We’ve frequently warned about the myriad of potential risks arising from the massive capital flows from active to passively managed accounts which will eventually, and inevitably, wreak havoc upon the markets. It is, in fact, this transition which is inextricably linked to the market’s apparent disregard for traditional valuation metrics as it surges to all new highs with each passing day.
As we’ve noted before, unlike actively managed funds (the good ones at least) that actually bother themselves with parsing through K’s and Q’s and analyzing traditional valuation metrics for individual companies, the only metric that passive investors seem to care about are their daily returns. Unfortunately, that metric is nothing more than a massive ponzi scheme as increasing allocations naturally drive returns which then lead to even more allocations…it’s a circular farce that will end very badly.
After reading Elliott’s 2Q 2017 investing letter, it seems that Paul Singer shares our views on this particular topic having described passive investing as a “blob which is destructive to the growth-creating and consensus-building prospects of free-market capitalism” and one which is “in danger of devouring capitalism.”
We are always amazed by decent ideas and insights which are stretched so far beyond their original version that they become caricatures of themselves and then sometimes contra-functional.
…the passive investing idea has been supercharged by the recent long period during which government manipulation of securities prices has created the illusion that simply holding stocks and bonds in their index weights and sitting back arms folded is the perfect investment strategy.
…passive investing is in danger of devouring capitalism. Active investing in public equities is declining, and passive ownership of Index Products is rising, at rates such that the lines may cross in only a few more years. The trends are self-reinforcing, because they cause the assets in the Index Products to outperform those that are not in those products, thus confirming the theory in the minds of both adherents and frustrated non-believers.
Most people believe that the “outperformance” of passive investors is the end of the story; case closed, summary judgment, passive is better, done. We do not agree. Part of the “outperformance” is due to the kernel of good ideas at the core of passive investing: lower friction costs from excessive trading, lower fees and the empirical underperformance (in aggregate) of active public equity investors. But there is more to this narrative. A good part of the outperformance is the effect of net money flowing into index-included equities and out of (relatively speaking) everything else. A handful of passive investing firms are now among the largest investors in equity and fixed income in the world.
We believe, however, that there is a fallacy of composition and that what may have been a clever idea in its infancy has grown into a blob which is destructive to the growth-creating and consensus-building prospects of free-market capitalism. This “overgrowth” is a drag on the power of capitalism to adapt, to continually strive for excellence, efficiency and creativity and to deliver goods and services for citizens in the manner in which it has done for the last couple of centuries. In effect, therefore, it is dangerous, ultimately divisive and may be an important reason the pro-freedom or pro-capitalism consensus dissipates over time.
Fortunately, for your reading pleasure, passive investing wasn’t the only hot topic on Singer’s mind this quarter. Here are a couple of other highlights from the quarterly letter:
On Central Bankers:
The combination of central banker-applied brute force (buying everything in sight) and deity-like central banker pronouncements has dampened market volatility and frisky free-lancing, but at the same time it has encouraged risk taking (in market positioning, not it business formation). We have thought, and still think, that confidence in central banks and policymakers has been unjustified and thus could erode or collapse at any time. Since the major financial institutions which comprise the financial system are still way overleveraged and opaque (in fact with record amounts of debt and derivatives at present), such a break in confidence could happen abruptly and without warning.
Investors should come to grips, intellectually and viscerally, with the likelihood that most fiscal and monetary policymakers’ knowlege of the world is somewhere between “close to nothing” and “way less than zero,” and that their pronouncements and policies usually range from “silly but harmless” to “dumb and dangerous.
On whether labor markets are tight:
Short answer: no.
Programs which foster long-term dependency are not creating social justice; rather, they are creating demeaned citizens and preventing people from experiencing the dignity and contribution to society of work.
Given record stock prices and low unemployment rates, the slow rate of increases in wages is “surprising.” But it clearly demonstrates that there is something wrong with the existing prosperity-delivering mechanism. In this regard, America is catching up (but not in a good way) with Europe, which long has lived with much higher rates of unemployment and long-term dependency.
On Chinese Debt:
In response to the world economic slowdown after the GFC, China undertook a large debt-fueled stimulus. In 2008, it had a non-financial sector debt-to-GDP ratio of 141% or $6.6 trillion; by 2016 that number was 257% or $27.5 trillion.
Combined with wild real estate booms and overbuilding, plus an unhealthy dose of corruption and severe neglect in “rule of law” infrastructure, a serious economic dislocation (or crash) is the obvious (but not necessarily correct) expectation based on the numbers, the leverage, the interconnectivity and the likely quality of debt.
A Chinese financial market collapse would likely push the global economy into a deep recession.
Whether they will succeed or fail is completely unknown as this letter is written. A reasonable conclusion about China is that it is foolish to ignore the signs of developing storm but also ill-advised to put a “clock” on it or deem it to be inevitable. Our instinct is that close to perfection will be required to avoid a very painful sequence of events in the global financial system and hence the world economy.
Finally, on our favorite topic of “Safe Spaces”:
Fifty or so years ago, campuses across America raged in support of free speech. Fast forward to the present, and we rub our eyes to see a 180-degree turnabout in rage-worthiness. Currently, many students on a variety of campuses are rallying against free speech. The “diversity” that almost all American colleges and universities claim to covet does not really exist, at least with respect to viewpoints, due to the ideologically extreme tilt (to the left) on virtually every “elite” campus. This bias is unfortunate, because intellectual and ideological diversity would be an effective tool in the creation of new generations of citizens and leaders who think for themselves, not just march in lockstep with the orthodoxy of the day.
But alas, intellectual and ideological diversity does not seem to have a high priority on many campuses. Philosophical and political imbalance is so extreme at a number of such institutions that a growing movement seeks to create “safe spaces” (both geographically and in terms of acceptable speech) so that the apparently fragile-as-eggshells students are not “assaulted” by opinions or thoughts that differ from those in their “Little Red Books.” At many colleges today, the enforcement of the 2017 version of Mao’s Little Red Book is by peer pressure, shouting down, and, on the vanguard of the “Free Speech If You Dare” movement, actual violence.
This fragility, an intellectual fetal position of sorts, apparently extends to the vast community of global investors. We make that assertion on the evidence that almost nine full years after the GFC, central bankers and policymakers are treating every single hiccup and little twitch in global stock markets as worthy of calming words and the promise of action “as needed.” This treatment of markets as being perpetually an inch away from a fatal attack of the vapors is remarkable at a time which is so long after the actual emergency period.
Couldn’t have said it better ourselves…