Complacency is our enemy

There is no doubt the ETF wave of popularity is creating a self-perpetuating dangerous and ‘unknown’ quantity with repercussions yet to be fully understood or played out. In my blog over recent months I refer to the many issues surrounding this ETF phenomenon taking hold of investors.

‘Passive investing is in danger of devouring capitalism’ – Paul Singer, Elliot Management.

‘ETF’s turn market into the ultimate Ponzi scheme’ – Alan Kohler

Two powerful statements from knowledgeable men that strike at the core of our stock market and its reason for being. Paul Singer added ‘what may have been a clever idea in its infancy has grown into a blob which is destructive to the growth creating prospects of free market capitalism.’

And again from Alan Kohler, ‘When the history of the next market collapse is rritten ETF’s are likely to figure prominently.’

Then from Howard Marks co-founder of Oaktree Capital ‘When management of assets is on autopilot, as it is with ETF’s, then investment trends can go to great excess’ He cautioned that ETF’s promise of liquidity has yet to be tested in a major bear market. “It is not clear where ETF’s and index mutual funds will find buyers for their holdings if they have to sell in a crunch.

The unknown quantity of ETF’s allows regulators to disown responsibility for what inevitably will happen when the potentially disastrous domino effect drags down many good stock prices just as now it pulls up many average stocks to well above their justified value. As we roll on without questioning this ETF issue we move ever closer to a 2007 disaster where regulators then failed to understand the CDO craze. When a financial product causes stocks to be priced on money flows (in and out of an index ETF product) rather than on specfic stock’s fundamental valuations then there will be trouble on the horizon and even of more concern is Paul Singer’s statement above. Passive investing threatens the efficent functioning of the market and may lead to more distrust of an essential capital raising vehicle which is for what the stock market was originally created.

There seems to be a very dangerous market complacency developing. Here are some figures for you which have been supercharged by manipulation, through interest rate and quantative easing, of asset prices by governments worldwide. The ETF market has exploded in size with more than $4tn in assets under management and $3tn in the US alone. The growth of quantitative and passive strategies now account for some 60% of US equity asset management up from 30% a decade ago according to ETFGI a London based consultancy.

But let’s not ignore the opinions of the providers. Martin Small head of US IShares said “suggestions that ETF’s are driving up the stock market or hindering efficient price discovery is fundamentally wrong and not supported by the data. ETF’s were having a profoundly positive impact, helping many more retail investors gain access to robust low-cost investment portfolio’s”. And that is of course true but whether that proves to be a good thing or not will be truly tested in the next market correction.

There is an amazing complacency in the EFT market that everything will be all right. This is the dangerous comfort investors favour until things go wrong which as history tells they inevitably will when a bubble such as the ETF one explodes. It is too big to ignore as the figures above suggest. Also characterising this danger is the proliferation of new products such as the inverse VIX. This is now the 34^th most traded ETF and eclipses volumes in stocks such as Chevron and Pfizer. Shouldn’t this ring warning bells?

Complacency is also showing up in the heavy skew towards the FAANG stocks as they pile higher and higher, stretching valuations without generating profits or returns to investors apart from this never ending growth spiral. This is something we know can’t continue and no its not “different this time”. This is not dissimilar to the race for market share that bred the Internet bust. We can also point to the charts of the Dow Jones, the S&P 500 and the NASDAQ. I have never seen anything like it. The straight line appreciation confirms a sustained money flow ‘effect’ rather than the natural ebb and flows of changing stock market valuations driven by the natural discourse of ideas and opinions.

The Stockradar approach is to deal with any market situation as it arises by being alert and vigilant and always understanding where and when you need to protect a position.