Two inexorable, price insensitive bids have propped up risk assets for a long, long time. In some cases, for longer than this or that newcomer’s entire professional career.
QE and accommodative monetary policy more generally have created a scenario where the mad dash down the quality ladder (which is part and parcel of the hunt for yield) has left everything but the dodgiest of credits priced to perfection. Meanwhile, the corporate bid for stocks in the U.S. is the real “plunge protection team” – no conspiracy theories necessary there, unless of course you count the fact that when management’s compensation packages are equity-linked, the decision to leverage the balance sheet in pursuit of bottom line beats looks rather myopic and incestuous, if not outright nefarious.
That combination – two price insensitive bids – has triumphed over geopolitical risk for years on end as markets digested Brexit, Trump, and all other manifestations of populism with relative alacrity, comforted by the notion that as long as global growth could be conceptualized as “synchronous” and as long as DM inflation could be fairly described as “still subdued”, the ubiquitous “Goldilocks” narrative was intact. Because “Goldilocks” underpinned the low vol. regime and because that low vol. regime had begun to optimize around itself thanks to i) the two-way communication loop between markets and central bankers, and ii) a series of self-feeding dynamics that reinforced local stability, markets seemed to exist in a vacuum, oblivious to exogenous shocks.
Operating alongside all of that was the epochal active-to-passive shift, facilitated as it is by the rampant proliferation of ETFs. There’s a sense in which that creates its own self-feeding loop. It’s worth quoting Howard Marks at length here (from a note out last summer):
The low fees and expenses that make passive investments attractive mean their organizers have to emphasize scale. To earn higher fees than index funds and achieve profitable scale, ETF sponsors have been turning to “smarter,” not-exactly-passive vehicles. Thus ETFs have been organized to meet (or create) demand for funds in specialized areas such as various stock categories (value or growth), stock characteristics (low volatility or high quality), types of companies, or geographies. There are passive ETFs for people who want growth, value, high quality, low volatility and momentum. Going to the extreme, investors now can choose from funds that invest passively in companies that have gender-diverse senior management, practice “biblically responsible investing,” or focus on medical marijuana, solutions to obesity, serving millennials, and whiskey and spirits.
But what does “passive” mean when a vehicle’s focus is so narrowly defined? Each deviation from the broad indices introduces definitional issues and non-passive, discretionary decisions. Passive funds that emphasize stocks reflecting specific factors are called “smart-beta funds,” but who can say the people setting their selection rules are any smarter than the active managers who are so disrespected these days? Bregman calls this “semantic investing,” meaning stocks are chosen on the basis of labels, not quantitative analysis. There are no absolute standards for which stocks represent many of the characteristics listed above.
Importantly, organizers wanting their “smart” products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks. For example, having Apple in your ETF allows it to get really big. Thus Apple is included today in ETFs emphasizing tech, growth, value, momentum, large-caps, high quality, low volatility, dividends, and leverage.
The large positions occupied by the top recent performers – with their swollen market caps – mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise. Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced.
Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever. If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold. It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch. In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual.
In the same vein, Wells Fargo has described passive as akin to “QE for equities” (there is of course a kind of second derivative of this in Japan, where the BoJ buys ETFs – it’s literal QE acting in concert with the fact that passive itself is akin to QE – it’s QE squared). Here’s what Wells said back in October:
First and foremost, we believe the ripple effects resulting from the aggressive move towards Passive equity investing are beginning to resemble the footprint left by QE.
With QE, the Fed removed from circulation a material part of the Treasury market (by our calculations over 20% at the peak). The decreased Treasury ‘float’ as well as the reduction in the amount of natural sellers (with the reduced float) coincided with the general upward trend in Treasury prices or lower yields. Read: Scarcity value and Fed front running.
Currently, the shift to Passive is coinciding with ever higher equity prices with many equity indices trading at or close to all-time highs. As QE seemed to exaggerate trends in the fixed income markets, so it appears that Passive equity flows are exaggerating stock movements.
Recently we’ve observed consistent net inflows to Passive Equity funds, which have morphed into a type of Black Hole. Money goes in and stocks never come out (as least for now).
That puts active managers in a tough spot. Essentially, you’re trying to beat benchmarks that, by virtue of the dynamics outlined above, only go up. You’re handicapped by the relatively higher fees you’re charging and so, the only option is to simply ride the wave – you buy the most popular stocks and hold onto those fuckers. Wells described this as follows:
Clients have said repeatedly that any time they’ve sold or tried to reposition in the last 3, 6, or 12 months, they’ve come to regret it. To fix this issue, they’ve decided to all together stop, or dramatically slow, their selling and it’s worked—relative performance continues to improve.
Right. And that mentality probably helps to explain why hedge fund turnover in the largest positions has hit near record lows according to Goldman and refused to budge even in Q4 when the tax bill seemed to suggest that it was time to rotate away from some of the most popular stocks into names that might benefit more from tax reform (click to enlarge).
And you know what those positions are, right? If not, here’s a hint (click to enlarge):
See any familiar names in there?
So I guess the question now is what if all of this is changing? We know that the central bank bid is fading (both the “stock” and the “flow” of global QE are in decline) and with the reset higher in equity vol., it could very well be that one of the self-feeding loops that inoculated markets from geopolitical risk in 2016 and 2017 is reversing on itself.
Meanwhile, the “Goldilocks” narrative that underpinned the low vol. regime in 2017 seems to be under siege. The threat of a global trade war could undercut the synchronous growth narrative while expansionary fiscal policy (and in the U.S., late cycle expansionary fiscal policy) could end up triggering just the kind of inflation shock that was at the top of everyone’s “tail risk” lists headed into 2018.
As far as the ETF/passive “perpetual motion machine” (to quote Marks again) is concerned, one wonders if the regulatory backlash could end up materially hurting some of the companies that everyone assumed were for all intents and purposes invulnerable by virtue of their role in shaping the future of humanity. In other words, the stocks that are at the center of the perpetual motion machine.
“Events in the large cap tech world could have long-term ramifications that change all sorts of attitudes and policies,” former trader Richard Breslow wrote for Bloomberg on Wednesday. Tuesday was a bloodbath for tech and for FANG especially. The FANG+ index is teetering at what looks like an important level (if you’re into lines):
If you look at the QQQ flows data of late, what you’ll discover is that it’s starting to resemble “hot money” – in theory, that kind of action could exacerbate price swings, in a manifestation of what Marks warned about last year. The more ETFs these stocks are embedded in, the more likely that is to play out.
What all of this seems to suggest is that everything we’ve grown accustomed to could be subject to change over the next six to 12 months. That needn’t be a bad thing if you’re used to two-way markets, but given that a lot of the folks manning the desks these days were likely in high school when Lehman collapsed, I’m not entirely sure the world is ready.
Bull hell, there’s always Kuroda, right?