We're going to explore the intersection of two major macro trends that have profound implications for the economy. We'll delve into how algorithmic passive investing coupled with job market data are potentially setting the stage for a volatile event similar to the 1987 crash.
Passive Investing
Conceptually, passive investing is when an investor buys a portfolio that mirrors a market index, such as the S&P 500, and holds it over the long term. It is an algorithmic model that uses very simple rules to purchase. It involves buying equities or bonds in proportion to their market cap anytime money is available. This approach has grown in popularity due to its lower costs and simplicity compared to active investing, where fund managers actively buy and sell stocks in an attempt to outperform the market. This type of investing can cause markets to veer off of fundamentals dramatically. According to a JP Morgan analysis in 2017, less than 10% of trading had a fundamental component to it, a significant decrease from the 60-70% prior to the global financial crisis.
Passive investing now accounts for approximately 44% of the US equity market, a significant increase from just a few years ago. One of the main concerns is the influence of passive flows on the markets. Passive flows refer to the money invested into passive funds, which then invest in the stocks that make up their benchmark index. As more money flows into these funds, they have to buy more of these stocks regardless of price, which then drives prices up further. This can lead to underperformance by active managers, who may have to sell their stocks, which could further drive up the prices of the index stocks as that money cycles back into passive funds.
There is also potential risk as more and more investors migrate to passive investing. If a majority of participants in the market are passive, it could lead to more severe implications if people try to make withdrawals under certain conditions. Passive investors are not looking to exit at a good price, but looking to sell to fund their lifestyles. When investor put their money into an index fund, the fund operates off of the world's simplest algorithm: if you give me cash, then buy; if you ask for cash, then sell. This can lead to buying at whatever price they can get, which is not an effective negotiation technique. The imbalance in the market could lead to a violent reversal or market crash, especially as baby boomers start retiring and the net flows threaten to turn negative.
As well, there could be implications for corporate governance. As more money flows into passive investments, there are concerns about the potential lack of oversight on company management. This could potentially lead to situations where management can act without sufficient checks and balances.
Another key issue is the distortion caused by market cap weighted indices. These indices assign a weight to each stock in the index based on its market capitalization due to larger companies having a greater influence on the index's performance than smaller ones. This will push more buying power towards a smaller set of stocks.
Market Cap Weighted Indices
An issue with passive flows going into weighted indexes is the disproportionate amount of automatic buying that will happen for certain stocks in the index. This is a major reason why the market is showing similarities to the 2000 period, where a few extremely profitable companies led the charge. The current market situation feels like a narrower version of this, with people increasingly investing in technology, abandoning traditional investments in energy, metals, and old economy stocks.
Passive investing amplifies the select companies to continually have their price drive up as passive investors like Vanguard and BlackRock do not have the discretion to sell when prices are high. They can only buy, and can continue to buy no matter the price. This can create positive feedback loops that cause prices to rise, similar to the dynamics of 2000.
The growth of Nvidia is particularly noteworthy. The company has become one of the fastest-growing companies in history and is expected to continue this trajectory. However, this growth has been accompanied by staggering statistics. For instance, Nvidia did not increase its spending on sales, general administration, or other areas despite a $10 billion sales jump.
Jobs Report
The BLS has reported a gain of 275,000 jobs in February 2024. However, its important to note that previous job gains have continually been revised downward. Over the past year, the BLS has been issuing positive numbers in its initial payroll reports, only to revise them lower in subsequent months. This pattern appears to be repeating itself. For instance, in December, the initial payroll report was revised from 333,000 to 290,000 indicating a loss of 43,000 jobs. Similarly, January's initial payroll report of 353,000 was later revised down to 229,000. This means that in just two months, there was a cumulative downward revision of 167,000. Considering the recent trend of downward revisions, it remains unlikely to stay at the 275,000 mark.
As well, the recent household survey has signaled a potential recession, primarily indicated by the continuous decline in full-time jobs. In February alone full time jobs fell by 184,000. The six-month average of the household survey is now negative, a strong recession signal. Since the late 1960s, there have only been 14 instances where the household survey level of employment was negative. Most of these instances were during outright recessions or periods leading up to recessions. This trend suggests that businesses are taking measures to cut costs in response to perceived weakness in the general economy.
Over the past six months, full-time jobs have decreased by 1.8 million, resulting in a six-month average of -220,000. This is the second recession signal from the household survey. A six-month average in full-time employment often aligns with officially declared recessions, with only a few minor exceptions.
Another signal is an increase in part-time jobs. During many recession periods, part-time jobs increase significantly as businesses cut back on hours, converting full-time workers to part-time to reduce costs. Over the past ten months part-time jobs have increased by approximately 1.7 million.
Connecting Jobs Data & Passive Investing
Despite the optimistic headlines touting a thriving economy and remarkable job growth, a closer look reveals a concerning trend: full-time employment has significantly declined over the past year. This downturn is particularly troubling because full-time jobs are a cornerstone of passive investing strategies. As employees contribute to their 401(k)s, often benefiting from employer-matched contributions, the erosion of full-time employment directly impacts the volume of these passive investments.
The persistent decline in full-time job opportunities, juxtaposed with a growing dependency on 401(k)s for retirement, is forging a precarious scenario for passive investment strategies. This dynamic, characterized by dwindling contributions from the workforce and increasing withdrawals by retirees, threatens to significantly diminish the volume of passive investment flows. In essence, as individuals exit the workforce—either through job loss or stepping into retirement—the once steady stream of capital into passive funds is at risk of not just stagnating, but reversing.
As well as passive investment strategies gain popularity, there's a noticeable drain of cash from the market. Consequently, when stock prices decline, there's insufficient cash on hand to "buy the dip," exacerbating the liquidity crisis. This scarcity of liquidity can trigger rapid market declines, often more swiftly than anticipated. If passive investment flows cannot maintain their levels to support stock prices or passive flows actually reverse, the market becomes primed for aggressive downturns similar to the crash of 1987.
Thanks For Reading!
To Read Past Newsletters Click here.
If you have any source you wish to see in our lineup, please reach out and let us know. We continually look to incorporate more independent sources to our weekly wrap-up.
A special note for the work Michael Green has done on passive investing and passive flows. He can be found on twitter here: @profplum99 and substack here. Highly recommend reading his material and listening to his podcasts about the topic of passive investing.