Market regimes change and so do underlying market structure dynamics. Many in the news and media are quick to speculate that the recent run-up of stocks like Gamestop, AMC, and Blackberry imply market mechanics are broken. However, a deeper look at current market fundamentals suggests to us that market structure has changed Post-COVID, driven by (what appears to be) a sustainable surge in retail trading activity.
In the late-90s the introduction of E*TRADE and electronic trading changed the way retail investors could invest, and lead to structural market changes that have persisted. Today the combination of trading apps like Robinhood, universal $0 commission trading, and the ability to transact in fractional shares is once again changing the structure of markets and how investors can invest. The ability for individuals to transact into capital markets is easier than ever, including the ability to purchase equities, options, and futures contracts.
The result of all of this has been a dramatic increase in notional trading volume, much of which can be attributed to “retail” investors participating in markets to a greater extent. In fact, since the “Post-COVID” period began in late-February 2020 daily equity market volumes have increased 78% from their post-2008 average.
In no other crisis has trading activity spiked to this extent or magnitude. And from this surge in trading activity comes changing market dynamics, including the ability for retail investors to pile into thinly traded stocks and move markets. And furthermore, the spike in volume has been sustained, even as the (hopefully) worst of the crisis is behind us.
If trading volume continues to hold at such elevated levels it suggests to us that we are entering a new market regime, and one in which market ripples can come from more places, and portfolio risk management (and risk understanding) will be increasingly important.
Searching for new places to diversify
The increased trading activity may be equity driven, but it’s impact is spreading to other asset classes, and impacting investor portfolio diversification.
Rolling correlations between stocks and bonds (S&P 500 vs. Barclays Agg) have soared post-COVID, but more importantly than the initial spike (which we see in most periods of crisis), the correlation spike remains elevated.
And even other domestic equity risk diversifiers, such as Emerging Markets, have experienced sustained correlation spikes.
Investors must understand underlying drivers of portfolio risk
All of this leads us to our idea that portfolio risk analysis and construction needs to adapt with markets. Long-term investors must adapt to these market structure changes, and among those changes is re-thinking risk models. As cross asset correlations become more positive, and market spikes more common, passive portfolio risk management is becoming less efficient.
Investors need to understand the true underlying drivers of risk in their investments, especially as structured investment products across equities and fixed income become more common. And furthermore, sources of liquidity remain essential. As we experienced in March of 2020 when most fixed income ETFs and mutual funds declined with the broad market, any type of market illiquidity is quickly discounted.
Achieving long-term investing goals is still possible, but will require more patience
We don’t believe the changing market structure will impact the achievability of long-term investment goals. But what it will do is create a bumpier ride getting there. This means investors will need the constitution to sit back and withstand the volatility, or look for ways to more actively control portfolio risk.
This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors.
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A word on risk
All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.