Ok, former trader and current man who swears to Christ he’s not trying to irritate you, Richard Breslow, is out with his latest daily missive and he’s revisiting a theme that’s near and dear to him and also to us. Namely that passive investing (think: ETFs) and price indiscriminate buyers (think: SWFs) are at least partially responsible for the sustained rally in equities.
This is just Heisenberg’s “Wave Paradox” (again). And because that’s what it is, we’re going to quote directly from the original “Wave Paradox” article (again):
Market participants of all stripes are no longer able to discern whether they are capitalizing off the prevailing dynamic or creating the dynamic that they’re capitalizing on.
This can be posed as a question: “Am I making good decisions or are the decisions I’m making only turning out good by virtue of my having made them?”
Obviously, this dynamic is always present in markets – more buying than selling or more selling than buying, etc. And it is of course readily observable in individual stocks when a heavyweight (say a hedge fund) bullies shares around. But currently, this is taking place at the aggregate level. That is, the entire market is subject to this phenomenon. And everyone from the whales to the minnows are unwittingly participating in it.
For instance, Norway’s $950 billion-ish sovereign wealth fund (the largest on the planet) seems to have lost track of whether they’re riding the wave or creating the wave they’re riding.
A big part of the reason you’re seeing those inflows has to do with the wave dynamic. Investors think they’re getting in on the action, but the herding facilitated by ETFs is actually helping to create the wave.
The irony there, of course, is that institutions and mutual funds, at a loss for ideas on how to generate alpha in an environment where the wave dynamic ensures that benchmarks rise inexorably, are simply overweighting whatever sectors and stocks are driving the benchmarks.
The problem with that is that it simply makes the wave bigger. And in doing so, it drives down volatility on the stocks that are driving up benchmarks and creates more momentum for those same shares.
Well, “there’s an ETF for that” when it comes to low volatility and momentum, and suddenly, the very same stocks are getting even more money thrown at them by investors plowing cash into low volatility and momentum ETFs.
It’s Howard Marks’ “perpetual motion machine.” It feeds on itself and ends up “working” precisely because it has to.
That’s what Breslow is getting at in his Thursday piece, which you can find below…
Another day, another set of record prices in global equity markets. But trust me, they aren’t doing it with the sole purpose of vexing you. How they are trading is logical and explainable. And I’m not saying that to irritate you either. It’s just that you can’t look at the current valuations and then reread Graham and Dodd in hopes of a simple explanation.
- To make matters worse for those who don’t trust this market, you needn’t be a hopeless optimist, oblivious to geopolitics, overly complacent nor stupid to keep piling on. Even allowing that corrections are, of course, inevitable, you can’t accurately predict when they’re going to happen
- The most simple explanation will also be the least satisfying. The market keeps going up and quant models and passive index funds don’t care why, just that it is. And they choose to or are forced to keep participating. Breadth and volume and all other sorts of arbitrary measures come and go into focus over time. But as factors in a model they eventually get downgraded and become part of the error function. Putting continued emphasis on them is a subjective decision not based on current statistical proof–in today’s world. Models understand what a definition of a trend is, they aren’t at all bothered by measures claiming overly bought or sold levels
- And this is especially important because if there is one additional characteristic that separates this trend from many of those in the past, is it isn’t driven by get-rich quick schemes. Quite the opposite. If it were, many fewer people would suffer such pain every time we go higher. This is classic supply and demand
- Sovereign wealth funds have been gobbling up stocks at an increasing rate. They are classic long-term, buy-and-hold investors. So each quarter when you see their reported equity holdings bulge some more that represents shares not available for you to take off their hands. Add in stock buybacks and comfort with added leverage at these silly interest rate levels and you realize that the percentage of “hot money” to the overall size of the market continues to shrink
- Even if you do think the world is full of bubbles, fund managers have to pick what passes for relative value in this environment. You could talk yourself into believing the equity story whether you hate or love bonds. That’s the beauty of healthy debate. Or fishing for the answer you want. Same for credit. And when charging fees, you have to try to be invested. A phenomenon that is being exacerbated by the shift to passive versus active funds. A rotation that is only accelerating and now, with added regulatory encouragement as MiFID II approaches
- The reality is, you don’t have to like equities to buy them. And that will remain true until it isn’t. For now, beauty is in the eyes of the holder