Indexes - a policy tool
“Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion." - Ben Bernanke, The Washington Post, November 3, 2010.
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A decade of zero/negative interest rate policy and massive liquidity purchases broke the most sacred relationship in finance: the relationship between debt and interest rates.The unintended consequences were a structural shift in debt and equity markets toward passive investment vehicles, misallocation of resources, and consequent slowing of the "real economy." The stock market is now a policy tool of the Fed.
A dangerous symptom in the stock markets was the capitulation of active asset managers to passive indexes and quantitative programs. As seen at right, passive assets grew from $1 trillion to over $4 trillion, surpassing active funds in early 2019.
"According to estimates by JP Morgan, passive investments now control about 60% of the equity assets, while quantitative funds – those relying on trend-following models instead of fundamental research – now account for approximately 20% of the market share. This means that about 80% of the US equity market is driven by investors who do not look at the individual stocks in their portfolios.
- CNBC, June 29, 2019
The outperformance of passive indexes and algorithms over active managers in the past 10 years is not evidence that markets are efficient; rather, this was a period when these markets became inefficient.
The track record from the period should not be measured by the virtuous circle of the Bernanke "wealth effect," which drove asset prices through passive investment vehicles and quantitative trend-followers, but by its effects on the "real economy." Wealth effects are temporary, only productivity growth creates long term sustainable wealth.
As can be seen in the chart below, the US economy in the period between the Global Financial Crisis (GFC) and the end of 2019 experienced its slowest recovery in history - with 2.2% annual GDP growth and 1% annual productivity growth. This occurred despite a four-fold increase in the Fed's balance sheet to about $3.5 trillion in that period.mThe doubling again of the Fed's balance sheet in March and April of 2020 to approximately $7 trillion will only punctuate an awful capital allocation cycle.
The long-term damage to capitalism, slower economic growth, and crushing debt are likely to be the true legacy from the period.
These effects will be long lasting.
The stock market has devolved into a policy tool of the Fed to an extent that Ben Bernanke may not have been able to visualize in 2010.
The stock market will need to clear in order to resume its traditional and powerful role as a productive pricing mechanism for individual stock risk.
“If everybody indexed, the only word you could use is chaos, catastrophe… the markets would fail.”
- Jack Bogle, founder of Vanguard - 5/6/17
"The aggregate risk of index investment vehicles is disconnected from the real assessment of underlying security risk. Price discovery is concealed by a wall of passive money."
Moses Grader - Little Harbor Advisors LLC
"The US stock market offers unprecedented opportunities to capitalize on the pricing and structural inefficiencies of the last decade. Markets are not efficient – they have never been more inefficient – nor has there been a better time to be a bottom-up, long/short equity, active manager."
-Chris Galizio - Focused Capital