MAN vs. MACHINE

Too much liquidity, too much technology, too much complacency.

Barron’s had a fascinating article this week regarding passive index/ETF investing. It’s simple. Give your money to the fund manager, pay a small fee and forget about it. The computer does the rest while you play golf or sail around on your yacht. No problem. Stocks keep rising as more investors keep piling their cash into passive and quantitative investment funds. On a related note, Federal Reserve Chairwoman Janet Yellen just said on June 27th another financial crisis is unlikely in our lifetime. That’s quite a remarkable statement coming from what Jim Cramer calls “a PhD who doesn’t know how the markets work and has never bought or sold more than a savings bond in her life.”

In the article Barron’s writes “We still call it a stock market, but these days it has many more indexes than it does stocks: There are nearly 6,000 indexes today, up from fewer than 1,000 a decade ago. Meanwhile, the number of stocks in the Wilshire 5000 Total Market Index has shriveled to 3,599, from 7,562 in 1998. The exchange-traded-fund industry has been enthusiastically churning out new products and the burdens of public listings and easier access to private capital has shrunk the available number of stocks. When money pours in, passive funds must buy stocks in the same proportion as the indexes they track—with no regard for stock price or fundamental valuation. Therein lies the conundrum: Indexing works because it can piggyback on the wisdom of the crowd, but its very rise shrinks the crowd whose decisions help make the market.”

Our friend and bond broker extraordinaire, Chris White of Cantella and Co in Boston, had some very poignant observations about this Barron’s article, the Fed and liquidity. He says, “We are seeing massive inflows into Passive funds vs. outflows of Active funds. The argument, which is somewhat circular, is as follows: Central banks have pumped so much liquidity into the market place that volatility has been crushed. Lack of volatility has caused Passive managers to outperform Active managers. Passive managers buy their respective indices when they get funds, not discriminating about values of what they buy. This works as long as Central banks continue to pump funds into the market place. Despite the Fed raising Rates and the ECB talking about tapering we have not seen a reversal of flows…….YET…..What will happen to this paradigm when the outlook changes from Central banks supporting the markets? We will see a draining of liquidity, volatility will increase and Passive funds start to underperform and then will we see a reversal of tactics? Here are some things to think about: Global stocks have added 10 trillion in value the last year from 66 trillion to 76 trillion, or around 15%. Money funds assets have fallen below the lows of 2000 and 2007. Margin debt is increasing. Assets in low volatility ETFs have increased at 150% annual rate since 2009. This one is wild! Vanguard owns over 5% or more of the 491 companies out of the S+P 500. Per JP Morgan, only 10% of trading volume originates from fundamental discretionary traders.

Even JPMorgan Chase CEO Jamie Dimon had some seasoned observations about the current state of affairs from a conference in Paris last week.

Bloomberg quotes him as saying “We’ve never had QE like this before, we’ve never had unwinding like this before.”

“Obviously that should say something to you about the risk that might mean, because we’ve never lived with it before.”

“When [the unwind] happens of size or substance, it could be a little more disruptive than people think.”

“We act like we know exactly how it’s going to happen and we don’t.”

Dimon finalized his comments by saying “That is a very different world you have to operate in, that’s a big change in the tide, the tide is going out.”

Today, major stock indices are at lifetime highs, money continues to pour into stocks at an increasing rate and the Fed is stuck with trying to figure their way out of this epic bubble they created with — the Great Unwind.

This surge in momentum and asset valuations could all end with a reversal in ten minutes, days, months, or years. Then again we could be looking at Dow 30,000 in the next year or two.

So, since the Federal Reserve Chairwoman from Bay Ridge, Brooklyn says another financial crisis is “unlikely in our lifetime” and passive funds keep buying stocks without regard to price or valuation, the “Great Unwind” may never happen. Right?

Have a safe and prosperous summer!

J. Brock Hamilton
July 14, 2017