I’ve gotten numerous reader requests to discuss a recent podcast episode. Usually podcasts don’t become a hot topic, so you know this one struck a nerve.
For those unfamiliar, the episode in question is an interview with Grant Williams and Mike Green. Green is a co-manager of hedge fund Logica Capital, and he previously served as fund managers elsewhere as well. Williams is an author/publisher who was previously involved in media outlet Real Vision and is now a strategy advisor to a Singapore-based hedge fund.
In Williams’ podcast End Game he explores how the current Fed-driven stock market paradigm may reach its conclusion.
What Changed In 1995?
The question at hand is specifically: What shifted in 1995? The stock market’s behavior changed substantially in that year, with stocks going exponential for the next five years, and the market seemingly being “broken” since then. Many analysts blame overly aggressive Federal Reserve policy that Mr. Greenspan instituted and other Fed chairs have subsequently followed. Green, however, says it was due to the rise of Vanguard and other index fund providers.
Green came to this idea in 2014. He watched a huge run-up (500%) in Shanghai-listed Chinese shares. This was caused, he says, because Shanghai-listed companies only had 5% of their float available to the stock exchange. This made it impossible for people wanting to take positions to get a meaningful chunk without causing stock prices to go exponential.
Shanghai has a “limit up” system where stocks stop trading if they go up a set amount in day. During the run-up in Shanghai stocks, numerous individual companies went limit up every day for weeks on end without any meaningful trading volume.
This obviously made no economic sense, but passive fund managers had been mandated to buy Shanghai stocks mechanically and there was simply no supply of them to offset the necessary buying. Finally enough insiders sold stock and new secondary offerings emerged to eat up this extra demand, and shares subsequently plunged.
The Western media said this was simply an example of crazy Chinese gamblers having a moment of euphoria. Green says this explanation is nonsense, however, as ETFs instead drove the excitement.
Could it happen in the U.S.? In fact, is it already happening in the NASDAQ today?
The Fundamental Shift
Green lays the stage with the following observation: Those under the age of 40 have the majority of their assets in passive investments. Those over the age of 65, however have less than 20% of their assets in passive investments, according to Green.
Thus, regardless of what the market does, active fund managers will continue to lose assets going forward and passive will gain more, simply due to demographics. Retired people draw down their savings out of active funds, while young employees invest more for the future via QQQ and SPY with each paycheck.
Green notes that Vanguard has suffered weekly net outflows on fewer than five occasions. Even when folks want out of the market in general, they tend to take money away from active funds, while leaving their capital in passive or even adding more. To that point, Vanguard kept receiving more funds to invest even in March 2020.
Green describes how active fund managers have built-in limits. When markets plunged in March, for example, active funds refused to sell securities at low prices — in some cases even shutting their funds for a time to prevent funds from leaving at silly prices. Similarly, if you give cash to an active fund near market peaks, there is a good chance they will delay in allocating it due to a lack of attractive opportunities. Passive operates differently on both counts.
Passive assumes that: “Every price is the right price.” It has no mechanism for taking a pause to reconsider things if the market is acting strangely. All it can do is buy or sell when its rules dictate.
When you give money to an SPY, QQQ or other such ETF, it immediately allocates 100% of it into a set basket of stocks. Similarly, when you say sell, those funds immediately sell their stakes. The passive fund has zero discretion whatsoever – the market prices are always right. Taken to extremes, this can lead to bizarre outcomes.
You may say, who cares, active managers invest their money too. But it’s not that simple. The average active fund carries 5% of its capital as cash at any given time. Green says that back in the 1990s, this ran as high as 9% for extended periods of time. Thus, let’s say, folks had $10 trillion in a set of retirement funds; we’re talking $500-$900 billion of that money sitting in cash at the active fund.
Now, with ETFs, that extra money all goes into the stock market immediately. And sure, even $900 billion may not sound like a ton of money – Apple’s market cap is now $2 trillion after all.
But as we’ve seen this year, it only takes a small amount of money to cause large marginal moves in stock – the market cap is set by the last transaction after all, not the overall amount of cash put into a security. If, theoretically, passive funds were reset to 5% cash tomorrow, instead of 0%, and had to sell hundreds of billions of dollars of securities to effect that purely rules-based change, it’d cause a massive decline in the indexes.
Stocks To Infinity – Or Zero? Not So Fast.
Green expands on the above idea around minute 54 of the above-linked broadcast, explaining how stocks could potentially go to near infinity – or zero. This is the part of the interview that caught the most attention and drew alarming headlines from Zerohedge. It’s a shame, because the claim is sensationalistic and detracts from Green’s otherwise sober and thoughtful message.
Anyways, Green says that in a world with no active investors, prices would theoretically approach infinity or zero. When no one has any cash at all — all money is stuck in 100% invested ETFs — there is essentially no buyer or seller of last resort. If every investor in the world is already fully invested and then, let’s say, an earthquake hits San Francisco and devastates the economy, what happens next? There’s literally no one to sell to, when no one has any cash but stocks need to be sold, what price does that next transaction occur at?
While that’s a fun thought experiment, it’s obviously impractical. As we saw in March, plenty of passive investors (millenials and younger) reacted to the market crash by buying SPY, QQQ, and other such ETFs.
What’d they buy those funds with? Cash they had in their savings account, or which arrived from government assistance checks. Point being that there is always some cash on the sidelines, even if the ETF itself holds no liquid money. As long as humans have human brains, there will be folks willing to buy dips and sell rips.
This idea of markets going to zero (or infinity) may be theoretically possible in a highly artificial and constrained technical set-up, but it won’t actually play out in a market where humans still make decisions. And that’s even if active funds are gone. The choice whether to buy or sell passive ETFs is still driven by human emotion in many cases, and you always have contrarians trying to fade the crowd.
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Another important idea Green gets into is that these passive funds are distorting secondary market functions. Take short selling, for example. In the past, it was extremely difficult to short nearly bankrupt companies. Now, though, with passive funds are obligated to own the whole stock market, including utter rubbish. And with management fees so low on ETFs, they make their money lending out stock to short sellers rather than from the management fee.
Thus, ETFs like the Vanguard Total World Market are forced to buy stuff that is obviously going to zero, like Chesapeake, Hertz, Washington Prime, or American Airlines, and in doing so, they also lend their stock out to short sellers. This is a bizarre malfunctioning of normal market dynamics and creates the opportunity for investors to bet against failing companies at an attractive price.
Green also details how many ETFs and also pension funds and other formulaic managers are now using option selling strategies to try to increase yield in this low-rate world. We’ll get back to that idea in a second, as it potentially offers the most applicable investment idea from this podcast.
He also argues that:
“The dominant force in passive is momentum. How do I choose how much to allocate to something? I allocated on how much its market cap is. How did the market cap get there? It either went up or went down. If it goes up, I allocate more, if it goes down, I allocate less.”
That, in a nutshell, is why tech stocks keep going up, and value stocks (and most other things) aren’t working. As long as ETFs driven by simple rules (receive cash, buy more of whatever is going up) make market prices, you’ll get more of the same.
Apple (AAPL) is in low-volatility, high-quality, socially responsible, tech, consumer, and dividend ETFs (among others) in addition to the usual suspects like SPY and QQQ. Meanwhile, your 8x P/E auto parts manufacturer is hardly in any of the cool ETFs and thus is probably getting actively sold as some 75-year-old retiree cashes out their mutual fund.
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When does it stop? Green suggests that we are approaching a natural limit of these passive strategies. Many of the institutions driving things are target date funds. These typically own a mix of the classic ETFs (SPY, QQQ, etc.) and also bonds.
Up until now, these strategies have been going exceedingly well. You’ve heard Dave Portnoy: “Stocks only go up.”
And consider the other leg of the trade. Interest rates only go down nowadays, as well. (remember, falling interest rates = rising bond prices)
Conveniently, many institutional strategies don’t just own bonds – and thus profit from this decades-long bull market – they do so with leverage.
Up until now, that’s been a winning play. The Fed doesn’t allow interest rates to go up anymore, so the risk of capital loss is limited and fleeting. Meanwhile, using leverage, you get more yield even as rates have declined.
The gravy train, however, may come to a screeching halt once interest rates go under zero. Green suggests that many fund managers will no longer be willing to leverage up when they have to pay for the privilege of owning bonds. Doubling a 0.7% interest rate is fine if not especially exciting. Doubling a -1% interest rate, by contrast, is not so appealing.
Green intriguingly argues that the Fed has actually caused stock prices to go up by guaranteeing that the value of bonds never drops. As the value of your collateral goes up, it allows you to take more risk. And within the passive framework it forces you to take more risk, as it is algos — not humans — making decisions.
The Central Banks are forcing up the value of bonds. As bonds rise, passive investors have more capital. And the rules of target date funds dictate an even mix of stocks and bonds, so as your bonds appreciate, you have to buy more stocks to keep the balance.
Thanks to this cycle, all these momentum-based fund vehicles have been able to gorge on more and more stock exposure, with the confidence that their bond hedge is always profitable.
What might happen when that changes? Green suggests it will make for mess — and one that will soon be upon us, as the 10-year is rapidly running out of room to drop more between here and 0.0%.
So, What To Do With This Information?
In a previous interview with Bloomberg’s Odd Lots podcast, Mr. Green faced the question of “what to do in the meantime?” while waiting for this passive investing bubble to play out.
Green responded that his fund is buying both put and call options (straddles, in effect) to bet on volatility increasing in the future. The idea being that passive investing will cause prices to go up faster than they should during normal bull markets, and crash more quickly than anyone could imagine on the downside. What’s happened in March and then subsequently to that certainly supports this view.
Generally, buying straddles by itself is not a great idea, as volatility is overpriced. The famed investor/author/Twitter provocateur Nicholas Nassim Taleb has written numerous books espousing the idea of preparing for volatility. Yet his actual hedge fund where he bought straddles shut down after disastrous returns in the early 2000s.
However, if Green’s theories are correct, the world has changed since Taleb’s theories failed when applied to actual markets. Now, Green contends, passive ETFs are setting prices, yet options markets are still structured as though human fund managers were the marginal decision-makers.
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If you want to apply Green’s theories, consider swapping some of your stock holdings for call options positions in those same stocks, for example. If Green is right, there’s a good chance that stocks will either soar farther than anyone expects, or they’ll crash through the floorboards. If stocks soar, the call option gives you leverage to the upside. If stocks crash, you only lose your call option premium rather than your underlying investment.
If you recall my March call option play in Sabre (SABR), I figured volatility was underpriced as the stock had a good chance of either going bust or regaining its prior losses. As it turns out, the stock went from $12 to $3.50 and back to $10 in a few months – volatility was indeed badly mispriced, though puts would have been the better choice than calls. Still, paying $1.40 for an option that went south is obviously superior to losing as much as $8/share in this case as the stock crashed in the face of much worse lockdowns than previously expected.
For a more cheerful example, you may recall that I gave a Top Idea pitch to buy State Street (STT) long-term call options last year. These subsequently went up 9x from my entry price. State Street stock had dropped from $110 to $55 at the time of publication, yet they were giving away long-term call options in the $70s strikes for under $2. If a stock can quickly drop 50% without the fundamental business significantly changing, there’s a good chance it can go back up quickly as well. That’s the sort of scenario where you can get huge amounts of leverage at a really reasonable level of premium.
State Street stock subsequently went from $55 to $85 in six months. Great if you owned the stock, and downright heavenly if you had options.
Don’t go crazy buying call options tomorrow just because you read this. Do some studying on the subject and try backtesting some performance historically. I’m happy to take questions in the member chat as well. Remember, options buyers (usually) lose money on net, and options sellers make money.
However, if Mike Green is right, we’re currently in a paradigm where that old market law no longer applies. That could create some interesting possibilities. I’m on the lookout for some call options that could add nice upside kickers to the aggressive portfolio in particular.