How The American Stock Market Ends…

Passive Investing has gotten to the point where concentration in the S&P 500’s top stocks has hit a level of pure insanity. When liquidity dries up, these big names will go boom.
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 We’ve been discussing the nonstop surge in NVIDIA () and other Magnificent Seven stocks., Passive Investing started as a simple idea to replicate the performance of the S&P 500 with the S&P 500 Select ETF ().However, the practice accelerated into a price-agnostic business model that distorts market behavior into a perilous condition.Today, companies like Blackrock, State Street, and Soros Management buy up shares of public companies based on themes, sectors, and other possible strategies.They sell these Exchange Traded Funds and passive funds to pensions, endowments, and other investors based on whatever their mandates require.They don’t care if the stocks go up or down, left or right.They then loan the outstanding shares to short sellers, who gamble on price action. The passive investment funds get a management fee (called an expense ratio) and keep the voting rights of whatever shares they own.Meanwhile, other ETF managers have abandoned thematic approaches or strategies.A faith-based services advisor launched a thematic, active fund in 2016.It was, more or less, an active ETF strategy built around “Catholic values” to be sold to endowments, etc.

After underperformance and to justify their fees, the managers spent $750 million to create the hilariously named Global X S&P 500 Catholic Values ETF ().

It’s just a replication of the SPY’s top 10—less one stock—and very soon, they’ll need to buy more NVIDIA to change the weight of their holdings.
           
Everyone’s doing this… mainly because they are trying to replicate their benchmark – and don’t care about price sensitivity when they rebalance. 

Notes from Carlos
 I recently noticed another person expounding on the rise of passive investing and what is now inevitable in this market.  Carles Iborra is an MIT finance expert with two decades of experience in wealth management. For years, he’s been sounding the alarm on passive investing and this phenomenon with mega-cap stocks. He posted this chart earlier this week. You’ll note that October 12, 2022, is the bottom of the recent liquidity cycle. What happened next?            Passive investing mixed with massive flows into those top stocks… that’s what. Iborra writes: 

In a market where passive investing will continue to grow larger and active investing will continue to shrink due to ongoing trends and flows, and where investors are becoming unwittingly valuation agnostic, quality agnostic, and strength-of-balance-sheet agnostic, we should realize that the main stock indexes will trend higher and the largest firms will become constantly larger.

Remember, passive managers can only buy and sell the entire basket of index constituents in response to fund inflows and outflows, and they are totally price-insensitive.

We are already experiencing figures never seen before, and the problem will only grow. In this environment, the rest of the market is becoming increasingly more attractive in terms of valuation, but the shrinking universe of active buyers is not big enough to take advantage of the opportunity.

As a result, active investors only pay attention to firms benefiting from a buying flow of stocks (e.g.: stock buybacks). In that regard, there has never been a better opportunity for private equity funds to take quoted firms private or already established businesses to consolidate the market.

This is another way passive investment encourages less competition, which is bad for us consumers.

Needless to say, the scenario will flip when inbound flows stop and outbound flows skyrocket. The largest firms will then drop like a rock (and so will indexes) because buyers will disappear.

 That’s a serious problem. But this crowding is also why, as the liquidity cycle continues to expand into next year, I predicted the S&P 500 would hit $6,000 by the end of the year (or early 2025). Now… onto the smaller picture… 
What Happens to Public Markets If this keeps up, there will be a pretty BIG IDEA possible for this market. The expectation is that as these valuations fall, private equity will look to take more companies private, limiting the capital flows into other companies and then pouring more and more into the concentration at the top. From there, it becomes a fantastic bubble that is completely detached from reality and stifles public competition at nearly all levels. When the buyers eventually stop (as does liquidity), these indices will slump rather quickly. And that needs to remain on everyone’s radar. Passive investing and funds attempting to replicate the benchmarks are driving the momentum in this market. With more companies going private… will more companies replace the ones leaving? I argue there’s no incentive at all to be public anymore. There’s plenty of money for investors in the “private” investment chain. Sure, some funds may want to IPO, but only if they are very large companies with the possibility of entering the passive benchmarking frenzy. Why go public with a $100 million market cap? I’ll tell you why you shouldn’t… With the government still pushing even more insane provisions on public companies around carbon emissions, DEI, and other costly compliance provisions still linked to Sarbanes Oxley, fewer companies will go public… and more companies will go private. That will limit the pool of public stocks (already down more than 50% in the last two decades, thanks to Sarbanes Oxley). The stock market will be unrecognizable without continued liquidity support from central and shadow banks. Consolidation will continue. If the trend continues to exacerbate, it will be the end of the active stock market. We’ll need to determine which companies are most likely to go private… which are most likely to sell to bigger players… which will likely go bankrupt… and which will not even bother going public. And when the bottom falls out… it becomes a game for institutional and accredited investors who can play in the private markets while average Americans are either speculating on the S&P 500 itself… or get stuck buying T-bills to support the Federal debt load through stupid proposals l It seems overly simplistic, but you can see the finish line if you squint hard enough. It’s almost like the regulators don’t understand how unintended consequences and bad incentives due to policies work. 

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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