In all cases, the underlying trend in need of correction remains intact. The FANG stocks are still up massively for the year, and the rest of the world is not. The NYSE Fang+ index (which also includes American depositary receipts issued by some big Chinese internet names) has still outperformed the equal-weighted S&P 500 by an astonishing 74%. Logically, it is hard to see how this can be sustained:
So if the correction so far has been healthy, then by the same logic it would be healthier still for the correction to continue a while. If that involves investors coming to realize that the internet platforms will not be able to gobble up everyone else’s profits forever and a day, that would be healthy on a number of levels.
That said, the continuing move in volatility suggests that the greatest excess caused by speculation in call options has now worked its way through the system. The VIX index measures volatility by how much investors are prepared to pay to protect against future swings through the options market. Usually, the VIX will move in the opposite direction to the stock market. When equities are doing well, the options market shows less anxiety. In the last four weeks, there was first the sight of the S&P 500 spiking higher while the VIX also rose, and then in the last week gradual declines in both the stock market and the VIX.
The worst excesses from the options market, at least, have been corrected. And that is healthy.
Herd Mentality
Herding by fund managers, arguably exacerbated by the increasing importance of indexes and passive investments as competition, hasn’t improved performance for their clients. Usually, the brave contrarians who pick the least crowded stocks get rewarded with much better performance than those who stick with the herd. This year is a big exception. In the following chart, from BofA Securities Inc.’s quantitative equity strategist Savita Subramanian, the yellow bars show the performance of the 10 most overweight stocks among equity fund managers, while the blue lines show the performance of the 10 most shunned. Usually, there is good money to be made by betting against the crowded trade. This year has been very different:
According to Subramanian, the spread of 19.2% in favor of crowded over under-owned stocks is the strongest in a decade. So this is a market that is becoming narrower, and where it is harder than usual to make money by betting against the consensus. Subramanian also published a chart using the concept of “active share” — the proportion by which a fund’s portfolio differs from its benchmark. The higher the active share, the more fund managers are deviating from their index, and avoiding a herd mentality. A hugely influential paper published in 2006 by Martijn Cremers and Antti Petajisto suggested that higher active share was associated with stronger performance, and since then it has become increasingly common for institutions allocating money to fund managers demand a high active share. As the chart shows, active share did indeed grow after the crisis, but has now been declining for several years. The success of crowded trades this year makes it easy to understand why:
Herd mentality is in the news, as well as herd immunity. Whatever its role in combating the pandemic, it has long played an important part in the world of investing. Professional investors are paid not to make the most money possible with the least risk, but to accumulate the most assets — which generally means doing a bit better than their peers. That makes big contrarian bets very dangerous to their careers, and creates an incentive to hug their benchmark. It’s often best expressed in terms of herd psychology; in a herd of antelope, it is safest to be in the middle, as it is those at the front or the back who are most likely to be attacked by lions.