“I am no longer looking for a sentiment correction. We have now had a near-war and a potential global pandemic”, Kevin Muir, of Macro Tourist fame, sighed last week. “Heck, half of Asia is holed up in their apartments, and yet the American stock market keeps blasting higher”.
It sure does, Kev. It sure does.
In fact, US equities hit new records on the benchmarks last week, even as the virus headlines finally managed to sap some of the joie de vivre on Friday. It was, ultimately, a great week for stocks.
The bottom pane is deliberately understated – a minimalist work that might carry the ironic title “Pullback”.
This is the kind of thing that drives some traders and active managers to the brink of drinking binges. How to do you outperform benchmarks that rise in perpetuity come hell, pandemics or high-tariffs? And what do you do when the vehicles available to track those benchmarks charge what might as well be nothing in fees? Zero commissions to buy those vehicles are just insult to injury – the final bit of salt rubbed in the wounds of active management.
On an admittedly simplistic assessment using HFRI data, equity hedge funds have underperformed for a decade, with 2019 marking a year nearly as bad as 2013, the last time the S&P rose some 30%.
Regular readers know I am squarely in the camp that believes you can always have “too much” of a good thing, and we may well be approaching that threshold with passive investing.
Index ETFs almost by definition encourage herding and indiscriminate buying. It stands to reason that if the buying is indiscriminate on the way up, the selling will be similarly indiscriminate on the way down. Indiscriminate capital allocation invariably leads to misallocated capital. It also encourages mindless participation in markets and discourages stock- and sector-level analysis.
And please, spare me your efforts to extoll the virtues of indexing. That indexing is the best thing since sliced bread isn’t up for debate. It is objectively the best way to invest for the vast majority of the investing public. But that does not mean that ever more passive investing is desirable. After all, if the entire market were to ever be comprised solely of passive flows and indexing, the market would cease to function.
I bring this up now because, while it’s always a sore spot for those who pine away for the swashbuckling days of yore (when stock pickers and super star fund managers lorded it over the clueless masses whose access to capital markets was restricted by fee-charging gate keepers), it’s even more vexing for those folks during times like these, when equities press to new highs even as headlines warn of global military conflagrations and pandemics.
Consider this quote from Michael O’Rourke, JonesTrading’s chief market strategist:
The passive flows are set on a schedule the way they come in. They create this underlying bid to the tape that is just there. They don’t care if they buy the market at 10-times earnings, 20-times earnings, 30-times earnings, 50-times earnings.
He is, of course, correct. And passive flows are a key cog in what Howard Marks famously described as a “perpetual motion machine”. Recall these passages from a 2017 Oaktree memo:
The large positions occupied by the top recent performers – with their swollen market caps – mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise. Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced.
Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever. If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold. It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch. In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual.
Again: This kind of analysis is objectively correct. And the idea that ETFs and passive flows have “zombified” the market does have merit.
But, as Bloomberg’s Sarah Ponczek wrote Sunday, “such tales are spun anytime the market shakes off bad news… and whatever happens in markets, someone will say it’s bad, and someone will blame ETFs”.
As active managers continue to struggle, a measure of comovement has risen at the briskest pace since the selloff in late 2018 (see the rise of the purple line in the bottom pane).
Interpretations will vary depending on who you ask. One line of thinking is that passive flows contribute to herd behavior during times of turmoil, and that, eventually, we’ll all come to ruin because of it.
But, however you interpret it, the recent rise in correlations is just one more thing for the active community to be irritated about. As Ponczek goes on to note, “that companies are moving together in the middle of an earnings season, a time when stock pickers theoretically gain an edge, is even more disconcerting for those that have lagged behind”.
There’s still hope for active managers, though. As one Twitter follower put it on Sunday, the tide could turn back in favor of the stock pickers during “the f**king next bear market”.