It’s Coming From Inside the House

It seems that the first few trading days of the new year have shown a different character than the one to which we had become accustomed.  In the weeks leading up to the holiday season, it was typical to see futures rallying overnight – often around 2-3 AM ET – then getting another lift as the regular session opened.  It would then be up to domestic buyers to pick up the mantle from the exuberant futures traders.  Sometimes they did, other times they didn’t.  Lately we have seen the opposite, with overnight futures trading sideways before stocks picked up steam throughout the day.  If this persists, it could become quite meaningful.

It is extraordinarily difficult to draw conclusions from small sample sizes, but this mini-pattern implies that domestic institutional investors, rather than quick-triggered traders, are driving the activity.  When institutional investors like pension funds put money to work in long-term investments, they tend to be relatively deliberate.  They are navigating a battleship, not a speedboat.  Every tick is crucially important to a trader whose time frame might only be minutes or less; a long-term investor is more concerned with minimizing the impacts of their portfolio maneuvers. 

Large institutions will often allocate hundreds of thousands of shares in a group of stocks at a time.  Of course, there might be times when their brokers happen to find a willing seller and consummate a large block trade, but more often than not, those large orders are worked throughout the course of a day or a few days.  Buy-side traders are keenly aware of a stock’s average daily volume and are loath to place orders that would unduly inflate that statistic unless their portfolio managers specifically request that they do so.  (There are times when an actively managed portfolio manager spots an opportunity that might be fleeting and wants to act upon it.) 

As a result, many institutional buy-side traders are judged on their performance against the daily volume-weighted average price (VWAP).  They are content to work their orders slowly and throughout the day with the goal of matching or bettering either the close, or more likely, the VWAP.  That often means slicing their orders into small pieces and tracking the time and size of the stock’s trading.  It might also mean leaving a little extra to be executed in the last half hour or so in order to increase their odds of beating their benchmark. 

Bearing all that in mind, that is why I assert that this week’s trading has been driven by institutional allocations.  It is reasonable to assume that institutions have received or expect to receive some new money at the start of the new year that needs to be invested.  We have also seen some relative outperformance from more economically sensitive sectors, in what I believe is a bit of a delayed reaction to the positive GDP surprise of December 23rd.  The persistence of the current pattern will depend upon whether individuals continue to add funds to institutional accounts, including ETFs, and expectations for continued economic growth and/or monetary accommodation.