- Central banks create wealth, not economic polices. Or do they?.
- Bernanke's wealth effect is behind index ETFs' huge success.
- ETFs are distorting valuations.
National Socialism made a striking comeback in Europe last weekend. Journalists seemed shocked. "Earthquake" was the title in Le Figaro. Investors, on the other hand, couldn't care less. European markets were up on Monday and continued their steady march to new historic highs with only one focus: will Draghi ease monetary policies even further on June 5?
Markets no longer sanction bad policies. Protectionism, xenophobia, isolationism, currency wars, trade wars or more state intervention? None of that matters anymore. European investors believe Draghi will lower interest rates and probably start a new money printing "QE" on June 5 and that's all they want to know. Following the lead of the US, European - and Japanese - smart money knows that economic policies no longer matter as long as central banks continue to bail out politicians. Wealth is being created by monetary policies, not the old fashioned way. Bernanke calls this the wealth effect.
Markets no longer sanction bad companies either. Too big to fail takes care of the corporate establishment. But with central banks' unprecedented activism, markets have figured out that a rising tide lifts all boats, even those that are not seaworthy.
Asset inflation benefits all stocks, but index ETFs have channeled the money flow undeservedly toward bad companies. ETFs are bypassing the filter of fundamentals. By definition, money that goes into SPY, VOO or IVV is used to buy all the stocks of the S&P index according to its weighting. Each stock gets thus the same proportional buying interest, no matter how well the corporation is performing.
This is nothing new. What is new is the ETFs' huge success. They have become the dominant force in the markets. Hence, when a stock has disappointing results, traders will briefly punish it. But soon after, the flow of money into ETFs creates blind demand for that stock and puts a floor on its valuation.
Many stock pickers, short sellers and active managers have been caught wrong footed. They still paid a premium for quality, growth and valuations, all factors that do not matter in an asset bubble. On the contrary, when "risk is on," the lower the quality, the higher the leverage. The resulting underperformance of active managers vis-a-vis indices has logically led to the diversion of even greater money flows into index ETFs, thereby reinforcing the new paradigm.
Everybody gets a participation trophy in the ETF markets. Markets no longer assign a premium to good companies or punish bad ones. Or, at least, it reduces the inequality between them.
The market is already overpriced by historic standards. Incidentally, the historic high multiples are on historic high earnings margins. Even more concerning is that these high valuations apply disproportionately to mediocre companies because of the ETFs' lack of differentiation.
This implies that the companies with the weakest fundamentals tend to be the most overvalued relative to their long-term prospects. Unlike the dotcom mania or the frenzy for the go-go stocks of yesteryear, in today's environment, investors are inflating stocks that are not even sexy.
Similarly, because of the large index ETFs, when this latest folly unravels, the good (not-so-overvalued stocks) will suffer just as much as the bad ones. That is when stock pickers will have their chance. However, most will have lost their jobs by then.