Retail investors rush to find the next stock market unicorn

The writer is president of Bianco Research

For a sign of the current mood of stock markets and retail investors, one index put together by Goldman Sachs provides a telling insight.

The investment bank has compiled an index of technology sector shares that do not produce profits, traditionally a main driver of stock market valuations. Since mid-March, the index is up nearly 400 per cent.

Why have such stocks gone up in value so quickly? One argument is many of these companies are high margin, high-growth businesses that reinvest profits back into the business to achieve scale. They are less concerned with earnings and more concerned with growing at a rapid pace.

This could very well be valid. But this was not this the case from September 2014, when the Goldman Sachs Non-Profitable Tech Stock Index was launched, until March 2020. The companies in the index in essence traded sideways during these years, even as the broader market advanced. If the markets viewed them as having high growth potential, should not they have been outperforming the same way even a year or two ago? What changed?

We would argue this index’s unusual pattern is the result of an important shift in investor preferences that took hold last spring. Many individual investors long ago abandoned actively managed vehicles such as open-ended mutual funds. Some are also beginning to sour on passively managed vehicles including exchange traded funds tied to indices. Instead, retail investors are chasing individual names.

There is no one definitive measure to show this shift, but the signs are unmistakable. Trading in individual stock options has been booming to new records, according to data from the Options Clearing Corporation. This has been led by purchases of options to buy stocks in lots of 10 contracts or fewer. Nearly 15 per cent of all trades are for one contract.

Penny stocks have recently caught the fancy of investors. In December 2020, they traded 1tn shares, according to data firm SentimenTrader. That easily exceeded the previous monthly record.

Such trading does not happen if the public’s money is caught in a battle between a professional money manager in Boston or a passively managed ETF. Neither of these two groups traffic in these areas.

Instead, three things have dramatically changed the public’s investor preferences. First was the cutting of brokerage commissions to zero in 2019. Then, widespread adoption of fractional purchases added further fuel to the fire. Finally, the massive increase in savings from government assistance payments led to increased trading. This started with the Cares Act last March and continued through the $900bn stimulus package passed last month. The Biden administration is promising more of the same.