Mauldin: With This Extent Of Passive Investing, Even A Minor Correction Will Be Disastrous

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by: John Mauldin

Summary

Stock prices do go higher in a bull market, and sometimes, as the end approaches, they make value investors very uncomfortable.

“When ETFs sell, who will buy?”.

The indexes will eventually fall lower than any of us think likely right now.

Last week, Doug Kass sent around an e-mail comparing today's markets to Queen's classic "Bohemian Rhapsody." I know that seems odd, but it was actually a good fit.

The point is that, like the song says, "Nothing really matters" to whoever is buying stocks these days.

They just keep buying and pushing prices higher. Stock prices do go higher in a bull market, and sometimes, as the end approaches, they make value investors very uncomfortable.

Neither Doug nor I quite understand the "Nothing really matters" attitude, though we have some theories. Doug is probably more bearish than I am. He has a long list of open questions. I zeroed in on one, which is critical: "When ETFs sell, who will buy?"

Passive Investing Is Taking Market Distortions To New Extremes

The enormous extent of passive indexing has side effects that I suspect will make markets sick at some point. Passive investing distorts the financial markets' core economic function, i.e., efficient capital allocation.

In terms of stimulating buying interest, a company's fundamental business prospects are now much less important than its presence in (or absence from) popular indexes.

We've created this environment in which badly managed companies can still see their stock prices rise along with those of well-managed companies. The actual facts about a company don't mean all that much in a passive-investing world.

Capitalization-weighted indexes aggravate this already problematic phenomenon.

Money is pouring into stocks like Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN) simply because they are big. The resulting higher prices make them bigger still, and they pull in yet more capital. Here's a look at the five largest stocks in the S&P 500:

  • Apple: 23%
  • Microsoft (NASDAQ:MSFT): 6%
  • Amazon: 20%
  • Facebook (NASDAQ:FB): 25%

What about the QQQ or the NDX?

The five stocks above represent 42% of the NDX and 13% of the S&P 500.

That means every time you buy an index based on the Nasdaq, 42% of your money goes into just five stocks, leaving 58% for the remaining 95.

By the time you get past the largest 25, you are under 1% per stock. Apple alone is 12% of the Nasdaq 100 Index and 4% of the S&P 500. That explains, in part, why the Nasdaq has outperformed the S&P 500.

In This Environment, Even A Minor Correction May Be Disastrous For Stocks

Be careful out there.

Doug asks, "When ETFs sell, who will buy?" The ETFs of the world may quickly begin trading below their actual net asset values (NYSE:NAV). This is called "price discovery," and the arbitrageurs will not be slow to take advantage of that difference.

This means the indexes will drop much faster than they have gone up. I am neither a fortuneteller nor the son of a fortuneteller, but there are a few things I've picked up along the way. One of them is that, next time, stocks are going to go down breathtakingly fast once they begin to roll over.

This bull can't end well, but it will end. At that point, Doug's question becomes critical: Who will buy? I don't know, but someone will. Prices for good and bad stocks will drop to whatever levels attract buyers.

The indexes will eventually fall lower than any of us think likely right now. Whether that will happen next month, next year, or next decade is anyone's guess.

As a side note, you should think of cash as an option on your ability to buy the stocks that will lose 50% of their value and suddenly become the value stocks of the future.

The option value on your cash today is not that much. You don't make much on it, but you don't lose much holding it. The time is going to come when you will be glad you have a little cash to put to work.

Think March 2009.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.