When I completed my MBA back in 2011, in Finance and Entrepreneurship, almost everyone talked about fundamental analysis and value investing. They taught things like the “efficient market hypothesis,” where the market mechanism would efficiently reflect all available information into the most recent stock price. This was all part of the old order – value investing Warren Buffet style – which lead to ideas such as mark-to-market accounting and praised the construction of GAAP. Mark-to-market was abandoned in March 2009, which helped set the low for the US stock market and sent it back upward. GAAP (Generally Accepted Accounting Principles) was abandoned later on for the much more flexible IFRS (International Financial Reporting Standards). This flexibility allows companies to report better earnings metrics, making it easier to reclassify expenses as one-time costs for example.
Despite this change helping to buoy reported earnings, traditional investers have been totally baffled by the changes in the investment landscape. You have an inverted yield curve and a manufacturing slowdown – the S&P marches higher. The Coronovirus shuts down major cities in China which is the world’s second largest economy by GDP and a world-wide manufacturing hub – the S&P continues to reach all time highs. How can the efficient market hypothesis have any bearing at a time when Apple – one of the biggest companies by market cap – doubles its valuation in a year? It’s easy to get baffled and throw in the towel because nothing makes sense based on the old rules. But don’t get discouraged – the market can be reasoned when you start to acknowledge the enormous functional changes over the last decade.
The following article mentions another game-changer in the last decade. The gist of it is that the SEC changed the rules in March 2008 in a way that made it a lot easier to create ETFs (Exchange traded funds). These funds exploded onto the market and became wildly popular, making it relatively easy for ordinary investors to buy into a big basket of stocks such as the S&P 500 or the NASDAQ. The idea of safety through diversification began to replace any need for investment research or fundamental analysis. https://en.wikipedia.org/wiki/Exchange-traded_fund
Passive investing through ETFs (Exchange Traded Funds) is the biggest game changer in investing in the last decade. They sell on their low management fees – they don’t need professional research or oversight – and their performance has simply trounced that of active investment funds over the last decade. Many are calling for the end of active management as passive investing can replace it entirely – but can it? I encourage everyone to take a look under the surface to see how this new machine works, and why it has such a tremendous track record.
Here are some of the important mechanics and requirements for passive investing through ETF’s…
- Most passive ETF’s are limited to the universe of highly traded large cap stocks. This is simply because they have to purchase or sell large amounts of stocks at a moment’s notice. If you try this with a small stock you end up paying too much to buy and getting too little back to sell … so they stick to large stocks.
- The most viewed indexes, such as the S&P 500 and the Dow Jones Industrial Average, are weighted by market cap. This means the higher the price, the higher the weighting in the index. As a result, funds tracking these will end up purchasing more of a stock simply because it’s share price rises.
- The FAANG stocks (Facebook, Apple, Amazon, Netflix & Google) make up 15% of the S&P 500. They are also in a number of popular index funds that track the NASDAQ, technology and growth for example. As a result, any money entering any of these funds leads to large purchases of these 5 stocks, and this is amplified as the S&P responds by increasing their weights.
If you think about it, the structure above explains some of the curious behavior in stocks over the past decade. Value stocks and smaller stocks have underperformed while large blue chips have been marching relentlessly higher and a small number of the most highly valued stocks went up enormously.
Here’s how I picture the stock market moving over the past decade.
1. Large passive index funds start to gain popularity. There low fee structure is aimed primarily at attracting money from actively managed funds with higher fees.
2. Actively managed funds have to reduce their portfolios to accommodate the shift to passive investing. They tend to be weighted a lot more heavily in stocks that they consider underpriced, such as value stocks and small caps with promising growth. This relentless selling pressure causes the performance of these assets to lag.
3. Passively managed funds grow in leaps and bounds. This money is split according to simple rules, such as purchasing stocks with the same rough weighting as the S&P 500. This is done without regard to valuation, creating relentless buying pressure at any price, and causing the underlying holdings to outperform.
4. Central banks around the world engage in new and extreme policies of zero to negative interest rates and large balance sheet expansions known as quantitative easing. This creates a large pool of money that pools into whatever assets the central banks favor – such as bonds – and drastically reduces the potential returns for bond investors. Many of these investors – such as pension funds – are pushed into other markets such as stocks and private equity funds in order to get returns on investment.
5. The economy and labor market slowly recovers from the “great recession,” increasing the number of employees regularly putting money into widely used 401k plans, most of which heavily favored stocks.
6. The money going into 401k’s is considerably accelerated as large swaths of the well-paid boomer generation save like crazy as to prepare for a rapidly approaching retirement.
7. Stock buybacks began to be not only allowed in massive amounts, but often encouraged by the US government. Companies such as Apple, GE and Boeing have spent enormous sums of money in buying back their own shares, often issuing corporate debt to do so.
7. A relentless supply of money was provided to the stock market because of 4, 5, 6 & 7 causing an enormous bull market in stocks.
This chart will help you visualize this trend: https://theatlas.com/charts/S1lPjxkM-
By March 2019, passive funds already controlled over 45% of the US stock market.
We are at a time where baby boomers are retiring en masse as their average age hits 65. After this time, they will stop adding to their 401k’s and begin drawing from them. The following Gen-X is a much smaller generation and they typically earn significantly less. They won’t offset the buying pressure that the boomers had. Neither will the regular investments of the larger millennial generation, as they are all in adulthood but their pay and benefits are much smaller than that of their elders.
At this time, an enormous amount of money has been blindly crowded into a relatively small number of large stocks due to passive investing. These investors don’t even realize it, as they believe that their passive funds offer safety through diversification. As cash flows continue to go into stocks, particularly into passive funds, this doesn’t seem to matter as the market relentlessly climbs.
However, these flows are destined to reverse at some point – and then the question becomes who will buy and at what price.
The market correction in Oct-Dec 2018 was caused by a reverse of funds as the federal reserve reduced the size of its balance sheet and raised rates, shrinking the amount of money going into investable assets. It turned sharply with the 2019 Powell pivot but began to peter out mid-year, until the federal reserve bumped its balance sheet higher at a rapid pace from October 2019 through January 2020. The Coronavirus ironically helped the US stock market considerably as the financial easing in China designed to “stabilize markets” created a new wave of money, some of which rushed to the safety of US stocks.
With the worldwide manufacturing slowdown becoming more apparent and exacerbated by the growing economic affects of the coronavirus (cities shut down, reductions in trade and travel, etc), we may be destined for a significant correction here. I wouldn’t bet short though, as I expect the US president, the federal reserve, and central banks around the world to respond to any significant decline.
I’ve been accumulating gold mining stocks in significant amounts lately and they now comprise 30% of my portfolio. 54% is sitting in cash on the sidelines in case of opportunities arising from an overdone pullback, and the remainder is primarily in defensive sectors with high dividend yields, such as consumer staples. The technicals on both Gold and the Gold miners have been extremely bullish, and they seem set to benefit tremendously from central bank intervention. I feel I have enough allocated there at this time however, as better buying opportunities may come ahead in other areas.
Right now I don’t think we have seen the top of this decade-long bull market in US stocks, though the chances of hitting that tipping point will increase considerably in the next few years. I also don’t think we have seen the top of the passive investing trend … that continues to gain steam which means the overpriced FAANG stocks will probably go up even more over the next year. I won’t bet on those though because the risks are too high for me to sleep comfortably with them in my portfolio.
Remember this … fundamental valuation does not drive stock prices. The famous Dutch tulip mania did not happen because of any increase in tangible value or usefulness. Valuation is driven by cash flows, and long-term outperformance comes when your understanding of the trends driving those cash flows allows you to position properly.
Happy trading, and may the odds be ever in your favor.