Sunday, May 29, 2016

Why Institutional Participation Matters in the Stock Market

Above we can see a chart of SPY (blue line) from 2014 to the present.  The red line represents what I refer to as Institutional Participation.  It is a measure of total upticks and downticks among all NYSE stocks each trading day.  Going back to 2012, if we divide daily institutional participation into quartiles, we find significant relationships.  Specifically, when participation is in its highest quartile, the next ten days in SPY average a gain of +1.72%.  When participation has been in its lowest quartile, the next ten days in SPY have averaged a loss of -.28%.  

Let's think about why this might be.

Suppose we measure institutional participation each minute of the trading day.  To achieve a high reading, we would have to see a great deal of upticking or a great deal of downticking at that time.  In other words, there would have to be broad-based buying or selling among shares--a surge of demand or supply.  Such surges are most likely to come from institutions deploying a great deal of capital, buying/selling stocks overall as an asset class, not just accumulating/distributing shares in a particular name or two.

The broad accumulation of stocks is associated with momentum--a continuation of price strength.

The broad distribution of stocks is associated with value--the reversal of price weakness.

When there is little institutional participation, neither momentum nor value motivations to own shares is present.  Returns are subnormal.

One of the greatest mistakes I see traders make is focusing on "fundamental" reasons for short-term stock market movement.  This leads to frustration, as many market moves seemingly "make no sense".  Fundamentals are very relevant to investing, less so to trading.  Trading is about gauging market flows, and flows are not best measured by chart patterns or earnings levels.  In gauging the buying and selling behavior of institutional participants, we can assess whether flows are waxing or waning--which tells us if momentum or value are likely to be drivers of future price action.

Further Reading:  Institutional Participation and When to Exit