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…”
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.