10 March 2021

Day traders: the Modern day Canary?

Since the Reddit/GameStop saga of January 2021, much has been written about those who make investment decisions for themselves with no advice, typically via an execution only stockbroking platform.

These investors are often referred to as private investors or day traders:

Editorial quote

…all of the above?

Much of the initial shock has dissipated now, but it did highlight a trend: there has been a large increase in private investors utilising day trading platforms, particularly the app Robinhood. Robinhood is an American app that not only allows you to buy and sell shares or fractions of a share but also offers zero commission charges and promotional discounts on share purchases. As is the claim of most disruptive technologies, the Robinhood app aims to “democratize” investing, an activity rife with social and financial barriers. This would be a laudable aim, had this not been done before. 

Day trading first surged in 1999 and again in 2007 through companies like E-trade that still operate today. Those years are significant; in both occasions, the increase in day traders coincided with the top of the market before the dot com bubble in 2000 and the global financial crisis in 2008. 

I do not wish to speculate on whether or not we are at the top of the market now, but there are some similarities. Between 1999-2000 and 2007-2008, US unemployment was low and wage growth was strong giving the public more cash to spend. Though 2020 has seen a spike in unemployment due to the COVID-19 pandemic, there is the similar situation of excess cash in people’s bank accounts thanks to government disbursement payments that pushed the US personal saving rate to a record high of 32% in April 2020.

But just because people have excess cash, does not mean they are willing to lose it. Typically, direct investments into one or a handful of equities are not attractive to the majority of people due to the high risk associated with their lack of diversification. Why put your savings towards a single investment that could theoretically wipe it out in a day? A small minority consider the risk of that happening to be low to non-existent and you see other people making easy money!

There are a number of reasons why this attitude pervades private investors currently: high levels of market optimism, the gamification of investing and social media.

In the last year, the global economy ground to a halt, the GDP of major economies contracted and most of us have not been able to leave our homes in months. Yet, the S&P 500 hit record highs. The momentum of the market seems unstoppable even by a global pandemic! It’s hard to shame anyone for wanting a piece of the pie. This market optimism or market exuberance is due to a disconnect between share prices and the company fundamentals that underpin it. So when it begins to seem like nothing could go wrong in the stock market, that prices will only go up, many people - typically averse to such investments due to the risk - pile in via day trading apps. 

And the day trading apps have made it especially easy to do so. Within minutes (i.e. the time to download the app, set up an account and transfer money) you are able to buy a share or a fraction of a share in some of the largest companies in the world and track their performance.

This market exuberance is also exacerbated by trading platforms like Robinhood and E-trade gamifying the process with bright colours and confetti, creating an atmosphere so similar to a casino that regular gamblers and sports betters reportedly found refuge on Robinhood when sports matches were cancelled in 2020.

Day traders of today also have social media, which further amplifies the ‘fear of missing out’ on easy money. Forget market makers…meet the market “influencers”, a small number of users around whom the new legions of day traders congregate for advice, investment ideas and memes. Many of these “influencers” gathered large followings through the simple message of “Stocks Only Go Up” and displaying their personal large portfolio gains as evidence. 

Day traders are not the originators of this larger-than-is-warranted market optimism but are rather a late stage symptom.

Due to this concentration of thought leaders and discussion boards, it is not surprising then that there is such a high level of crowding and momentum trading involved in day trading, which because many of the stocks that attract their interest are smaller and therefore more volatile, helps underline the inherent risks in this kind of investing. Prior to the active collaboration that fuelled GameStop’s rally, most of the users were trading the same stocks anyway, continually building on the momentum generated from these crowded trades. 

GamestopJeremy C. Stein, a macroeconomist, said this of the “crowded-trade” effect in 2009: “[crowded-trade] can result in prices being pushed further away from fundamentals”.

This disconnect between prices and fundamentals predates this new wave of day traders, but their presence compounds the effects.

So should we be fearful of the private investor phenomena and what are the consequences for the wider market?

Price Earnings Ratio (P/E) for the S&P 500 Index

Whilst empirical evidence supports the view that stocks tend to move up over the long term, day traders have applied this logic to weeks rather than years, to their detriment. As such, the volatility produced from their stampede of trading should largely be ignored by long term investors. However, the underlying cause of their presence, that is the disconnect between valuations and earnings should be cause for concern.

The presence of day traders then should re-focus our minds on the fundamental analysis used to identify high quality companies worth owning. They may also prove a useful ‘canary in the coal mine’ of stocks we should perhaps stay away from.

Illustration by Elliot Elam

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