Profiting Off the Herd Instinct

An article was published in the WSJ yesterday titled “The Herd Instinct Takes Over”, with interesting implications. The article was based off a chart published by Birinyi Associates showing the increased correlation between individual components of the S&P 500, and the author hypothesized that one potential reason for this is the increased use of ETFs.

If investors are buying into (and out of) the S&P as a whole while ignoring the individual companies, the correlation between stocks should rise. Even if ETF traders are looking at sectors, the effect will be the same. Interestingly, a research director from Birinyi was quoted as saying “It is harder for individual investors and even for mutual fund managers to distinguish themselves by doing individual stock picks. They might get the product right and the earnings right, but the market goes down and the stock is going to go down as well”.

While some investors or portfolio managers might consider this a risk, really it’s an opportunity. The risk exists for those with very short time-horizons, like portfolio managers who are under pressure to outperform on a monthly basis. If that’s the case, an investor can’t afford to make a good investment when the risk of being dragged down by the S&P is too great. But if individual stocks are deviating from intrinsic value because they’re being pushed around by index buyers, there’s more opportunity available for legitimate analysts to dig into companies and find compelling values.