Comment

Robinhood traders are going to get their fingers burnt

Despite their 'follow the herd' strategy, the new crop of day traders on the Robinhood app are not driving stock markets as a whole 

“Buy low, sell high.” These four words sum up the basics of equity-market investing. However, some of the biggest market moves now involve a strategy of “buying high, selling even higher” as novice investors use commission-free trading apps to buy the latest fashionable shares.

After sending Tesla shares to the stratosphere earlier this year, the latest company to send millennial traders on apps such as Robinhood into a frenzy has been Eastman Kodak. This is all likely to end in tears.

Robinhood is a US trading app that offers commission-free trading and has immense popularity among millennial and generation Y traders. The average age of app users is 31 – and it appears that many young Americans flipped their government stimulus cheques into equities using such apps. Research by US data aggregation group Envestnet Yodlee found that trading stocks was among the most common uses for the government stimulus payments in nearly every income bracket.

Unlike other brokers, Robinhood is open about what its platform users are buying, regularly publishing trading data. This means it can describe itself as more “transparent” than other platforms. But the data also adds to the momentum in individual stocks – if everyone know the latest company that is in fashion on the trading app, it encourages other investors into the trade, increasing the momentum.

Its forms a sort of unvirtuous circle that will inevitably blow up bubbles which will rapidly deflate. These bubbles appear to have – at least in part – been funded by the US government.

Shares in Eastman Kodak rallied almost 1,200pc over two days recently and it became the most-traded company on Robinhood. This followed news on 28 July that Kodak had secured a $765m (£572m) government loan under the Defense Production Act to undertake the production of ingredients for generic pharmaceuticals to treat Covid-19.

These include hydroxychloroquine, a drug that has previously been used to treat malaria and that Donald Trump has suggested could be effective in treating Covid. However, Dr Anthony Fauci, a leading member of the White House coronavirus task force, has repeatedly said that hydroxychloroquine is not effective against the virus.

Furthermore, the stock collapsed by about a third on reports that the US government was blocking the loan.

Nonetheless, Robinhood traders had embraced the story and had been buying into the shares with zeal. The SEC has now unveiled an investigation into how the deal was announced, as there were a significant number of trades on the day before the news was officially announced.

Eastman Kodak has a bit of a history of pivoting towards trendy investment fads. A couple of years ago it tried a “pivot to Blockchain” – something that was also causing share prices to explode. Perhaps Robinhood buyers of the shares don’t remember this history.  

The rise of digital photograph and smartphone has meant that Eastman Kodak has been a company in search of a new business for quite some time. In January 2018, it announced a partnership with Wenn Digital to launch a digital currency and blockchain-based platform, with an initial coin offering (ICO) expected at the end of January.

The KodakCoin announcement doubled the price of Kodak shares but none of it came to pass. Before the Covid story, the shares were trading at about a third of the level seen before the KodakCoin announcement. This should all make investors cautious.

But history is irrelevant for momentum traders – as are fundamentals. It is a trading strategy in which investors buy securities that are rising and sell them when they appear to have peaked. Then, the investor takes the cash and looks for the next short-term uptrend and repeats the process.

Of course, so-called momentum trading isn’t new. Its most famous proponent was probably Richard Driehaus, who generated impressive returns in the 1980s and 1990s using momentum strategies based on results "surprises" as buy and sell signals. But the current momentum traders are not using fundamental data – they are looking at lists of popular stocks and trying to ride the wave. The problem with momentum investing is that moves could be just as rapid on the downside as they are on the upside.

Some say that these new millennial-generation traders are responsible for sending markets up since the lows hit in March. It is true that equities are trading at levels that imply future earnings are going to be significantly higher than they are likely to be. But this effect appears to be centred on a limited number of shares.

In June, Barclays published a study of moves in the S&P 500 and positions taken by "Robinhooders". It concluded that retail investors speculating in stocks are not responsible for the market’s rally and the top picks of the app’s users tended to underperform and moves in the S&P 500 were independent of the positions taken on these apps. Nevertheless, some of the most popular stocks traded on the Robinhood app have been some of the biggest winners in the market – but correlation is not causation.

Of course, there will be some Robinhooders with big gains. However, this strategy needs a lot of attention to follow market moves and it seems inevitable that most will eventually lose money. But despite their "follow the herd" strategy, they are not the main drivers of the market as a whole. 

Garry White is chief investment commentator at wealth management company Charles Stanley