of a broader trend that has seen individual investors driving demand for investments that take environmental, social and corporate governance, or ESG, standards into account.

“Rather than criticizing retail investors and their behavioral pattens, it is better to slot them into the money equation,” they wrote. “After all, it is not only office workers who are locked down at home on snowy days but also very active day traders with access to inexpensive platforms.”

Cabin fever is hardly the only factor seen driving the renewed interest in the market by individual investors, whose ranks aren’t made up solely of rapid-fire day traders.

Leveling the field

Some individual investors who previously shunned equities might finally be succumbing to the notion that ultralow yields on bonds and elsewhere leave little alternative to the stock market. Equities still look attractive when it comes to dividend or earnings yields, Konstantinos said.

Moreover, there’s the leveling of the playing field between institutional and individual investors over the past few decades. Regulation FD (for “full disclosure’) and other regulatory changes as well as the rise of low-fee trading platforms have put individual investors “on a closer footing to institutional investors than at any other time in history,” he said.

Indeed, some market watchers have argued that the conventional branding of individual investors as the “dumb money” looks increasingly misguided, particularly after the GameStop episode showed supposedly “smart money” investors shorting more than 100% of the company’s stock, leaving them wide open to a painful short squeeze.

Calvasina noted that some of the more well-known trades pursued by individual investors over the past year — buying stocks in the middle of a recession, buying airlines and cruise lines last summer, and implementing short squeezes this winter — come from a playbook that’s been largely abandoned by institutional investors over the past decade in favor of growth-, momentum- and quality-investing strategies.

On that point, highly shorted names have outperformed the market since the March 23 lows when it comes to both small- and large-cap stocks, a development that typically occurs after the market has put in a mid-recession low, she noted.

Still, the frenzy in retail trading that surrounded the short squeeze on GameStop and a handful of other heavily shorted small-cap stocks raised a red flag to investors on the lookout for the sort of froth that signals a rally is entering the sort of euphoric phase typically followed by a pullback.

Next leg?

While that may prove to be the case in the near term, some investors contend a sustained pickup in active individual investing interest could help drive the next leg of a bull market.

Individual investors could continue to fuel interest in more value-oriented, smaller capitalization and higher volatility names, Konstantinos said.

And sustained interest in individual securities could mean more “dispersion,” or variation in returns between individual stocks and sectors, said Clissold — an element that was missing over the past decade to the pain of active fund managers.

Calvasina argued that retail interest in specific stocks is likely to ebb and flow, as it has done over the past year, but probably won’t fade away.

“Unless the door closes (i.e. through a major regulatory change), we fail to see why retail investor interest in trading specific names will completely go way given how elevated cash on the sidelines is among consumers,” she wrote.