As Optimism Multiplies, Risk and Disappointment Expand
"For now, however, simply being in an index fund provides automatic exposure to the big winning stocks and groups. And active managers are crowding into the big tech winners. It remains an almost circular argument; that to keep pace with the relevant index (which is weighted by market cap), a manager has to load up on the biggest names, which in turn pushes those stocks higher. Which is how it was in the last tech bubble when the Nasdaq Composite first hit 5000.
To be sure, it's a different tech boom, with actual profits instead of just eyeballs. And only the As in FAANG-Apple and Amazon-were public then. But between the rush into tech-heavy index funds and active managers following in their wake, there's a whiff of the same exuberance out there."
--Randy Forsyth, Barron's, "Trump's Big Tax Challenge"
Investors are being blinded by the consequences of the domination of quant strategies (risk parity and volatility trending and others that are geared to algorithm-derived, momentum-based "investing") coupled with the popularity of exchange-traded funds and their short-term impact on the markets at the expense of the previously lauded but now increasingly disowned high fee-based active managers.
Quant strategies that worship at the altar of price momentum and allocate to perceived risk by asset classes and ETFs that rebalance serve to exaggerate short-term market moves and, as currently structured, result in a virtuous circle of a market that increasingly favors the winners, such as (T)FAANG, and orphans the losers (of these there is a growing list).
Wile E. Coyote: Allow me to introduce myself, my name is Mud.
Bugs Bunny: And remember, Mud spelled backwoids is Dum.
--"Operation Rabbit" (1952)
Wile E. Coyote and the Road Runner were created for Looney Tunes and Merrie Melodies by Chuck Jones for Warner Brothers in 1948.
In the cartoons, the Coyote repeatedly attempts to catch and subsequently eat the Road Runner, a fast-running ground bird, but is never successful, leading to a virtuous circle for the Road Runner. Instead of his species' animal instincts, the Coyote uses absurdly complex contraptions (sometimes in the manner of Rube Goldberg devices that may resemble our quant funds of today!) and elaborate plans to pursue his prey, resulting in his devices comically backfiring, with the Coyote often getting injured in slapstick fashion.
For now you gotta be in it to win in -- i.e., (T)FAANG -- but I assure all of you that this will not be a permanent condition, as markets, sectors and individual stocks are like rubber bands that are stretched -- they always return to their original state.
The aforementioned market influences that consistently have emerged over the last decade are unique, are not being soberly studied and their impact is not being considered seriously as measured by most volatility measures. Most importantly, they run a cumulative risk, as I have previously written in "This Ain't No Seder -- I Now Have Eight Questions!," of becoming Portfolio Insurance Act II.
Indeed, the performance of the second act is closer than most investors think as I, again, ask:
"With the specialist system now extinct, when Risk Parity, Volatility and ETFs sell, who will buy?"
I have learned through four decades of experience that once most market participants are conditioned to one way of action, the other way quickly may surprise them as rising markets brings rising expectations. In its extreme, long periods of prosperity can produce a Minsky Moment -- a condition that may be approaching.
"Nor is the people's judgment always true, the most may err as grossly as the few."
I understand that there's a certain comfort in crowds, as well as a distrust of the remnants of individual opinion. I suppose that's a function of the human condition, human spirit and human nature.
But in today's flat, networked and interconnected world, all market, business and economic cycles arguably change with the greater rapidity than at any other time in human history. So, smart investors must be adaptive, anticipatory and stay on the alert.
Market expectations can be argued to be at their highest level at any time in this bull market that started in the first week of March 2009.
Optimism in and of itself is not dangerous, but it is tautological that risk and disappointment expand as optimism multiplies.
Today's market is no cartoon -- brace yourself.