About 10% of trading in the stock market today is driven by investors discriminately picking stocks as they search for fundamental value. This is according to recent research from JP Morgan.
In theory, investors should buy shares in a company because of its intrinsic value.
Through fundamental analysis, these investors estimate the future cash flows the company can generate and then discount all of it to the present to determine the value of the company. This analysis captures whether the company is being mispriced in the market. It also captures the companies’ potential to return wealth to shareholders like through a cash dividend.
But in today’s market, investors and traders are going in and out of stocks for all sorts of other reasons. They may abandon the idea of value altogether and trade based on patterns they see in stock price charts. They may indiscriminately buy massive baskets of stocks through a plethora of exchange-traded funds offering low-cost access to broad market indexes, so-called “smart beta” strategies, growth stocks, value stocks, or dividend-paying stocks among thousands of other options.
Whatever the case, the focus on single-stock valuation has become significantly less important.
“Stocks are increasingly caught in powerful cross-currents of passive and quantitative investors,” writes JP Morgan analyst Marko Kolanovic in a note to clients this week.
“To understand this market transformation, note that Passive and Quantitative investors now account for ~60% of equity assets (vs. less than 30% a decade ago). We estimate that only ~10% of trading volumes originates from fundamental discretionary traders. While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals.”
Stocks are not, then, trading based on whether the businesses’ prospects look favorable but are more likely traded based on whether they are included in an index that mimics a strategy which happens to include that stock.
Take the FAAMG stocks — or the FANG stocks, or the FAANNG stocks, and so on — for example.
Facebook (FB), Apple (AAPL), Amazon (AMZN), Microsoft (MSFT), and Google parent-company Alphabet (GOOGL) have been powering the market higher, responsible for about a third of the S&P 500’s gains this year. On the one hand, these companies are quite clearly dominating our modern economy and it seems reasonable that investors are, in this light, betting on continued profitability.
But as Kolanovic notes, these stocks are also large growth stocks, and, because they’ve been going up they are momentum stocks. That is, they’re stocks that are expected to see future price moves driven by recent price moves.
And as the market gets increasingly chopped up into indexes that invest in stocks exhibiting certain characteristics, the FAAMG stocks become more than just “the economic engines of today and tomorrow” but parts of an index catered to investors that just want growth, and so on.
In addition to big-cap tech companies outperforming, another theme that has dominated markets this year is low volatility. This, ostensibly, represents a lack of fear among investors that stocks will fall. (Though as Bloomberg View columnist Matt Levine has outlined, a lack of fear is something for investors to in fact be fearful of. And on it goes.)
Last month, The Financial Times reported that one trader had been dubbed “50 Cent” by markets after buying millions of dollars of options linked to an increase in the VIX index. And on Tuesday, The Wall Street Journal chronicled how the VIX — known as the “fear index” on Wall Street and an index which represents the market’s expected future volatility — and volatility-related trades have become an ever-bigger part of trading strategies across the industry.
Kolanovic, however, sees no real reason for volatility to be so low. It is, like the elevated valuations of major tech companies, a function of the products that offer investors ways to play specific strategies.
“Low Volatility is not a new normal or fundamentally justified,” Kolanovic writes, “It is result of macro de-correlation and massive supply of volatility through yield generation products and strategies.”
In other words, there’s a lot going on in the markets, and little of it has to do with investors making stock-specific decisions based on company value.
“Finally, Big Data strategies are increasingly challenging traditional fundamental investing and will be a catalyst for changes in the years to come.”
Myles Udland is a writer at Yahoo Finance. Follow him on Twitter @MylesUdland
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