Originally Published by Prudential.
Anyone paying attention to recent news about the markets has heard this warning: Beware the crowded trade.
Market watchers inevitably blamed October’s technology-led sell-off on a “crowded trade” as prices dropped on the so-called FAANG stocks, comprised of Facebook, Apple, Amazon, Netflix and Alphabet’s Google.
The problem is that when most people refer to a crowded trade, they have no idea what they’re talking about, according to QMA, PGIM’s quantitative equity and global multi-asset solutions manager.
In “What ‘Hamilton’ Has to Teach Us About Today’s Markets,” QMA uses “Hamilton” tickets to tease apart exactly what isand is nota crowded trade, and why it matters for investors hoping to insulate portfolios from disruptions that could come in the months and years ahead.
If you are (or were) fortunate enough to score one of the 1,319 seats for a showing of the hip-hop Broadway smash about America’s Founding Fathers, you may pay face value for a ticket at the box officebetween $179 and $199 for most seats. If not, you might turn to secondary markets and pay a lot more (prices peaked at more than $1,900 per ticket in 2016). Either way, on the day of the performance, the theater may be sold out, but never “crowded.”
Just like seats for “Hamilton,” there are a fixed number of common shares for each public company. You may buy shares at an initial public offering or from a current shareholder. Stocks may become hot and prices may rise, but with few exceptions, common stocks are never crowded because all shares are held and there must be a seller for every buyer.
Therefore, a crowded trade has little to do with popularity or price, unless those prices correlate with an accompanying need for investors to immediately exit their positions at any cost.
The Black Monday market crash of 1987 was caused by institutional investors who swamped the market with an overwhelming number of stock index futures, trades that cascaded into the stock market. Similarly, highly leveraged institutional hedge funds also sparked the Quant Wreck of 2007 when they couldn’t cover their margins, leading to rapid and cascading liquidations.
In the recent FAANG sell-off, there were disappointed investors, but no obvious signs of extensive short selling or linked derivatives that would indicate a crowded trade.
As it turns out, whether a trade is crowded or not has to do with market liquiditythat is, whether assets can be bought and sold easily and quickly. So when it comes to the potential for investors to overwhelm the exits in a rush and find themselves unable to change their holdings, the risk is probably greater in more under-the-radar segments and vehicles beyond common stock trades, like those involving short selling, or certain types of exchange traded funds that offer the illusion of liquidity for an otherwise illiquid underlying asset like high-yield debt.
Read “What ‘Hamilton’ Has to Teach Us About Today’s Markets” on QMA.com.