To The Moon

Last year, amateur investors took financial markets by storm. This year, Wall Street professionals are watching them closely.

Fund managers who might have once derided small-time day traders as “dumb money” are scouring social-media posts for clues about where the herd might veer next. Some 85% of hedge funds and 42% of asset managers are now tracking retail-trading message boards, according to a survey by Bloomberg Intelligence.

JPMorgan Chase & Co. in September introduced a new data product that includes information on which securities individual investors are likely buying and selling, as well as which sectors and stocks are being talked about on social media. About 50 clients, including some of the largest asset and quant managers, are testing the product, the bank says. JPMorgan equity traders are also using it to help manage their own risk.

“The flow from retail is not something you can ignore if you are a professional investor,” says Chris Berthe, JPMorgan’s global co-head of cash equities trading. “It’s a whole new investor class that has emerged, and it’s an investor class that’s actually getting themes right.”

The shift illustrates just how much the rookies have changed the investing landscape. A year ago, market observers were questioning if the retail revolution would continue. Now many are asking what it will look like this year.

After shying away from active investing for much of the past decade, millions of Americans, hunkered down at home because of Covid-19, became day traders in 2020. Enticed by volatile markets and phone apps that made it free to trade stocks, they flocked to social media for investing ideas. That year, they piled into stocks like Hertz Global Holdings Inc. (and ultimately were rewarded when the car-rental company exited bankruptcy). It is estimated that more than 10 million individual investors opened new brokerage accounts in 2020, according to Devin Ryan, director of financial-technology research at JMP Securities.

Avoiding Crowds

The total number of stocks with at least $10 million in short interest rose last year, but the number of the most heavily shorted stocks declined.

Last year the trends from 2020 accelerated. JMP Securities estimates that a further 15 million Americans signed up for brokerage accounts in 2021. Social-media forums became increasingly used for trading. Some individual investors used their growing numbers to send stocks including GameStop Corp. and AMC Entertainment Holdings Inc. flying. Many newbies relished in inflicting steep losses on some hedge funds and demonstrating that traditional playbooks aren’t the only way to win.

Investments that made little sense on paper became valuable in 2021 because day traders declared them so. Joke cryptocurrencies such as dogecoin—up more than 1,900% in the past year based on late Friday levels—minted self-proclaimed millionaires. A market for nonfungible tokens (NFTs), or digital images of items such as bored-ape avatars, exploded.

JPMorgan estimates that individual investors accounted for more than a third of daily trading activity several times over the past 18 months, reaching nearly 40% of shares traded on peak days.

To be sure, many of the newbies lost money. Some took on debt without understanding what they were doing, leaving them vulnerable to steep losses when stock prices fell. Riskier investing strategies, including options trading, exploded. Many amateur investors bought into buzzy shares near the top of rallies, only to watch the prices rapidly plummet.

Individual traders in 2021 purchased a net $292 billion of U.S. stocks and exchange-traded funds, according to Vanda Research’s VandaTrack platform, which tracks and sells data on the purchases of U.S. equities by individual investors. That is more than seven times the amount in 2019. Individual investors so far appear poised to continue similar levels of buying activity in 2022.

Analysts expect a bumpier road ahead for U.S. stocks this year, and some money managers believe that any prolonged volatility could wash individual investors out of the market. Many say that today’s activity resembles the late 1990s, when individual investors piled into trading only to flee when the dot-com bubble burst.

So far, individual investors have shown a strong stomach for bumpy days. Last year, the group’s eight largest buying days by dollar volume occurred when the S&P 500 sank 1.3% or more, VandaTrack data show. Several academic papers have found that individual investors have at times helped stabilize markets, providing liquidity in times of volatility.

The big names notice

By some accounts, the newbie investors have already altered some professional investors’ trading strategies. One way in particular: the way some make bearish bets.

Meme stocks like GameStop had high levels of short interest before they caught the attention of Reddit traders. That means that other investors—usually professionals, like hedge funds—were betting those stocks would fall. When shorting a stock, an investor borrows shares of a company and sells them, hoping to buy them back later at a lower price.

When the amateurs sent GameStop and other stocks soaring, the short sellers were sometimes forced to buy back shares, often at much higher prices.

These days, investors are avoiding taking big chances with their short-selling plays, according to an analysis by Ihor Dusaniwsky. He is head of predictive analytics at S3 Partners, a technology and data analytics firm that closely tracks activity by short sellers.

Just seven stocks in the U.S. market had short interest of 40% or more at the end of 2021, according to his analysis of stocks where at least $10 million of shares had been sold short. That was down from 40 stocks at the beginning of January 2020 and 19 stocks in January 2021. And unlike the previous periods, no stocks in his analysis had short interest of 70% or more at the end of 2021.

Last year, S3 started offering new tools that tell clients which stocks have crowded levels of short interest and which could leave them vulnerable to sudden losses if individual investors pile in.

“In the back of every hedge fund’s mind is, ‘I don’t want to be on the wrong side of a meme-stock play,’ ” Mr. Dusaniwsky says. “It’s a full-time job to make sure you don’t get hit by a bus.”