Passive Investing Not as Benign as Once Thought; Stock Market Crash Could Be Logical Result
Investing in exchange-traded funds (ETF) continues to be a favored strategy for investors. ETFs offer all sorts of advantages over competitor instruments like mutual funds, when it comes to cost, convenience, flexibility, and more. Their popularity keeps soaring, to the point where active portfolio managers might go the way of the dodo bird if trends continue.
But are ETFs as benign as once thought? According to one analyst, the answer is a clear “no,” and risks associated with them threaten to bring on “Stock Market Crash 2017” if the selling turns into a crescendo.
Advertisement
According to Lance Roberts, chief portfolio strategist/economist for Clarity Financial Inc., ETFs are like a financial instrument of mass destruction, making the market “like a tanker of gasoline.” It’s hard to imagine stronger rhetoric being used, but he could have a point. (Source: “Lance Roberts: This Market Is Like A Tanker Of Gasoline,” Peak Prosperity, May 30, 2017.)
In a nutshell, the influx of passive investing in ETFs is creating a “herding” effect, in which stocks of sector leaders are being purchased much more broadly than they otherwise would. This creates a cognitive dissonance between an individual stock’s true intrinsic value, and the actual value due to forced buying.
For example, when investors purchased technology stocks like Apple Inc. (NASDAQ:AAPL) a decade ago, stocks tended to increase or decrease in value based on individual merit. If earnings per share were on the upswing, investors bought a particular name to gain exposure; if the price-earnings ratio (P/E ratio) was suppressed, investors may have added a particular name based on expectations of future valuation expansion.
The key takeaway is that self-directed investors used to be more inclined to purchase individual names based on fundamental or technical considerations. Managed diversification primarily came through mutual fund ownership, which constituted a much larger market share than is the case today.
However, with investors piling into ETFs at record clips, market dynamics are much different today. Trends in so-called “passive investing” or “indexing” are luring people into investing in a top-heavy basket of securities (i.e. ETFs). Top names like Amazon.com, Inc. (NASDAQ:AMZN), Facebook Inc (NASDAQ:FB), and Netflix, Inc. (NASDAQ:NFLX) within technology funds are being bought at much greater volumes than they would as stand-alone assets, due to investors’ insatiable need for diversification. The same can be said for different sector leaders in other industries.
This also means that the droning melt-up seen in equities the past several years is likely being caused by the steady-drip buying seen for passive ETF investors’ strategies. While this itself isn’t a problem, it’s a huge concern because it’s driving up valuation levels much higher than they otherwise would be. Algorithmic program buying tends to skew higher over time and, as long as heavy selling stays at bay, markets keep trending up. It doesn’t matter how illogical and divorced from the fundamentals that stocks are becoming. Passive investor “drip” buying demand through ETFs is likely the straw that stirs the drink, from a buy-side perspective.
Dangerously, the trend shows no sign of abating.
In 2016, for example, only three out of the top 10 actively-traded securities in America were individual stocks. The other seven? You guessed it, ETFs. In lockstep, ETF trading volume was up almost 17% in 2016, after rising 50% in 2015. That’s versus only a seven-percent increase in trading volume from 2014 for individual stocks in the U.S. market. But the kicker: actively managed mutual funds have seen $1.2 trillion in redemptions since 2007, versus $1.4 trillion of net inflows into ETFs. (Source: “ETFs are eating the US stock market,” Financial Times, January 24, 2017.)
We’ve also seen the ETF craze lead to numerous successful “robo advisors” in recent years. These self-directed investment planning platforms have gained traction because of the popularity of ETFs. There are literally millions of accounts with sitting assets waiting to capitulate in a stock market crash. Much of this selling volume will be directed toward shedding ETFs when the time comes.
If you haven’t been attuned to the immense reliance of the ETF passive indexing trend in recent years, you haven’t been paying attention.
A Healthy Correction, or Something Worse?
Whether we see a simple correction or something more sinister is still an open question, since this is the first real ETF bubble that America has experienced. However, in a scenario where strong and persistent selling takes hold, the market could experience a real problem. Picture the slow and steady market melt-up in reverse, except with 10 times the downside force. This is due to forced selling in big-sector ETF leaders as investors withdraw capital, creating a domino effect.
The much-vaunted “stability” ETFs may look much like garden-variety stocks after a bad earnings report. As the old market axiom goes: markets are like escalators on the way up and elevators on the way down. It probably won’t be any different during the next stock market crash just because the ETF is “diversified.”
An even worse scenario envisioned by Roberts could take place in the event of a “gap down.” This happens when securities open the market session lower than the previous day’s close. Since millions of investors are herded into a handful of popular ETFs, when the market breaks, everyone will rush through the tiny exit door at the same time. A vacuum in prices could appear, with ETFs opening at magnitudes of order lower. It is then that Roberts believes there will be “a gap down so sharp and so fast that it not only paralyzes most investors…but then will start triggering margin calls.” (Source: Ibid.)
If you’re not familiar with the carnage that forced selling from margin calls can cause, a stock market crash 1929 primer may be in order. That multi-day selling event was mainly caused by overleveraged investors being forced out of positions as the market cascaded lower. Selling begot more selling in a series of waves that wiped out everyone at the bottom. The market then took a decade to recover.
As it stands today, recent margin debt is near the highest level on record. In April 2017, the margin debt for the New York Stock Exchange securities market was almost $549.2 billion. In April 2007, it was just under $318.0 billion. That ‘s an increase of 72.71% over 10 years! (Source: “Securities market credit,” Nyxdata.com., last accessed June 5, 2017.)
For those who believe that margin debt isn’t a factor, think again. Roberts likens it to a can of gasoline in the middle of a room. It’s perfectly non-dangerous if it isn’t touched, but light a match to it and it’s a different story. The popular ETFs are the can, and investors are the matches. Should the matches be set alight, the market may turn into a blazing inferno before you can do anything to protect yourself. That’s why investors believing they can avoid danger before the true selling starts might be lulled into a false sense of security.
Also, there’s historical precedent to the deleterious effects that higher margin debt has on expected returns. As the chart below shows, New York Stock Exchange bottoms and tops largely jive with the amount of latent margin debt within the system. So much so that the negative 15-year correlation of margin debt versus returns stands at -81.9% from 1995 to 2010.
Again, with more investors concentrated than ever into top-heavy ETF funds, will the historically-low volatility and orderly march upward turn into a waterfall on the other side exacerbated by high margin debt? Time will tell, but it’s something that every prudent investor should be thinking about.
Where Do Valuations Go from Here?
Are stocks overvalued?
Without a shadow of a doubt, especially in this low earnings-growth environment. With the U.S. economic outlook 2017 languishing early in the Trump presidency, from an economic perspective, it’s a case of “new boss, same as the old boss.” The hopes that many Americans had for economic revival—regardless of politics—are slowly exiting stage-left. Partisan bickering and obstructionist politics from all sides are grinding the legislative process to a halt.
This means that things like tax reform, tax cuts, and deficit containment look dead in the water. This is not a recipe for further valuation extension beyond already-historic norms. Given this reality, prudent investors should be challenging the accepted notion that ETFs are well diversified, so they must be safe. This is not untrue, but it doesn’t answer the question of whether ETFs can snap under the weight of immense selling. Most likely, they can.
As such, it’s dangerous to assume that there will always be a buyer one or two percentage points down because ETFs are liquid and diversified. This is the case in 99.9% of the “normal” trading action. But, as recent flash crashes in market indexes have shown (most recently in the iShares Russell 2000 Index (ETF) (NYSEARCA:IWM)), liquidity can turn into illiquidity in the blink of an eye.
In the end, extreme levels of investors herding into ETFs, combined with record levels of margin debt, are an especially bad combination. Some might say it presents a clear and present danger to the health of even a diversified portfolio. Lance Roberts’ warnings will no doubt be ignored by most. But they should at least be acknowledged as a possible outcome in this mad world of bubble economics.
