Yesterday we reported that according to Goldman Sachs, creator of the Hedge Fund VIP Basket of 50 most popular stocks among the hedge fund community, the recent underperformance of this basket…
… coupled with the disappointing response to stocks beating in Q1 earnings season, was a growing threat to market stability as it portended that a liquidation “cliff” event could be just one sharp drop in the S&P away.
This is how Goldman phrased it:
Investors should be attentive to the positioning dynamics currently driving stock performance. If the S&P 500 takes another turn lower, popular positions will likely underperform, with mutual fund and retail favorites particularly vulnerable, while hedge fund favorites look poised to outperform if the market continues to rally.
This growing concern about hedge fund skittishness emerged as, somewhat paradoxically, retail investors turned increasingly more bullish after a period of broader liquidation at the start of earnings season; in other words as hedge funds turned more bearish, retail investors become increasingly bullish. Said otherwise: the smart money has been increasingly selling to the dumb money.
Needless to say, this is a very precarious disequilibrium, as the subtlest hint of a trend reversal within the retail community – ostensibly a confirmation that the smart money has been dumping – could unleash a retail liquidation wave. Which is a problem because as the next chart from Goldman shows, retail investors have been a growing influence on markets, with retail trading soaring to record levels at the start of 2018, and prompting the market “blow off top” that prompted many concerns among the institutional community.
Indeed, as Goldman adds, household equity allocations entering 2018 were at the highest levels since 2001:
Equities in total accounted for 42% of household financial assets at the start of 2018. However, increased allocations to global equities have kept domestic equity allocations from exceeding the 2007 level of 32%.
At the same time, US margin debt has risen to the highest levels on record as retail investors have never been more levered to further market upside (putting them at great risk of margin calls).
In other words, while the HF VIP basket has been getting hit recently, making hedge funds increasingly cautious, retail exuberance soared, however that too appears to be ending.
As Goldman further notes, whereas retail sentiment rose sharply with equity prices after the passage of tax reform in late 2017, declined as the equity market corrected in early 2018; furthermore “the difference between shares of bullish and bearish respondents to the American Association of Individual Investors (“AAII”) survey reached 44 pp on January 3, the largest spread since December 2010. In January and February sentiment began to weaken, and turned net bearish in late March.”
As sentiment fell, retail investors reduced broad market exposure through mutual funds and ETFs at the same time as they trimmed their individual equity positions. US equity mutual funds and ETFs experienced nearly $30 billion of inflows in late January, shortly after AAII readings peaked. From February through early April, $63 billion flowed out of US equity funds alongside falling sentiment. In late April, however, AAII sentiment and flows both recovered; equity funds have received $14 billion of inflows during the last three weeks.
So what happens if this bearish sentiment persists? Goldman could not be any clearer, warning that “if the S&P 500 takes another turn lower, popular [hedge fund] positions will likely underperform, with mutual fund and retail favorites particularly vulnerable.”
And while we already know the Top 50 most popular hedge fund positions (shown here), what about the “retail favorites” that Goldman believes would be crushed in the next downturn? Courtesy of Goldman, here is the bank’s estimation of the names that make up the retail trading favorites. This is how Goldman screens:
Our screen of “retail trading favorites” is constructed using fund position filings and Google Trends search data. The list consists of Russell 1000 stocks that outperformed the S&P 500 in 2017 while experiencing little to no increase in hedge fund and mutual fund ownership, as disclosed in positioning filings at the start and end of the calendar year. Stocks in the list also evidenced high average Google search volume during the year. The list attempts to capture stocks for which retail investor trading is an important driver of share price movement, in contrast with stocks where retail investors make up a large share of ownership but may be less active traders
If Goldman is right that a market correction would lead to a liquidation of the most widely held names, shorting this basket, while going long the most shorted hedge fund names (detailed previously) could be one of the more profitable pair trades heading into a volatile summer season.
Here is the list of top retail favorite stocks:
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