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Passive Investing is the Flavour of the day – Central banks entered the markets to provide a feedback loop

  1. Central banks Trying to create the wealth effect – Bernanke’s easy money policy was intended to boost economic growth by boosting shares as well – November 2010 he argued: “Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
  2. Think of a financial market as a forest – Aus seen some fires recently – arson can be a cause – but if the Greens won’t let burn offs, then throw fertilizers around and forests grow out of control – enter a dry period – small spark leads to massive fire that can destroy everything in its path –
    1. Tell-tale sign – lower volatility and the unprecedented magnitude of Central Banks’ interference in markets
    2. Peak Quantitative Easing – never before this high: $300bn+ monthly asset purchases, or annualized passive flows for $3.7trn globally – the ensuing rising mania for passive investment vehicles: the tulips of ETFs and passive


Where has a lot of the money has been going?

  1. Index funds, Risk Parity funds – two-thirds of which are trend-chasing – close to $8trn globally
    • the ensuing capitulation of active investors who default to chase passive ones, as they fall prey to mental loops like ‘recency bias’ and ‘induction trap’
    • The Positive Feedback Loop between Fake Markets and investors creates System Instability, and Divergence from Equilibrium

Many fashionable investment strategies these days are based on the easiest option – ETFs

Creates a feedback loop – they successfully profit from an artificial set of variables – people buying ETFs pushes the market up – derives an artificial signal of future prices movements –  

  1. In circular reference, artificial markets feed, and are fed, by a crowding effect in high-beta long-bias in disguise.
  2. However – a downturn, they may likely play as hot money or weak-hands, exacerbating a down-move
    1. 90% of inflows are passive strategies – creating a bubble in some companies over others – if it is in the index, it is bought regardless of if it should be or not
    2. Weak hands are investors who are brought to like an investments by certain characteristics which are uncommon to the specific investment itself, such as its featuring a low volatility, diversification, and liquidity


ETFs – their meteoritic rise – ETFs oftentimes oversell liquidity and diversification, attracting swathes of unaware, unfitting investors in the process.

  1. Investors who are unlikely to stomach bouts of volatility, and who will likely exit prematurely upon them, thus exacerbating volatility. Furthermore, a growing body of research blames ETFs for reducing markets efficiency, creating stock markets that are both ‘mindless’ and too expensive.
  2. ETFs themselves represent a great financial innovation – became popular after 2009 in AUs – What one must consider though, is their implications for price discovery (do they make bubble/bust cycles more extreme?), liquidity (is liquidity overstated?), market responsiveness (is volatility depressed but tail risks – extreme drops – bigger?).
    • Specifically to this market cycle, it is also worth asking what happens when the liquidity tide turns on QE ending, or when markets dive.
  3. Until then, the positive feedback loop implies that markets are helped rising by ETFs themselves, who are then rewarded with further inflows with which they can buy more. The more expensive valuations get, the more they disconnect from fundamentals, the more divergence from equilibrium occurs, the larger fat-tail risks become.
  4. To protect fees and in a bid for survival, many active investors capitulated and started pricing risk out of portfolios. A higher-beta, longer-bias ensued. As they are still rationally sensitive to valuations and risks in the macro outlook, they stand ready to switch when the moment comes.


The current state of markets – Twin Bubble – thanks to Quantitative Easing – The major risk is central bank tightening

  1. Twin Bubble – Bonds and Shares simultaneously- Markets have forgotten how much of current valuation is due to Quantitative Easing – around a time over the next few years QE in the US may be phased out
    1. The episode on bonds v shares – https://financeandfury.com.au/bullish-shares-versus-bearish-bonds-which-one-is-correct/
  2. The ‘wealth effect’ failed – Printing money – making people feel rich and spend more – QE did not spur consumer spending, corporate profits, real wages, and inflation
    1. But did for financial assets – hard asset pricing in house and shares
    2. QE for risky assets: the liquidity tsunami that lifts all boats
    3. Central Banks, differently than in the past, may be less keen to save the day for financial markets, or less keen to do so for mild sell-offs (within -20%). They may even use a weaker stock market as a top-down rebalancing act. Market participants believing that Central Banks have their back may be mistaken.
  3. Biggest assets that have been risen – property and Passive/Index ETFs
  4. ‘Fake Markets’ are defined as markets where the magnitude and duration of artificial flows from global Central Banks or passive investment vehicles managed to overwhelm and narcotize data-dependency and macro factors. Artificial money flows.
    1. Central Banks flows, we live through Peak QE this year -> Passive Vehicles trade on Central Banks flows, outperforming active managers in the process -> More inflows for passive vehicles (mania) -> Active managers capitulating and joining in -> Retail joining in. All around, fitting economic narratives are formed to justify the dynamics of artificial markets: chasing yield (financial repression) -> chasing growth -> chasing earnings.
    2. If QE is the sea all around town, QE Tapering or Quantitative Tightening (‘normalisation’) is like navigating the sea towards the horizon. We know how that ends. We know it ends.

The Positive Feedback Loop between Fake Markets and Investors creates System Instability and Divergence from Equilibrium

  1. Central Banks flows, markets are helped rise by certain classes of investors, which are then rewarded with further inflows, with which they can then buy more. The more expensive valuations get, the more they disconnect from fundamentals, the more divergence from equilibrium occurs, the larger fat-tail risks become.
  2. Many fashionable investment strategies these days are not un-contingent to the Fake Markets they operate within: ETFs – they successfully profit from an artificial set of variables, they cannot but derive as artificial a signal from it, and are bound to a life-cycle which is no longer, no shorter than the life-cycle of the Fake Markets themselves.
    • Markets and investors then enter into a positive feedback loop, which increases the system instability, no different than what happens for positive feedback loops in cybernetics, chemistry, biology. The day artificial markets end, we can assume a reasonable chance that some or all of such strategies will face rough waves, and exacerbate a market downfall in the process.
  3. Take an upward trending market in low and decreasing volatility, as passive flows from Central Banks progressively crowd out active ones and interfere with price discovery.
    • Price Discovery in markets is from active decisions to buy or sell based around company fundamentals – if everyone is buying the index – all companies in the index rise
    • A long-bias on risky assets is a winner, so long that a major Central Bank commits to bail them out endlessly and supports them every single week with hard cash. A short-bias on volatility is also a sure winner, so long as such passive flows are sustained for.
  4. Crowding effect of high-beta long-bias in markets these days, hidden in plain sight. As this bias is both passive and not presented as a long-only investment, we can safely assume for it to be comparable to ‘hot money’ flows and ‘weak hands’. When the tide turns, it will move along fast, helping markets overshoot.

Liquidity – two-fold

  1. Passive investors have no cash buffers
  2. Cumulative flows into passive investments – selling ETFs very hard – Finding a seller

Signs of complacency and disconnect from fundamentals abound. So to sanity check, it may still be helpful to periodically remind ourselves of a few recent ones. In no particular order:

  • Argentina uses defaults as a recurrent macro-prudential policy, to tackle debt overloads from time to time. Most recently in 2014, 2001, 1989. Yet, this year, the country issued a 100-year bond for 7.9% yield. Red-hot demand. It was oversubscribed 3.5x.
    • Similar levels of complacency and expensiveness are not uncommon in financial history. Amongst others, 1999 and 2007 come to mind, where expensive valuations match raced with low levels of realised volatility. In both instances, complacency was breeding an unstable market environment, where gap risks eventually materialised.
    • Across financial history, complacency and Zero Volatility bring about expensive valuations. In terms of Price/Earnings multiples (Shiller CAPE, adjusted for the cycle and inflation over a 10-year period), the US equity market is only cheaper than the markets of 1929 and 2000: in both instances, large downside loomed ahead.
    • The Bank of Japan now owns almost 75% of the entire Japanese ETF equity market. As a result, the BoJ will likely be the major shareholder in 55 companies by the end of 2017 – To entrench firm buy-the-dip reflex in the investment community (and their algos), “the BOJ’s ETF purchases help provide resistance to selling pressure against Japanese stocks,” says Rieko Otsuka of the Mizuho Research Institute
    • The Swiss National Bank bought $100bn between US and European stocks. It now owns 26 million Microsoft shares (read).
    • Leverage to buy stocks at the NYSE (margin debt) hit an all-time record of $549bn this year – doubled up since 2009.

Easy monetary policy and bubble valuation in risky assets may similarly be at their endgame. A few more moves are left possible, but the degrees of freedom imploded, all the while as system pressures mounted on fragile markets.


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