Rule of thumb

There is an implicit assumption in markets that share price movements reflect broad changes in sentiment towards both companies and indeed to risk assets as a whole. I don’t think that, on average, this is an irrational perspective – but there are some important exceptions.

While not quite a ‘rule of thumb, what the market does over summer (and in August in particular) is frequently reversed – or at least the trend that is established is not continued – come September. Why is this? The simple, but probably accurate, explanation, is that the number of participants in the market falls sharply with the summer holiday season. The consequence of this is that volumes traded are much lower, and so relatively small trades can have substantial impacts on both individual shares and in aggregate on the market as a whole.

There are of course other (perhaps complimentary rather than counter) arguments as to why we might see this summer phenomenon. Firstly, some argue that the holiday season sees many mutual funds managed on a “care and maintenance” basis by deputies, who effectively seek to maintain existing exposures and rebalance with any cashflows – barring major stock-specific events – and so markets “trend”. Secondly, there is the argument that a summer holiday gives market participants the time to refresh their views and return to work with a fresh perspective – which often results in a substantial (in aggregate) change in market trends.

While all of these arguments probably have some truth in them, I would contend that the impact of volumes should not be overlooked – which brings us on to where else this matters: smaller capitalisation stocks. Most investors have a familiarity with the concepts of liquidity and average daily volume (the average number of shares traded in a day). When considering a trade, an investor will need, depending on their planned trade size, to consider whether there is sufficient liquidity in a stock to make the transaction in a single trade or on a single day. Fund managers with high AUMs are frequently forced to trade over successive days or even weeks to avoid substantial market impact which can be deleterious for their performance. However, fund managers do not always have the luxury of being able to do this – large in or outflows from their funds can necessitate rapid trading in a stock even if it has a market impact.

We all see attention-grabbing headlines of “stock A rises / falls 20 per cent in one day”. The question we should ask ourselves, when presented with this news, is what has driven the change. Is it a general change in sentiment by the average market participant? If so, perhaps we can infer that some form of newsflow (either company-specific or on an industry level) has led the average owner of the stock to react (in the case of a fall in the price) or caused other participants to buy the stock, or existing holders to increase their positions (in the case of a price rise). However, what if, for example, one large shareholder was forced to redeem his or her position? Actively managed funds generally hold a degree of transactional cash (that is, to help with outflows and to delay the need to invest inflows), but this does not necessarily provide enough of a buffer for days with particularly large flows. So, in an extreme example, one small cap fund manager seeing a large outflow might become a forced seller of a stock, pushing down its price even though his or her investment view on the stock is positive. The share price move could indicate one sentiment, but the reality is the opposite.