ZERO HEDGE published an article entitled, “Hedge Fund CIO: “Expect Enormous Losses In The Next Correction As There Is No Price Discovery In Index Investing”. According to that article,
“The CIO [Chief Investment Officer] of One River Asset Management spoke on the one topic that is first and foremost on the minds of the active investing community: the unprecedented shift from active to passive management, and what it means for not only the industry, but for markets during the next “normal correction.”
The CIO was speaking of the difference between “active” and “passive” management of stock portfolios.
By “active management” he apparently meant the process of “actively” investigating each potential stock investment on an individual basis and then comparing each stock to each of the other stocks that you might invest in. Based on that “active” investigation of each stock, investors would “actively manage” their stock portfolios.
“Passive” stock investments apparently refers to investment strategy of purchasing a stock index like the Dow or S&P 500. Instead of investigating each stock you might purchase on an individual basis, you simply invest in an index composed of 50 or 500 stocks. You essentially “buy ‘em all” without sorting through to buy the best stocks and avoid the worst.
Active stock management is difficult, time-consuming and endless.
Passive stock management is comparatively easy.
However, as the CIO observed, there may be adverse consequences for “passive” stock management. For example,
“Each day since the election $1bln has moved from active to passive management. When you buy the S&P 500, you pay the prevailing price for every one of those stocks. [Therefore,] there is no price discovery in index investing.”
Thus, the “passive” stock management strategy of investing in stock indexes rather than individual stocks results in no real “price discovery” for individual stocks. For example the S&P 500 is a “conglomerate” of 500 individual stocks. Passive stock managers may know the price for the S&P 500 index, but they don’t usually know the prices or fundamentals for each or any of the 500 component stocks. Those who invest in the S&P 500 do so as a barometer for the entire economy but don’t know or discover the individual prices of any of the individual, component stocks. The information on individual stocks is available, but “passive” investors don’t look for it.
Result? There’s a growing disconnect between stock prices and investors because there’s less and less active “price discovery”.
However, the fundamental purpose for all investment markets is “price discovery”. Thus, what exactly is a “stock market” that doesn’t provide full “price discovery” for individual stocks? Is it still really a “market”?
• What are the fundamentals that support or move the S&P 500 “economic barometer”? Average price to earnings (P/E) ratios? Inflation rates? Unemployment rates? But who provides those “fundamental” indicators? Barack Obama? Donald Trump? The Federal Reserve? Congress? Can passive investors really trust the economic claims made by our government? As passive investors put all of their economic “eggs” into a single “basket” (like the S&P 500) based on passive “blind faith” in government claims and controls, don’t their investments actually become more vulnerable?
Isn’t it common knowledge that the government manipulates economic indicators and stock market indices in order to create an illusion of economic strength and prosperity? Isn’t that manipulation easier when investors only look at the rising and falling of a single stock index (like the Dow or S&P) instead of actively investigating the economic and financial fundamentals of individual stocks and pricing those individual stocks accordingly?
Isn’t one of the results of passive stock investing a Dow that’s over 20,000—but no one can tell you why?
“It just is”?
Why will the Dow go over 21,000?
“It just will”?
Market indices become things in themselves that increasingly reflect public psychology rather than individual stock fundamentals. The indices are increasingly subjective (psychological) and decreasingly objective (seeking price discovery for individual stocks based on fundamentals rather than presidential cheer-leading an Federal Reserve monetary manipulation.)
Thanks to passive stock investment, stock index prices are increasingly psychological and subjective. Stock market indexes are increasingly vulnerable to government manipulation, irrational exuberance, and panics. As the Zero Hedge article observed, insofar as there is no real “price discovery” when stock indices are rising,
“[T]here will be no price discovery on the downside either. The stocks that have been blindly bought on the way up will be blindly sold.”
• Once confidence in stock indices fails, the prices of indexes and component stocks could freefall because there’s been no active price discovery mechanism resist the fall. Because passive investors have been fixated on the prices of stock indexes, they don’t really know what the objective prices for individual stocks may be. That ignorance will foster fear and panic. Without the objectivity that price discovery for individual stocks provide, we can suppose that a market that’s due for a legitimate 20% correction could freefall by 60%.
According to the One River CIO,
“$500bln has shifted to index investments, distorting the way equities are valued and the historical relationship between short sellers and buyers. This flow creates artificial demand for poor-quality securities that have few natural buyers.”
“I don’t know when the next major crisis will hit, no one does. But I do know that even in the next normal correction, the market’s losses will be amplified enormously by this move away from active management.”
• In the end, “price discovery” is merely a fancy word for “haggling”. I.e., one investor wants to buy a stock for, say, $100; another investor wants to sell that stock for $150. They haggle for a while and eventually agree to buy/sell the investment for $125. The haggling usually takes a little time. That time expenditure slows the market’s rise or fall. The stock market reports the sale and the resulting “discovery” that the price of that stock is now $125. That “discovery” will help to guide others seeking to buy or sell that particular stock.
Virtually everyone knows or suspects that markets like the Dow and S&P 500 have been artificially “stimulated” by Federal Reserve monetary policy and government fiscal policy. That “stimulation” has resulted in artificially high stock prices that are far removed from legitimate and objective “price discovery”. Thanks to artificial stock market stimulation, there’s been no legitimate “price discovery”. Therefore, current prices are irrationally high and virtually certain to suffer a severe correction.
Apparently, there’s no free lunch. Insofar as stock prices have been artificially and irrationally elevated, we can expect they will soon suffer an irrational fall.
• The Zero Hedge article’s observations concerning the loss of price discovery seem insightful and valid. But that’s not the end of it. Traditional price discovery may have also been lost to other market changes including computer trading.
There’s little in computerized trading that relates to the human haggling called “price discovery”. Instead, what we see is a kind of computerized chess game where one computer seemingly “plays” against another to see which computer program is better.
But, what difference does it make to the average investor if “Deep Blue” can beat Sargon? There’s more to reason than just digital 1’s and 0’s. There’s a human component to reason that may something like common sense or maybe like a woman’s desire to buy a new purse.
There’s a human element to investing just as there’s a human element to professional football. Do we really want to watch a Super Bowl played by robots? Or do we want to see real competition between real, flesh-and-blood players?
Likewise, are we really interested in markets run by computers and devoid of human input? Do we really want to compete against machines?
There’s a human requirement to compete against other people. There’s a human fascination with seeing how other people perform under pressure. That fascination is not really satisfied by watching computers compete—even though a computer program may produce the fastest, most logical and efficient investment decisions.
Increasing efficiency sounds great but it also removes people from the “equation” and thereby renders institutions irrelevant to people
Without real “price discovery,” the markets become less “human”. Computers react without real understanding, comprehension, fear or greed. Their reactions aren’t simply logical. They can also be programmed to react to political pronouncements rather than to economics. Did the Federal Reserve engage in Quantitative Easing to actually stimulate the economy? Or did they use QE to artificially stimulate the Dow Jones Average in order to deceive the American people into having false confidence in government and the economy? From the government’s perspective, is the objective behind QE to help individual investors make profits? Or is the prime objective to manipulate investors to support the government and have false confidence in the economy? Are average investors still active players in the markets? Or are they objects whose confidence government seeks to capture.
• The previous questions and conjecture faintly imply that anything that increases the speed and efficiency of markets also makes them less human, less “reasonable” and more prone to price spikes up and flash crashes down that can occur for no discernable reason. A market that moves without discernible reason will soon be abandoned.
In the last few years, I’ve heard that the markets went down in the first quarter of one year because of an “unseasonably cold” winter. Next year, the first-quarter markets also went down, but this time it was because the winter was “unseasonably warm”. I’m waiting for another first-quarter market decline that’ll be blamed on an “unseasonably normal” winter.
Today, when markets move up or down, a variety of reasons are provided. But does anyone really know why the markets moved? Does anyone have confidence in the explanations offered for market movements? Yes, the explanations often seem valid. But, just as often, don’t we all feel that we’re being played? Do we really want to participate in a game that we know is rigged? Do we want to see the Super Bowl if we know the outcome is already fixed? Likewise, there is something about the loss of price discovery haggling that will also cause potential investors to lose interest and abandon the markets.
You can’t have a real “market” without real people. The haggling is critical to not only “price discovery” but to the very existence of the market, itself.
• So far, I’ve explored the possible consequences to stock markets that have been deprived of real price discovery by passive investments in stock indexes. Without active price discovery, index prices have been artificially increased.
Similarly, precious metal market manipulation has also caused the loss of price discovery for gold and silver. Without legitimate price discovery, the stock markets have gone up and the gold and silver market prices have also been artificially diminished . Does anyone doubt that the gold and silver markets have been manipulated to suppress the legitimate prices for gold and silver? Doesn’t that manipulation, by definition, deprive those markets of legitimate price discovery?
If a purported market lacks legitimate, free-market price discovery, is that market, by definition, rigged?
If there’s been no legitimate price discovery while the PMs have been held down, there’ll also be no immediate “price discovery” to slow rising prices when the PMs initially break free and soar.
Legitimate price discovery in American markets will probably not be restored until after stocks have bottomed and gold has peaked.