🔋All In - Pt. 2

Passive investing through retirement funds is sending stock valuations to the moon, but when does this train stop?

Sep 25, 2024

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Last week I discussed how the buy-and-hold strategy has been particularly successful since 2009. The neglected side effect is that it leaves you open to large downside risks which can take years to recover from. This could set you back on your financial goals or your derail retirement plans. The buy-and-hold success has been used as justification for products like index funds, which have actually outperformed most money managers over time.

Perhaps professional money managers aren’t immune to the psychological tricks of the market which can be the reason for the underperformance, or is there something more sinister going on?

In theory, the efficient market hypothesis suggests that stock prices reflect the combined knowledge and research of all market participants. It is unlikely that a random person, even an expert can know more than the combined knowledge of the market to outperform (known as alpha). In this sense, the only way for you to make greater returns is to seek riskier investments or just track the passive portfolio with a small fee. While this might sound like a good explanation for what’s happening today to cause passive outperformance, we are far from an efficient market as I will explain.

This piece is strongly inspired by Mike Green, a veteran portfolio manager who has been a part of groundbreaking financial research on passive investing. Much of the information contained is from his podcast appearance on Forward Guidance in August. In the efficient market framework, the presumption is that the investor is truly passive and not impacting prices. This idea was created in 1991 by Bill Sharp with the assumption that the passive investor who buys an index of equities and holds it for years is not transacting or affecting the price. At the time, this was true as passive investing made up 1% of the market share so this assumption could be taken as an axiom. Today, passive investment makes up a whopping 40% of equity markets, meaning this model does not hold up today.

What this means is that the passive investor is now the dominant player in markets. Since each passive investor acts the same way, they are by far the largest market participants. People buy in proportion to the index (i.e. S&P500) which is weighted proportionally to the size of the company. This means that Apple, Microsoft, and Nvidia make up a much larger share than a company like Best Buy or Clorox. Further, there is little stock substitution available today like there should be in an efficient market. In theory, you should be able to replace United Airlines with Delta, but you cannot replace Apple with another company.

Problem

The passive investor is someone who buys an index and does not actively manage, re-distribute, and re-allocate the funds. This could be a buy-and-hold investor, but more importantly retirement and target date funds such as IRA and 401ks. In short, the problem with this is that it has grown to such a size that there is a constant buy order for these stocks and no risk mitigation taking place. 40% of the market does not care about what price, valuation, or fundamental cash flow of the companies they are buying. Sure, if they are the top companies in the world you can assume they are the best, but this is a slippery slope of negligence.

Active funds carry cash to provide portfolio safety, deploy for new investment opportunities, buy more without selling assets, and meet redemptions. The Fidelity Contrafund is a good example, which holds $1.5 billion in cash for $136 billion in assets. On the other hand, the passive Vanguard total market index has $1.2 trillion in assets. Would you like to guess how much cash they keep for this portfolio? The answer is negative, they had to take a line of credit to meet obligations. Any rational investor would look at that and say that is absurd. There is no risk management other than they are the biggest fund in the world and control regulatory apparatus.

The problem is that these passive funds push the market higher artificially because we do not have an efficient market where these buyers are not transacting. These passive purchases make up a large chunk of transactions that do not care what price, as long as they buy. This props stock prices up, especially those that are already large, and acts to push the gap between the largest stocks wider. People often care about which stocks Warren Buffet and other Whale investors buy because they can impact the stock prices. We know that Vanguard is the largest holder of all the largest companies, so why wouldn’t we also assume this pushes the price higher as well?

Art auctions go online in bid to drum up business — CNBC

Consequences

Things have gotten whacky and the investors are just keen to comply with the changes. For example, in an efficient market, a stock’s market cap should increase in proportion (or fraction of) its inflows. Recently, Nvidia had an increase in market cap of $225 billion of of only $5 billion in overnight trading volume. Yes, overnight trading is less liquid, but the efficient market and intelligent investors would take this into account and not buy the highly-priced stock. Instead, the company keeps getting bought at these higher and higher levels with no natural buyers/sellers.

Each trade must consist of a buyer and seller, but new research suggests that it is the company and insiders selling shares. This in turn subsidizes employment capability, wage costs, and cash flow for the mega stocks. This improves profits exclusively for the mega-cap stocks which turns into a feedback loop.

With the addition of stock buybacks by these large companies aided by the extra cash, Apple is more richly valued as it captured more market share and raised earnings which is not what you would expect. Typically, a company increases earnings and grows into its valuation, but valuations have just continued to increase. Apple can only grow so big as it is saturating its market. Unless there is some magic new market opportunity investors think they will gather, it is either a bubble or the boost from passive investing.

Money Managers

While some don’t realize the importance of passive, money managers are allocating more to mega-cap stocks to capture this phenomenon. Money managers and target date funds are allocating higher percentages to mega-cap stocks and even using spread trades where they buy large stocks and short smaller stocks.

In a normal market with active managers, the propensity to buy stocks is inversely correlated to market valuation (something I talk about as being overvalued currently). This means as stock gets expensive, people are less likely to buy. This is also the basis for mean reversion and CAPE ratio to estimate market valuation. If normal market conditions are a mean reverting sinusoidal wave around a comfortable market valuation, that passive market is one of constantly expanding valuations.

This has multiple consequences. managers mathematically cannot compete, and the market has become detached from normal valuations and exposed to elevated risk if passive stops.

Active managers mathematically are unlikely to keep up due to Mike Green’s research. Mathematically, active managers’ alpha or ability to beat the market is negative which means they are better off following the index which is exactly what has happened. Hedge funds and other managers come closer and closer to just imitating index funds themselves, defeating their own purpose and contributing to the issue. With less active managers analyzing the market for opportunities and risks, there is less market resilience. This has manifested for example in less short interest in the stock market.

Potential Outcomes

What stops this train and does this mean the market will go up forever?

Honestly, this is a tremendous tailwind for stocks and generally bullish. The flip side is that it creates fragility in asset values for when the passive flows slow or even reverse. There are multiple scenarios in which passive flows could be negative and cause extreme downside cascades in stocks.

In a recession, many people lose jobs which translates to less passive inflows as well as fearful investors drawing out their retirement funds. We’ve never seen passive truly sell. March 2020, Aug 2015, and a few days in 2008 were the only times where this occurred to some extent. Vanguard advertised that only 1% tried to sell their funds in 2020. If things are worse than the mild recession in 2020, it could happen.

With the inverted demographic pyramid in the US, when a large chunk of boomers soon reach retirement age, their funds will begin withdrawing instead of contributing. They may come to find out the inelasticity of their stock holdings. Since their portfolios are larger, the incremental contribution means little to them, but market volatility can lose or benefit them greatly.

Finally, another research paper suggests portfolio rebalancing as a mechanism for changes in these flows. Many funds have set allocations like 60% equities and 40% bonds. When the bond side goes down, the portfolio sells equities to rebalance the weighting of the portfolio. This helps explain what happened in 2022. As bonds decreased in value, stocks were sold to rebalance contributing to the market correction.

This also should work in the opposite direction which we will see soon if the Federal Reserve lowers interest rates and switches from quantitative tightening to easing which works to boost bond prices.

While I’ve suggested that this has little effect on stimulating the real economy, it does affect equities through portfolio rebalancing. As bonds become more expensive, portfolios automatically sell bonds and buy stocks. This could manifest in stocks performing surprisingly well heading into the rate-cutting/quantitative easing cycle where historically we should expect a pretty serious bear market.

Conclusion

In 2012, target date funds became the default for 401k contributions. In 2981, these funds accounted for $150 billion compared to $24 trillion today. Retirement vehicles like IRA/401k are clearly the largest wealth platforms in the world. If and when flows reverse, who is the natural buyer, and at what price?

This could be a momentous event causing a big drop in stock prices because there have been no “real” sellers at these levels. There have been infinite buy orders at ever higher prices getting sold to company insiders who are not rational buyers and sellers. What then when all that’s left is rational sellers, what price does that occur at? If mean reversion takes hold again, that could mean a 50+% drop in the S&P500.

It is unclear how and why exactly this could happen if it ever does. I suspect it will happen at some point as the system becomes increasingly fragile. Unfortunately, people are more dependent on assets now than ever before, think boomers for retirement. This is not something to immediately drop everything and sell stocks, but it leaves tremendous risks when the net selling of passive vehicles occurs.

Most people are not aware that this is a problem probing asset markets to higher-than-normal valuations. It has stripped the market of the ability to send information signals via price. Think of the student loans issue. If the government provides subsidized college loans for anyone, it doesn’t matter whether your return on that loan is worthwhile. You could get a 100k loan for medieval literature degree or mechanical engineering, but one has a better change of a good return. The market has lost its ability to send correct pricing signals just like the student loan market. This doesn’t end well for either. Until next week,

-Grayson

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