Why long-term investors need to think twice before going headfirst into the momentum rally

There are both structural and cyclical elements at play here. On the structural side, this isn’t new; trading commissions have been coming down over many decades, and as a general rule that’s a good thing. In recent months of course, some of the most popular online retail brokerage platforms have moved to a 0% commission model, and we have seen a pick up in the number of accounts and the volume of trade. While this leads to a greater volume overall, and we continuously see retail flows taking up headlines, they are still a small percentage of the overall amount of trading activity. However, as we have seen recently, they can be important when it comes to individual stocks. We’ve seen retail investors bid up a company that’s in chapter 11 bankruptcy, to five times its value. That is extraordinary, and it is a strange symptom of the times that we are in.

Although the overall impact on markets from retail activity is minor, there are second order effects. Take Robin Hood as an example, it’s a 0% commission platform but it’s not run that way out of charity, instead of making money on trades they make it by selling on the order flow to third parties, most notably high frequency traders. This amplifies the impact of a small number of traders, adding fuel to the fire of general euphoria. There’s a good George Soros quote on this that goes “When I see a bubble forming I rush in to buy, adding fuel to the fire”, and indeed that’s what a lot of institutional investors are doing, some through speculation and others through the guise of investing.

Clearly, retail activity is not the overall story here, nor is this a structural shift. But it is a cyclical change, and you could draw comparisons to the late 90s. There are parallels between this rapid drop in prices followed by a rapid recovery, which wasn’t really a bear market but more of a late cycle correction, as we saw in 1998. There, you had the S&P drop around 20% and the Nasdaq around 30% as the Russian Crisis and the Asian Debt Crisis unfolded. And similarly, there was general panic followed by a liquidity injection from the Fed that fuelled a late cycle rally. Retail investors piled in and options went up as people used them to speculate, and that’s something we’ve been seeing recently. There are definite parallels, and this kind of activity should serve as a warning sign to long term investors to be careful and look at valuations, but also to manage your fear of missing out. You don’t want to be drawn back into the marketplace by momentum. This happened to a lot of investors between 1998 and 2000, before the dotcom bubble burst. That’s one of the reasons that we balance our portfolios, not to be 100% risk on or 100% risk off, but a balanced portfolio against those two types of risk; both the downside risks but also the risk of a momentum-fuelled rally driven by liquidity in the marketplace.

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