Day trading distorts valuations

There has been an odd shift in retail investor attitude in the past month or two. Retail investors are buying shares but they’re doing it directly. Investment through mutual funds has slowed.

Systematic investment plan (SIP) volumes eased off in Q1, 2020-21 and so have other equity mutual fund inflows. At the same time, daily trade volumes are up considerably. Small-caps have led and outperformed other segments during the market recovery of the past four weeks. This is always a sign of retail interest. Delivery ratios have also fallen, which means day-trading is up with traders settling positions.

There are several possible reasons but there is also lack of data, or surveys, to confirm what’s actually happening. So the following thoughts are based on incomplete information and guesswork. Behaviourally, it may sound contradictory that somebody who invests via SIPs (a conservative style of passive investment) would also trade on margins. But there are individuals who do both.

We know that the number of retail investors has shot up because a lot of new accounts have been opened in retail brokerages. This mirrors similar behaviour in the USA where discount brokerages have seen many retail accounts opened during the pandemic. This could be at least partly driven by young individuals sitting at home with not much else to do.

One factor inhibiting SIPs may be that a lot of investors have seen, or anticipate, a loss of income. So they cannot make structured commitments. However, they have current cash in hand. This is possible. A trader could be using some funds, which he will soon need for household expenses. These funds cannot be committed to a SIP.  But there is a short window to use this as margin in the hopes of making a quick buck with high leverage.

Day trading is a high risk, high leverage mode. It can lead to vertical crashes or climbs. Day traders are typically under-capitalised and have to unwind in a hurry if there’s an adverse move. This creates feedback loops. Adverse moves get reinforced by more volume that push prices further into the adverse trend.

Small-caps do traditionally outperform during bull runs and underperform during bear markets but a high prevalence of day traders makes this behaviour more extreme. Most day traders are optimists favouring long positions. This trait is encouraged by authorities the world over, since there are usually curbs on short selling. This means that crashes are more likely to be reinforced as stop losses are hit and traders are forced out.

Very few day-traders make money but since trading is a zero-sum game, the winners make a lot of money.  It’s a “hyper-pareto” situation – say, 5 per cent of traders make 90 per cent of the money, while 95 per cent of traders lose.  Apart from the adrenaline, this is the bait for to attract traders.

A prevalence of day-trading changes the market environment. While programmed algo trading also leads to sudden leaps and crashes, algo traders are well-capitalised and focus on high-volume counter. There is a base volume level and float in such counters, and there is institutional support, which means that there is a floor on stock prices.

Retail day traders often focus on small-caps. This leads to circuit moves since it causes abnormally high volumes and low delivery ratios in counters without much float. That volume can suddenly dry up, leading to squeezes when counterparties disappear, and delivery becomes impossible. The lack of institutional positions also means that there is no floor on prices. Stocks can hit the circuit instantly and freeze as every trading session opens. Quite a few stocks in the small-caps segment seems to be heading in this direction. While the trend is up, this means soaring prices. If the trend changes, it can lead to deep crashes.

This sort of market behaviour leads to several types of incoherence. One disconnect is between the institutional attitude and the retail attitude. Retail traders are bullish and pouring money into the market but institutions are cautious at the moment. Their focus is on different segments.

Fundamentals in small-caps are often hard to judge. The lack of institutional coverage also means lack of due diligence. Day trading preponderance distorts valuations as well.  Investors should be very careful under the circumstances when entering small-caps in particular.