Retail Trading and Asset Prices: The Role of Changing Social Dynamics

Fulin Li, Joint Program in Financial Economics PhD student

Social-media-fueled retail trading poses new risk to institutional investors. This paper examines the origin and pricing of this new risk. Using data on meme stocks, I first establish that aggregate fluctuations in retail sentiment originated from a growing and concentrated social network. I then document that retail sentiment fluctuations induced changes in investor base composition. As sentiment increased through-out 2020 and 2021, retail investors built up long positions, while price-elastic long institutions started to exit the market since early 2020. Short interest stayed high in 2020, then dropped sharply following the price surge in January 2021, and remained low throughout 2021. I develop a model to show that retail sentiment shocks shift investor composition, which in turn determines the price of retail sentiment risk. In particular, following an increase in aggregate retail sentiment, price-elastic long institutions first hit their short-sale constraints. Then short institutions hit the margin constraints, leading to a short squeeze. As a consequence, the market for an individual stock becomes price-inelastic, and a moderate retail sentiment shock can have a large price impact.
The model reconciles the price, quantity and retail sentiment dynamics during this period. Finally, I conduct counterfactuals, which show that social network dynamics shape the distribution of sentiment shocks and have economically large impact on asset prices.