When to avoid crowded trades

Market crowding can be a positive, powerful force in its early stages, says David Picton, president and portfolio manager for Canadian equities at Picton Mahoney Asset Management.

Listen to the full podcast on AdvisorToGo.

The main problem, however, is investors who take part often ignore whether the prices of crowded trades make sense, adds Picton, whose firm is one of three managers of the Renaissance Canadian Growth Fund.

As a result, “[Crowding] can become a very dangerous force when flows and valuations become too large,” he adds. At that point, even a modest change in the outlook for a stock or sector can cause a mass exodus, meaning a holding will become too volatile.

Here’s an example: “We all remember FANG from last year—Facebook, Amazon, Netflix and Google,” says Picton. “The four were given a special name because we were in a low-growth environment, [where] world trade was slowing and central banks were easing. Anything that had growth was highly rewarded by the marketplace.”

So in 2015, “these were exceptionally good companies and they were [seen as] well-positioned for the exponential change that was occurring due to digitization” in the consumer space.

But at the beginning of 2016, Picton notes, “a massive amount of money had been dedicated to those four particular stocks. So we saw, from January to March 2016, significant sell-offs in these names.”

Now, however, “most of the four are trading back at all-time highs,” says Picton. “Once you removed some of the excess crowding, they again became very good companies to invest in.”

Looking to interest-rate-sensitives? Think again

Currently, crowding is occurring in interest-rate-sensitive and low-volatility areas of the marketplace, even though companies aren’t delivering, says Picton. “In some cases, these companies are missing numbers. But the market continues to reward [these names] because they have a dividend or they’re perceived to be low-vol holdings.”

This phenomenon has been benign so far, he says. “But you have to be cognizant of when it starts to go the other way and [aware of] the amount of money that has to escape those areas. We are later in the crowding game in these areas, so investors should be cautious.”

Read: Avoid interest-rate-sensitive trades

For example, says Picton, look at the Canadian grocery space; Loblaws and Metro, in particular. “The results that have come from these companies haven’t been that impressive, and you’re starting to see the investment in price being mentioned by these companies. Yet these stocks, given their low-vol nature, have been subject to all kinds of flows that have overwhelmed their valuations, [even while] fundamentals are changing for the worse.”

The same is true of Canadian telecoms, which are trading at all-time highs, he says. “You’re seeing all kinds of competitive pressures emerging in select areas throughout the space,” so use caution.

Read: Red flags for equity investors

Also, keep in mind that preferred shares were deemed a solid and safe investment last year, says Picton. But now, “we know that interest-rate sensitivity was maybe miscalculated on some of the resets, and we saw significant pain on what was perceived to be a low-risk part of portfolios.

“If you transfer this knowledge to U.S. Treasurys or dividend stocks that are trading at all-time highs, you realize you need to be aware that a change in growth expectations for these holdings—even short-term changes—can [mean] a very different environment than has existed year to date.”