Trader Patrick McKeon, center, works on the floor of the New York Stock Exchange Thursday, Jan. 30.The Associated Press
The way that the famous yarn is usually told, Joe Kennedy got out of the market before the 1929 crash because a shoe-shine boy was offering him stock tips, and that just didn't seem right.
Almost nine decades later, markets seem to be no less vulnerable to the proverbial "crowded trade" that lures investors like lemmings over the edge of a cliff. Exhibit A could be the crowds that bid the yield on German 10-year bunds down to almost zero a few months ago, only to later flee like a flock of scared birds.
These days, crowded trades are more likely to be hidden in black boxes rather than revealed over shine boxes. Researchers are still discussing the "quant meltdown" of August, 2007, in which "some of the most successful equity hedge funds in the history of the industry reported record losses," as one academic paper described it.
The growing popularity of smart beta strategies based on various investment factors has increased concerns about crowded trades, according to researchers at MSCI Ltd., who have attempted to develop a scorecard to identify and measure the phenomenon.
This is how they describe the dangers of crowded trades: An "overlap of positions among managers may result in extreme levels of risk when those investors experience negative shocks in other parts of their portfolios, forcing them to liquidate their positions (selling what they can, rather than what they would necessarily like to.) These 'fire sales' may then cause losses for other investors following the same strategy and result in further liquidations, driving stock prices into a downward spiral."
One example they cite is the crash of momentum stocks after the final throes of the last bear market. Momentum-factor strategies involve buying the best-performing stocks and/or shorting the worst performing. The strategy turned on its head when the overall market found its bottom in March of 2009, as seen in the performance of the Dow Jones U.S. thematic market neutral momentum index.
One clue that would've helped you know momentum was a crowded trade could be found in mutual-fund holdings, according to MSCI. Mutual funds were net buyers of momentum stocks in 2004-07, then became net sellers in 2008, the research paper said. Growth funds, especially, began changing their behaviour and dumping momentum stocks right before the reversal.
Similar crowding could be seen on the other end of the momentum spectrum, in which hedge funds piled into short positions on the worst-performing stocks and then quickly reversed.
The trading habits of mutual funds and hedge funds aren't enough to determine if a trade is crowded, according to MSCI. Investors also need to look for signs of rising correlations between stocks that rank among the best and worst in various factors of investment strategies.
And finally, the researchers advise, look for widening spreads between the valuations of stocks that score among the best and worst in a certain factor. For example, they show how highly levered companies became much cheaper than peers with less debt during the financial crisis, based on the ratio of book value to price.
The big question now, of course, is whether there are currently any crowded trades at risk of unwinding. The MSCI analysts believe there are reasons to be "moderately concerned" about crowding in momentum-factor trades, based on the four indicators they laid out.
So next time you get your shoes shined, ask the shiner about "momo." While we're at it, it's worth noting that other tellings of the shoeshine-boy yarn place J.P. Morgan in the chair. Maybe Morgan and Kennedy had the same shine boy? Talk about a crowded trade.