How strong is the relationship between the consistent new highs being set by the US stock market and the huge ETF inflows?

As we know from previous commentary in the Radar Newsletter there is an ETF ‘force’ that is causing stocks to be elevated to levels that that are artificially, abnormally and dangerously higher than the market would normally take them. This significantly heightens downside risk.

To answer the question posed requires some heavy number crunching to match a stocks performance with its current price levels. Current price levels are to a large degree supported by sentiment, EPS and sales growth especially in the very ‘rich’ area of technology i.e. the FANG stocks. How much of their elevated price levels are to do with the fundamentals and how much is caused by the ETF ‘forces’ is hard to determine but what we do know is that the huge inflows into the passive ETF market are having an effect. So the ‘how much’ is hard to determine but the fact is that it is happening and if you hold an ETF you are exposed.

It is interesting that the US market, which is 30% of world markets and has the majority of ETF’s, is far and above exceeding the performance of every stock market in the world. The current up trend has been unusually ‘steady’. Is the US economy that good? I wonder, or is it accelerated by the ‘ETF effect’?

Without knowing the exact answer we are aware of its factual nature and thus as investors we need to understand what it means to us and what will be the effect should the market take a turn for the worse. At some stage it will so where does that leave us and how can we protect ourselves. As an ETF holder we can’t unless we sell and that leaves us neutral on the market. It’s an all or nothing approach.

If we observe retail behaviour in the last market decline of significance it was one of an overriding fear effect and in that case all reason was swept aside in the name of perceived survival. We can thus expect capital repatriation to occur and the ‘magnifier’ effect of the upside is likely to occur on the downside too. It could get messy.

The important point here is not to panic nor take this as a sell signal but to be aware of the potential effect while still riding the waves of strength. We can either be in the ETF market (passive) or in specific stocks (active). The effect will be on both but the specific stock approach can be managed far more effectively. So what has been perceived as a great low cost way of accessing a rising stock market judging by the enormous growth of ETF’s has its own shortcomings and ignores the peril of a market down swing.

What do we know about ETF’s?

Firstly they can never give you outperformance and stock market averages can also drop. When they do, passive investors will ride their indexes or baskets down just as they rode them up. An actively managed fund, by contrast, puts thought and attention into 1) protecting against downside and 2) choosing stocks that have the best chance of going up, regardless of where they are in an index.

My tip: Ride the waves higher but watch your stock specific stops and you’ll be safe.

The purpose of this article is to offer you proactive awareness rather than be reactively discussing the problem once the market horse has bolted. ETF’s are low cost for a reason.