How are retail investor dynamics shaping equity markets?

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Eloise Goulder: Hi, and welcome to J.P. Morgan's Making Sense. I'm Eloise Goulder, and today I'm delighted to be joined by Edwina Lowe and Luca Rainero in our wider Data Assets and Alpha group to talk about the retail investor. And it's been another rollercoaster ride in equity markets this year, with the index now hitting fresh all-time highs. But of course, through March, we saw a significant drawdown, nearly 10% drawdown in the MSCI world as the conflict in the Middle East and the implications for the Strait of Hormuz and the oil prices unfolded. But of course, equity markets have been rallying in recent weeks. But one constant throughout this year, and in fact, throughout the last five or six years, has been the presence of the retail investor still making up around 20% of volumes in U.S. markets and even greater shares of volumes in much of Asia. So Edwina, what have we observed from the retail investor this year?

Edwina Lowe: So contrary to what some might expect, we've actually seen the retail investor to be particularly nimble this year. And particularly active in some of the key themes that we've seen play out in markets year to date. So to highlight a few examples late last year, we saw a sharp pickup in interest in silver. The SLV ETF more than doubled from early Q4 to its peaks in January. And this really played out in our social media dataset in which we saw a 20 fold increase in number of mentions versus historical averages. So to pick up on the software versus semi trade in fact, our social media data again, showed that in fact, it was the retail investor providing strong support for that trade over the last four months or so, so I think what these two examples highlight is that the legacy perception that some may have of the retail investor not being particularly nimble is quite clearly out of date.

Eloise Goulder: And when it comes to the market drawdown throughout March, as the Middle East conflict unfolded, to what extent did the retail investor participate in that equity market drawdown?

Edwina Lowe: It's a great question. So actually, retail sentiment held up for several weeks amid the geopolitical tensions, and only capitulated towards the end of March. And in fact, the retail sentiment capitulation coincided with market bottoming and signaled a rebound, and is now at about 50th percentile versus the full history.

Eloise Goulder: Well, it certainly has been helpful tracking both the institutional and the retail investor activity at the market level. Because as you say, Edwina, the trough in the markets was really marked by a capitulation or a significant bearish skew from both the institutional and the retail investor, and that proved a very valuable signal. So Luca, over to you. What are your thoughts on the significance of the retail investor this year?

Luca Rainero: If we go back to the early days of the COVID pandemic, in reality, many were wondering whether the retail investor was going to be a cyclical force or a structural force. And in 2020, many thought that retail was going to be cyclical. And there were actually good reason to think so. For example, with the global pandemic that was forcing many to work from home, retail investors had plenty of time to look at markets. And with stimulus check, they had more liquidity than expected to play on the stock markets. And it's quite clear that those tailwinds were not going to last forever. And so many thought that through the cycle, retail investors were going to disappear as this tailwind started to fade away. But this was actually not the case. The retail investor did not step back. And now we have plenty of evidence at this stage that it is a structural force in equity markets. So to some extent, while in 2020, many thought that inflation was going to be transitory, and that retail was going to be cyclical, while in reality, neither proved to be the case.

Eloise Goulder: It's fascinating that the retail investor has proved such a dominant structural force in equity markets ever since that spike up in 2020. Edwina, what do you think the drivers of that have been?

Edwina Lowe: I think first and foremost, access to information has really been a game changer. And really the barrier to information is just significantly lower. And therefore, it's just that much easier for the retail investor to form an opinion and then to act on that opinion. And as an extension to that, access to trading systems — they can then execute on that opinion and trade very easily, probably just using their own phone, and at a significantly lower cost than they would have done previously. And it's also worth pointing out that we haven't seen a sustained dip in markets since the global financial crisis. And therefore, the younger generation, Millennials and Gen Z have really never experienced that. So the younger generation have learned to buy the dip because it's rewarded them.

Eloise Goulder: It's a great point that for the younger cohort, there's been this absolute incentive to buy the dip in recent years. And so that has become part of the psyche, part of the mindset and certainly something that's being discussed online. But Edwina, the retail investor isn't just made up of that younger Gen Z type cohort, is it? We actually think that the age distribution of the retail investor is somewhat bimodal. There's also an older generation with higher savings rates, that's particularly clear in Asia, actively engaged in stock markets, in many cases, also discussing those ideas on social media. So that's absolutely a force as well, isn't it?

Edwina Lowe: Yes. In fact, if we look at retail share of volumes in Korea, onshore China and Taiwan, it's even as high as 60 to 65%. And if we isolate SMID caps specifically, it's even higher still. It's fair to say that the retail investor participation has had an impact on market structure, hasn't it?

Eloise Goulder: Yes, absolutely. Well, as a starting point, equity market volumes and turnover ratios as a whole have increased, particularly in Asia, followed by the U.S. in recent years. And a large contributing factor of that is the rise in presence of the retail investor. And the retail investor helps explain why volumes and turnover ratios here in Europe have not increased to the extent that they have in Asia, followed by the U.S. Because of course, the retail investor share of volumes is so much lower here in Europe. But also the nature of trading activity is quite different to other market participants. For example, the retail investor tends to trade throughout the day, whereas other market participants have been increasingly moving to trade at the close. So for example, if you look at closed share of volumes, the participation from popular retail stocks is surprisingly low, because the retail investor is in fact trading those stocks through the day typically. And partly as a result of this, we're seeing the share of volumes at the close in Europe far higher than the share of volumes at the close in the U.S. and in Asia, where the retail investor is more present throughout the day. The other talking point that comes up a lot is predictive power and the extent to which we can capitalize on the trends we observe from the retail investor in equity markets. So Luca, what have you observed in this space?

Luca Rainero: I think there are two key areas we can look into to better understand what is happening in the retail investor space. First of all, we can look at what the retail investor has actually traded. And then we can look at what the retail investor is expected to trade next. On the first point there are several algorithms available, which screen the order book to look for elements like size of the order, or price improvement versus the best bid offer to proxy retail trades. While imperfect, these solutions provide an helpful estimate of where directionally the retail investor is heading. On the latter part, which is what is the retail investor going to do next, we think that social media is an amazing avenue to explore. Retail investor, is often very vocal about the trading activity. And social media can be leveraged as a source to gain insight on such trading intentions. As for every road that you want to pursue, sometimes you have roadblocks or dead ends. So we need to be very careful in selecting starting out from the millions of posts that come through every hour, how we can filter these road messy data and reduce the volume to what really matters. And after putting lots of work into that, what we found is that we can reduce the volume to about, let's say, 10,000 posts per hour, which really, really matter. And they are great in help us tracking what retail investor wants to do next. Just to pick up on a couple of recent examples we found that names like Avis, which increased fourfold, and Allbirds, which increased sevenfold, had actually received lots of attention on social media before the price action. So it was very helpful for us to look at this type of signal to understand what the retail investor was focusing on.

Eloise Goulder: Well, it's been really validating, hasn't it? To see these stocks and meme stocks in general being picked up and discussed on social media. And it really speaks to the incredibly rich source of information available on social media, if you can filter it correctly. And in the aggregate, Luca, do we find that the retail investor tends to talk about trades before or after they actually execute? i.e., to what extent is the aggregate signal predictive?

Luca Rainero: Yeah, and to be honest, it is a bit of both. What we tend to see is that retail investor is often been described as following as a herd behavior. They like to be led by online personalities, we can call them influencers. And so when we try to quantify this relationship, we observe that across the Russell 3000, and this is especially true when we look at the smaller cap stocks. Those stocks that are mentioned more frequently than their peers over social media on a daily basis tend to perform well over 20 days horizon. So what we tend to see is a little bit of herd behavior with the initial talks then leading to a sustained price action. However, when we look at more refined, advanced metrics like sentiment, we can paint a more nuanced picture. In this case, we can even just focus on larger cap stocks like the S&P 500. And we notice a mean reversion signal on a relative basis. Those stocks with sentiment has trended up over the last five days tend to underperform the stocks with sentiment has trended down over the last five days, and is usually plays over a one week horizon. Hence, we believe that sentiment can be a good tool to highlight market dislocations in areas where the retail investor maybe got a little bit overexposed, and can be open to a correction.

Eloise Goulder: So in reality, we find that when we look at the volume of social media posts around a given stock, there is this short term momentum or trending effect, which is a really powerful one and has been very helpful at picking up some of these meme type rallies that we've seen in recent months. On the other hand, over perhaps a slightly longer time horizon, if we look at the sentiment around those stocks, there is more of a mean reversion signal there. Because of course, when these meme stocks rally, they often revert. And there is also a signal to go and find that.

Luca Rainero: Yeah, and as you were saying, time is of the essence in terms of making sure you pick the relationship early enough, and you're able to understand the trend as it develops. But at the same time, we're not talking about millisecond trends. These are movements that play out over multiple days or weeks.

Eloise Goulder: So coming full circle back to the reasons why the retail investor has been this structurally growing force in markets over the last five or six years. Edwina mentioned the sharp increase in availability of information and toolkits for the retail investor as driving that. And one obvious toolkit to speak about here is LLMs. Luca, to what extent do you think LLMs feed into this whole phenomena?

Luca Rainero: There is no question that LLMs are changing the landscape as we speak, both on the retail investor, but not only on the retail investor. But let's start with this cohort. What we see is that LLMs are helping them to access information more quickly. That's certainly true. But they're also helping the retail investor to run a structured analysis on this information and converting this information and this analysis into a precise trading action. Let's just take the latest geopolitical events as an example. Retail investor can now use LLM to source information on the events. Then they can ask LLM which stocks are going to be positively or negatively impacted. And assuming they trust the answer, they can quickly execute on these trades. So the whole investment cycle has sped up quite significantly for the retail investor. And this is clearly a tailwind to their activity. However, LLMs are changing the landscape also for the institutional investors, because they allow a much easier analysis of textual and unstructured data. And this has been so powerful for us because it has allowed us to develop much more nuanced and advanced analytics on the social media feed we're talking about earlier on in this podcast.

Eloise Goulder: And going back full circle to the market drawdown in March, and what marked the bottom in markets, we'd absolutely seen a drop, first of all, in institutional sentiment and positioning, and then in retail sentiment and positioning. And it was really both dropping that marked that full capitulation. And Luca, we've developed a toolkit around this, haven't we? Our Tactical Sentiment Monitor, which very much sits alongside our Tactical Positioning Monitor on the positioning side.

Luca Rainero: Yes. So what's quite interesting for us is that so far, these two indicators of sentiments seem to be still quite independent one from the other. Although honestly, one might wonder whether with all these new tools coming up, the retail investor might start to converge toward the institution investor. And this differentiation that we see at the moment will actually start to fade away as informational barriers are being removed.

Eloise Goulder: Yeah. This idea that if LLMs and AI toolkits as a whole are democratizing the ability to access and process information, then isn't this risk that the retail investor starts to converge on the institutional space, that the institutional investor starts to converge on the retail space by analyzing social media as we're doing. And even within the institutional investor, we've had similar questions around whether the quant investor, for example, is now accessing a lot of textual and unstructured data that was previously the preserve of the discretionary investor. And the discretionary investor is accessing toolkits and back-testing frameworks that were previously the preserve of the quant investor. And isn’t all of this convergence potentially leading to greater crowding risks? That has absolutely been a question we've been getting. And it's an area where we've done a lot of analysis and perhaps a conversation for another time. But I would say there's two schools of thoughts here. There's the convergent school of thought, which is that everyone is looking at everything and therefore coming to the same conclusions and isn't that driving greater crowding risks? But there's also a divergent school of thought, which is that we've seen this enormous proliferation in datasets available over recent years. And we've seen an enormous proliferation in analytical toolkits available, whether they're very simplistic linear, let's say, toolkits or whether they're machine learning driven toolkits. And therefore the number of permutations and combinations of conclusions that one can derive from all of this data and all of these techniques is actually more widespread than ever. And therefore market participants might be landing on different conclusions. That's the divergent thesis. And in reality, if we look at the data, I would say it's not that conclusive. Obviously, there's a lot of nuance under the surface, but specifically when it comes to the retail versus the institutional investor, we still see, if anything, a negative correlation, don't we, between the positions, i.e. a lot of institutional underweights remain retail overweights.

Luca Rainero: Yeah, absolutely. And I think so far, we still see the retail investor being a differentiating factor or a factor that can help diversify the risk from the traditional position held by the institution investor. But the space is moving so fast. So we'll definitely want to keep an eye on these and see how this trend evolves over the next few months or years.

Eloise Goulder: Yes. Well, as always, so much to discuss. And as always, in recent years, the retail investor remains so dominant and so significant in markets. Thank you so much, Edwina and Luca for taking the time to discuss all of this today.

Edwina Lowe: Thank you, Eloise.

Luca Rainero: Thank you, Eloise.

Eloise Goulder: If you have any questions or would like to discuss this in more detail, please do go to our website at jpmorgan.com/market/data/intelligence. And with that, we'll close. Thank you.

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