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The Markets Achilles Heel


Uccmal
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Article by Joe Nocera in Blomberg:

 

https://www.bloomberg.com/view/articles/2017-04-25/index-funds-are-finally-sexy-what-a-shame

 

"ETFs have gathered more than $2.7 trillion in assets today, of which around $400 billion is held in the three biggest S&P 500 ETFs (one of which is Vanguard's). But as SeekingAlpha noted recently, in March "$484 billion worth of these ETFs changed hands" — a turnover of 121 percent in one month. "This is not the action of buy and hold investors," the author concluded dryly.

 

Indeed, it’s not. If you look at fund flows, you’ll see that when the market dips, as it did early last year, money pours out of index funds — only to pour back in once the market is climbing again. In other words, just as they had in the days of hot funds and hot stocks, too many investors are buying high and selling low. Except this time, they are doing it with index funds."

 

When the market finally starts to correct index funds and etfs are going to amplify the correction.  Just as this bull market has gotten way ahead of itself, the downside is going to be equally severe. 

 

Buffett and Bogle are right to recommend them but they work on the assumption that people will buy and hold an index fund forever.  Their straw human behaves this way but real people acting on mass in a panic dont. 

 

 

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If I had to guess, I'd say the next downturn will happen very, very quickly. I don't know if it'll be a 1987 type level but I think it will surprise many. Most folks think the market is overvalued and are only looking at the market since cash yields next to nothing. Look at the "flash crash" of 2010. With social media, fake news and all the hatred of cash, I think this is a somewhat likely scenario.

 

On the other side, if interest rates stay low, the rally could continue for the foreseeable future. There is still a fair amount of fear and gloom out there.

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I feel that turnover argument is possibly quite fake.

 

There is likely huge amount of algo trading on biggest/most liquid ETFs. So people who say things like "Look a turnover of 121 percent in one month" are using a broken number. How do you know what percentage of that turnover are retail investors or any other long-term investors?

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If I had to guess, I'd say the next downturn will happen very, very quickly. I don't know if it'll be a 1987 type level but I think it will surprise many. Most folks think the market is overvalued and are only looking at the market since cash yields next to nothing. Look at the "flash crash" of 2010. With social media, fake news and all the hatred of cash, I think this is a somewhat likely scenario.

 

On the other side, if interest rates stay low, the rally could continue for the foreseeable future. There is still a fair amount of fear and gloom out there.

 

+1

 

There are too many factors at play like interest rates staying low for few more years and some form of tax cuts.

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This reminds me of this interesting post that I read recently about the impact of indexes/passive investing on how markets price equity risk premiums and the impact on the perceived riskiness of these assets:

 

http://www.philosophicaleconomics.com/2017/04/diversification-adaptation-and-stock-market-valuation/

 

It's long, but worth the read, like everything on that site.

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Retail investors have always bought high and sold low, that's nothing new. And can't investors sell Facebook and Tesla just as quick as they can sell the SPY ETF? Maybe ETFs amplify it some, but is the effect really that large?

 

Agreed. People buying stocks is apparently no problem, but if they buy the same stocks lumped together in an ETF it is the start of a giant crisis .. Right. Sure, there are some fringe issues but consider me skeptical about Vanguard causing the next global meltdown. Would be ironic though if John Bogle causes massive losses for retail investors.

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Retail investors have always bought high and sold low, that's nothing new. And can't investors sell Facebook and Tesla just as quick as they can sell the SPY ETF? Maybe ETFs amplify it some, but is the effect really that large?

 

Agreed. People buying stocks is apparently no problem, but if they buy the same stocks lumped together in an ETF it is the start of a giant crisis .. Right. Sure, there are some fringe issues but consider me skeptical about Vanguard causing the next global meltdown. Would be ironic though if John Bogle causes massive losses for retail investors.

 

I agree with OP and think there are many parts to supporting faster, more severe, drops in the future:

 

1) The absolute and relative value of U.S. indices compared to global peers

2) The movement towards passive that results in inflows/outflows in indexed names regardless of fundamentals

3) Lack of liquidity with banks removed from proprietary trading and market making

4) Explosion of leveraged algo/momentum traders that trade 1000s of times in a minute creating large amounts of demand/supply out of nowhere

 

When the tide turns, I expect the drop to be significantly faster than prior downturns. It won't matter that GM is trading at a P/E of 4x if retail investors are trying to exit exposure to the S&P - you'll get more selling pressure on GM regardless. Further, algo traders may jump in to short the market to chase momentum which has the potential to dramatically increase the supply of ETF units when retail investors are pulling back and liquidity from banks/market makers is non-existent.

 

We actually have already seen this happen in August of 2015 during the panic surrounding China. There was that day U.S. equity indices opened down several percent and ETFs fared even worse - the selling pressure was so intense that it broke the market mechanism that forces ETFs to trade at/near NAV and many less liquid ETFs traded at significant discounts to NAV.

 

That was a single day and was sparked by panic in a country across the globe. What happens if the selling is more prolonged and the cause for concern more acute to Americans? Chances are you get sharp drawdowns in ETFs that take a day or two to fully bleed into the underlying names as ETFs struggle to rebalance massive outflows on a daily basis.

 

Those who hold individual names may actually have the opportunity to profit simply by watching the movement in ETFs and buying/selling individual names that are large portions of the ETF accordingly since banks won't be playing that function anymore.

 

 

 

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Uccmal,

 

Good to have you back posting - I have missed your posts recently, holding me in check.

 

Have you considered, to which degree your original post in this topic is based on your own actual leverage?

 

Hi John, In so far as I am biased and prepared for a downturn, I suppose.  I was prepared by the summer of 2007 the last time.  I got caught off guard over a year later when I thought the worst had past and did some stupid investments on the way down.  Washington Mutual comes to mind as one. 

 

With inflows like what we are seeing into an overvalued stock market, things IMO are getting dangerous.  Part of the problem is outside of oil cos. I am not seeing any value.  And I am tentative with oil because it will get pulled down in a market crash, recession scenario. 

 

People have forgotten, as usual, how fast and how badly things can turn.  As usual I am probably early but in this case it doesn't really matter.  I am not losing any opportunity cost.  Snapping up a bunch of blue chips in a downturn when their yields go above five or six percent is worth the wait. 

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Uccmal,

 

Good to have you back posting - I have missed your posts recently, holding me in check.

 

Have you considered, to which degree your original post in this topic is based on your own actual leverage?

 

Hi John, In so far as I am biased and prepared for a downturn, I suppose.  I was prepared by the summer of 2007 the last time.  I got caught off guard over a year later when I thought the worst had past and did some stupid investments on the way down.  Washington Mutual comes to mind as one. 

 

With inflows like what we are seeing into an overvalued stock market, things IMO are getting dangerous.  Part of the problem is outside of oil cos. I am not seeing any value.  And I am tentative with oil because it will get pulled down in a market crash, recession scenario. 

 

People have forgotten, as usual, how fast and how badly things can turn.  As usual I am probably early but in this case it doesn't really matter.  I am not losing any opportunity cost.  Snapping up a bunch of blue chips in a downturn when their yields go above five or six percent is worth the wait.

 

I'm firmly in the camp that any sort of congregation of investors in any one strategy will result in some sort of large correction.  That correction in ETF's will simply take a much longer time to come to fruition, because you are talking about such a large overvaluation in the broad market...not simply in one sector.  Seth Klarman talked about this two years ago in his annual letter.

 

Can anyone tell me that the economic cycles for the stock market have not compressed with algorithmic trading, ETF computer trading and huge interventions in monetary policy?  We've seen this accelerate in the last 15-20 years.

 

As someone else said on here, Buffett and Bogle are correct long-term about index investing...but that is completely based on investors ignoring all emotion and simply holding or averaging into an index fund over the long-term.  But that is not how portfolio managers or the average investor behaves, and certainly not how computers will behave, if their programming directs them to push a sell order with no triggers to stop a cascading market.

 

I remember an encounter with a certain investment manager and his professor in Omaha, and we had a discussion on the markets.  I said at that time I was concerned about systemic risk and agreed with an article that Larry Sarbit wrote about how even money markets would break the dollar level in such an event.  It was why Sarbit was getting out of many financial investments, including Fannie Mae and Freddie Mac.

 

The professor turned to his protege and asked him the question I posed.  The protege thought about it for a moment and said that the likelihood of such an event occurring would be small because the treasury market was so large that a liquidity event was unlikely to occur to the money market industry on any given day.  The professor agreed and there you have it!  Two great intellects that clearly indicated how such an event could not occur.

 

Well a few years later in 2008, money market funds for the first time in their entire history of some 70 years, finally fell through the one dollar mark.  There is a reason why this Buffett quote is always on the inside cover of our annual report:

 

  “…Over time, markets will do extraordinary, even bizarre, things.  A single, big mistake could wipe out a long string of successes.  We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered.  Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.

 

Temperament is also important.  Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success.  I’ve seen a lot of very smart people who have lacked these virtues…”

 

Cheers! 

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As a general rule when you hear a lot about something it is usually too late and overdone and I think the S&P 500 is currently like that.  It is a similar theme to history.  Stocks get overvalued - investors lose a lot and get scared and sell cheap.  The S&P 500 is very overvalued in my opinion and most people don't have know what the S&P 500 really earns or approx what it is worth.  People are acting like there is no risk out there.  But fear can spread in a flash.  Nice point about August 2015.  Markets got a whiff of fear about China and tanked quick.

 

Here is something to think about - if there is a housing boom that should of went bust in year 5 but then went to year 10 before it busted what are the effects?  I think this is what has happened.   

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Klarman is a good investor but isn't perfect. He called index funds a "fad" twenty years ago and has been bearish since 2010.

 

Could be Klarman remains incorrect.  I just think there are certain systemic events that take much longer than expected to reach a tipping point.  People could be making money hand over fist during the cycle, but that doesn't mean that the risk doesn't exist.

 

If you have massive coordinated global quantitative easing combined with a broad concentration forming in index funds, I would imagine that could create such a circumstance where any change in policy or some sort of crisis, could result in a rapid correction as algorithmic trading systems kick in.

 

Klarman may get the end result correct, while looking foolish for a very long time.  Cheers!

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As a general rule when you hear a lot about something it is usually too late and overdone and I think the S&P 500 is currently like that.  It is a similar theme to history.  Stocks get overvalued - investors lose a lot and get scared and sell cheap.  The S&P 500 is very overvalued in my opinion and most people don't have know what the S&P 500 really earns or approx what it is worth.  People are acting like there is no risk out there.  But fear can spread in a flash.  Nice point about August 2015.  Markets got a whiff of fear about China and tanked quick.

 

Here is something to think about - if there is a housing boom that should of went bust in year 5 but then went to year 10 before it busted what are the effects?  I think this is what has happened. 

 

Yeah, the S&P 500 PE is 25 x.  That means it takes 25 years,to get your money back if you invest in SPY units for example or any kind if index fund.  And thats if you believe the Earnings as reported. 

 

Thats a 4% return, which is better than treasuries, at the moment.  But,  Its priced as if we never see interest rates going up again. 

 

 

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I agree Sanj that sometimes these things take a very, very long time to play out. And I really don't think the move to indexes is a fad though. In a downturn, the active funds (at least mutual) won't do any better, I'd imagine. And unless fees come down across the board, the hedge variety won't beat the market over the long term either.

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I agree Sanj that sometimes these things take a very, very long time to play out. And I really don't think the move to indexes is a fad though. In a downturn, the active funds (at least mutual) won't do any better, I'd imagine. And unless fees come down across the board, the hedge variety won't beat the market over the long term either.

 

Oh, I agree it's not a fad.  It makes long-term sense.  But you have a congregation of capital of enormous size going into them.  When a correction happens it will be bigger and faster.  The recovery will also be quicker.  Cheers!

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Longhaul.

 

Are you the friend who does the o&g consulting?  :-).

 

Uccmal,

 

Haha.  No I am not the friend.  I thought I would just help advertise his business as I think he has already helped people in the oil and gas area.  I have actually never invested in oil and gas in my life and know little about it.  My friend will be in Omaha if anyone wants to meet him.  Good guy and can often cut through the total nonsense that gets sold to O&G investors by mgmt teams that are full of BS, lying etc.  I generally think consultants are BS but if one has specialty technical expertise that can add a lot of value in a specialty then it can help a lot.

 

And your 25x was spot on regarding the S&P 500.  Index Funds may makes sense at most times - but not at 25x.  That is a ripoff.

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I agree Sanj that sometimes these things take a very, very long time to play out. And I really don't think the move to indexes is a fad though. In a downturn, the active funds (at least mutual) won't do any better, I'd imagine. And unless fees come down across the board, the hedge variety won't beat the market over the long term either.

 

Oh, I agree it's not a fad.  It makes long-term sense.  But you have a congregation of capital of enormous size going into them.  When a correction happens it will be bigger and faster.  The recovery will also be quicker.  Cheers!

Many things begun by smart people and end up being done by fools in the end.

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Those who hold individual names may actually have the opportunity to profit simply by watching the movement in ETFs and buying/selling individual names that are large portions of the ETF accordingly since banks won't be playing that function anymore.

 

Pension funds and hedge funds are playing that game and they are good at it.

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Personally I think all of you are wrong. This bull market will last longer than most people expect.

 

ETFs actually make the market more efficient and much less volatile. Individual investors are not really active traders. They are lazy and have other things to do with their lives like their jobs. On the other hand fund managers spend all their time investing and they have tremendous career risk. A fund manager cannot afford to do nothing while the market is tanking. Therefore the move to passive management implies less volatility and less sharp downturns. Its not surprising to me though that Seth Klarman or any fund manager would not believe this, given their incentives.

 

Additionally I see the main reason for a long bull is the high rate of corporate share buybacks and low rate of corporate investment. Corporate investment implies increased competition between companies which you often get at the tail-end of bull markets. This will lower returns. To me the danger signal will occur when people start feeling really good about the economy because that is the point at which companies will really start investing. That may happen as unemployment continues to go down and may happen faster if Trump gets his way in economic policies. But even if it does I expect the bull to go much much higher...say 35-40 pe before it comes crashing down.

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I'm not in one or the other camp here.

 

Personally, in reality, I think all fellow board members so far active in this topic - in principle - actually agree.

 

It's all about personal judgement about how will this play out going forward, and at the same time everybodys front screen is foggy, and personal judgements about opportunity costs, ref. Uccmals post including those considerations.

 

Yesterday, I actually found a piece - at least in my opinion - worth a read - if your thoughts are circling this issue/topic:

 

That piece is called "Capitulation":

 

I will just here lay out with the cons of this piece:

 

1. You can't buy it in physical form anywhere - It's existence is only digital - at least as far as I know - I might be wrong about that, however.

 

The pros:

 

2. You don't need it in physical form, [because you have already access to it, ref. below].

3. It's free - for you.

4. Yoy can do with it whatever you like - absolutely no strings attached. You can read it and disagree with it - thereby ditching it, you can ignore it, or you can read it, and try to - somehow - swollow and absorb it. It's all up to yourself. [Great - right?!]

5. It's actually just now right in front of your nose.

6. It's a great read, if you do your very best.

7. It's "publishing on demand" - no lead time between the authors thinking and writing the stuff, and publishing - meaning absolutely no hindsight bias in the situation - there is a time stamp on everything.

8. It's a product of team work among fellows in the same situation - basically - so it contains shades of perceptions of the situation -  thereby increasing its value.

 

Warning:

 

9. It requires a fair amount of work to digest this thing the right way, based on situational awareness.

 

Teaser:

 

It's not capitulation until people stop asking if it's capitulationn.

 

Long story short: - It's just great stuff - You find it here .

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Thats hilarious John.  At the very bottom, I was on vacation in Mexico with limited Wifi, trying to sell things at huge losses to buy Leaps in "higer quality" stocks. 

 

The most exciting few weeks of my life.  Not sure I want to relive it, though. 

 

 

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