Inverted Yield Curve and Indexing

I study the markets. I’m no great “student” but I do what I can. I’ve written about the problem of indexing. John Bogel may yet blow us up. Index funds and ETF’s now make up way more than 50% of the market. There are many “Active” investor funds that are closet indexers. The fund may own a big position in indexes (passive) and some single issues (active) and then charge 1.5% on the fees. The point of the fund is the 1.5% fees. The passive part is a Chevy, the active part is the Fuzzy Dice. This means in the main many active funds are passive funds with fuzzy dice and high fees which is why they under perform. Passive indexers like boggleheads like to sneer with the old nannie nannie na na, I’m smarter than you are without understanding why they are smarter. The problem with all this passive index investing is price discovery. An index hides the price. If I own a crappy company that happens to be in the S&P 500 a percent of my price goes up and down based on whether the S&P goes up and down. So my crappy company gets hidden in the weeds. Crappy companies represent excess risk, so by owning and funding the S&P 500 the index risk rises despite the % of crappy companies it owns. You think you are diversifying away risk, but part of that “diversity” is actually masked by inefficient price discovery. The index gets bought month in and month out automatically by indexers despite a rising (or falling) % of crappy companies. This was the case with the FANGS from a few years ago. The FAANG (6 stocks 5 +Microsoft) was 13% of the S&P 500’s return, and 40 stocks were 35% of the S&P’s meteoric return. That means 460 stocks were crappier stocks. Not a knock on them just a knock on the “safety” of the index. If the FAANG rolls over, the index rolls over, so the “diversity” is an illusion. Only 6 stocks control your fate, yet month in and month out you invest in the illusion and sneer at the dopes.

If the market is 70% passive and the price discovery is opaque you are crusin’ for a brusin’ because you can’t tell what’s going on, or at least you don’t try to discover that. The number of stocks positive neutral and negative in an index can be and is tracked, and you can bet those active guys track it and if they see the risk rising they lighten their load. Not the bogglehead however. He just sneers and blindly keeps buying risk oblivious to the real risk because he can’t measure it. Let me give an example.

A cat 5 hurricane is bearing down on my house. It’s 200 miles away. Its track is slated to take it within 47 nautical miles from my house. As of now I’m ground zero, the spot where the hurricane will come closest to the FL coast. My risk is higher than anyone else’s. Yet I sit here today, it’s a little overcast, a nice breeze, the temp is a balmy 84. By tonight the winds will pick up around midnight. By 2 am Wed the storm will be passing by my house headed on up the coast.

Look at the contrast of knowledge by my physical reckoning it’s a nice overcast FL day. By my electronically price discovered reckoning today is not a good day to close on a property (buy some risk). It’s a better day to board up and stay in cash and hunker down. In my case a little bobble in the path can make the difference between 60 mile per hour winds and 150 mph winds. So even though you’re a sneering indexer the opacity of the market can come up and bite you in the patootie when you least expect it. The pro’s know when to risk off you do not until it’s too late. Then you sell low and Buffet eats your lunch.

The yield curve is the precursor of a cyclical down turn. Because of FED policy the yields are low so the curve is flat and like my storm a little bobble causes the signal to flash. Yield curves often invert when shorts over power longs aka shorts are on the rise. In this market the shorts have been constant (more or less), but the longs have been leaving the trade. Equilibrium is based on the difference so an increasing short vs a stable long is one way to flash the signal. The other is a decreasing long vs a stable short. So the later seems to be flashing the signal. The signal none the less represents the market fleeing to quality but where is quality if not in bonds?

The world is rolling over everybody is in hock up to their eyeballs. Corporate debt is BBB and high, very high. Government debt is through the roof and inflation is low despite zero rates for 7 years, money printing and low unemployment. Pensions are underfunded and baby boomers are retiring NOW. Under water pensions therefore must buy more risk. Millennials went and bought gender studies degrees and beer belly’s on high interest non forgivable loans so all their money is slaved to greedy universities delighted to pick their pockets. With inflation comes debt relief. You “grow your way out of it” It’s the governments secret weapon and they could care less if gas prices go to 10 bux a gallon. Millennials would like that too, pay off their loans with cheaper dollars. Pensions funds would like that too pay off those damn boomers in cheaper dollars. Deflation however does the opposite. Deflation makes the dollar more dear and debt more expensive. You have to pay off your debt with more expensive dollars than you had yesterday, and of course those dollars have to come from somewhere either a job, or somewhere. So I think that’s where the longs are going, out of risk, all risk. Expensive stock risk, expensive bond risk, expensive debt risk, expensive unemployment risk, and into money. If dollars are going to be more dear the conclusion is clear own dollars. Everybody and their brother has been gorging on risk, seeking return while sneering at the consequence and putting on blinders to hide the probabilities. Just keep buying those low cost index funds and sneering your ass off. Why hell you read it on the internet. Money Mustache and Taylor Larimore laid out the road to perdition using St John’s good name. Freaky baby freaky.

I know, I know, this time it’s different. Now sing me the narrative “invest in low cost index funds and never ever sell…”

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PS Today I read an article on Bloomberg by Michael Burry, who successfully shorted the CDO fiasco in 2008. His analysis on index funds is similar to mine in terms of price discovery and market distortion.

8 Replies to “Inverted Yield Curve and Indexing”

  1. It is wild that two contrarian posts are published on the same day (White Coat extolling the stock market and you with the opposite view).

    Personally I have tried to hedge my bets and put my toes in various asset classes. I agree deflation is much more sinister than inflation but is rarely talked about.

    Hope the hurricane misses your place and you stay safe.

    1. It’s all in the time frame, for the next 20 minutes the market will do fine. Actually the trend is still up (barely) so it’s still reasonable to call it a bull. Hedging is good I bought more BTC it’s up 5.1% on a holiday! Hedging IS good. Right now the hurricane wind field will pass 15 miles east of my house so I’ll get strong tropical storm winds unless things change

  2. I follow the argument, and read the Burry article. Hazards are obviously there.

    I agree the mean reversion will come (as to when, my crystal ball is as cloudy as the next person’s). Provided the funds are not needed in the coming decade, I wonder if the indexing approach still has some utility, even factoring in the risk you so aptly describe.

    I invested my first retirement contribution as an intern in an S&P 500 index fund on my dad’s recommendation (blind leading the blind at the time) – it was July 1999. Kept plowing in contributions, small though they might be, for the next decade in my oblivious worker bee enthusiasm.

    First time I looked at my performance was a decade later, which was good considering that was a lost decade for the S&P 500. Head back in the water, kept swimming and contributing. Following decade looked up, now had my guy at Merrill so risk was better diversified but with some excess loads and fees. Pulled out cash for a downpayment on a home in 2007 – better lucky than smart.

    Then head back down and swimming for another decade, again kept plowing in contributions. Bull market was a reprise of better lucky than smart, with a newfound interest in finance ~2015 in assuming control of my finances and breaking up with my guy at Merrill.

    I see the value in taking some winnings off the table. Just as you’ve been promoting, a financially savvy cousin planted the indexing risk seed in my mind some years ago.

    I still think indexing is a decent and low-complexity strategy for many, not due to FIRE hubris as much as (apologies to Churchill) because, akin to democracy, it is the worst form of investing…except for all the others. I think of your 2 fund 60/40 of the EF as one fine example.

    Indexing, orchestrating a portfolio of uncorrelated assets, and aligning it along the efficient frontier could still potentially meet your platonic ideal of parsimony.

    I guess I still hang onto some hope for indexing (and the FI crowd), but considering you a trusted mentor, I’m trying to reconcile the divide.

    Am I just overly naive, my friend?

    1. The problem of indexing is one of scale. When you own 3600 stocks there is no price discovery. You have no idea if what you own is good or bad. The FANGS are the prime example 6 stocks out of 500 account for 13% of market gain and 40 stocks out of 500 account for 1/3 of market gain. That is a hidden concentration of risk. It’s like walking an a frozen river. If you walk where the current is not the ice is thick. If you walk where the current is, wear a life preserver but the whole river looks frozen. The risk is not uniform but looks uniform. In some respect then indexing is a momentum play. Since you can’t discover price you keep riding the behemoth hoping for the best. As more and more of the winners fail eventually all 500 fail as a unit. When certain levels are breached the robots come in and go from long or neutral to short, in the mean time you’re sitting there holding your ass in your hands hoping the buzz saw doesn’t slice you up. Also you have to consider size of funds relative to the markets. Indexing now represents more than 50% of the market which makes it a really crowded trade compared to 10 years ago.

      The other problem is stocks are a mirage. With cheap money corps have borrowed cheap, bought back shares which raised stock price without a concomitant rise in productivity to account for price appreciation. I read 19% of the present S&P is smoke from stock buy back. The S&P today is 2975 as I write this. A 19% discount would be 2409, a drop of 565 points. The credit that backs that S&P is BBB 1 step above junk and a lot of pensions and such can’t own junk. There is 3 trillion of BBB credit and the junk market is 1 trillion and is unable to absorb 3 trillion or even 1 trillion. If you need to sell and nobody to buy you sell for pennies on the dollar. This is why the market goes nuts when the fed tries to raise rates. Corporate debt is teetering on the edge.

      Pensions are way underfunded like 33% which means they need yield to survive. It’s the same as retiring at 30 on 1M and expecting that to generate 40K for 60 years. To get that math to work out you also need yield. So an underfunded pension is like an underfunded retirement. bad juju. Boomers are retiring calling for their pension dough NOW, so that’s sequence of return risk and you know what SORR does to an underfunded retirement. In addition retired boomers don’t spend money so the economy doesn’t get stimulated. We live in this fantasy of travel and luxury disguised as “frugality”, like generating bonus points are somehow free. Look in the garage at the pile of crap you accumulated to get those free tix. Lower spending and pension failure is destined to smash GDP which means some companies are going out of business and some jobs are going away a further hit on GDP. This can play out slowly or quickly. It can play out starting tomorrow or in a couple years.

      The US is in slightly better shape than Japan Korea or EU. Those countries are aging and won’t be able to replace workers without drastic social destruction. Since the US is built on the concept of immigration (but not illegal immigration) the US can maintain some slow steady growth. So I think the 2 fund is OK, I think adding some cash to the mix is OK, adding a little gold is OK and limiting equity risk by reducing size is OK. Greed kills. My portfolio is a bet on just what you suggest. I have a few more classes like a few percent of EM and BTC all on the efficient frontier.

      The caveat is if GDP continues to under-perform I would expect porfolio’s to under perform. In addition I would expect the low volatility we have experienced in the last decade to become higher to high. It’s going to be a bumpier ride and a longer glide path IMHO. For DIY investing for good or for bad it’s a variation of a 2 fund or set of more on the efficient frontier is pretty much what we have. People think they are bulletproof. I think one can become bulletproof but that’s all about risk mitigation, things like diversity, shorter retirement horizon, smaller WR, planning for health care and disaster expenses things like that.

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