The Indexing Vault

Passive funds did not dominate shareholder rosters over a decade ago. Most stocks were owned by a diverse group of institutional investors, in addition to individuals, employing differing strategies to determine their own appraisals of a stock’s worth. These players constantly evaluated the merits of their holdings. They could – and did – decide to buy or sell shares on any given trading day. This constant buying and selling, reacting to new economic and company-specific information is what kept stocks aligned with their inherent value.

With index funds dominating the investment landscape, the daily trading of the stock market has been dramatically altered. For all intents and purposes, shares that are bought by index funds are locked away from the market, never to been seen again. It is as if they were locked away in an old-fashioned bank vault. That is, unless the passive funds sell, which is not something that has happened – yet.

Index funds have enjoyed a steady stream of new investor money flowing into their coffers, so that any withdrawals by existing clients are met with more than enough cash from new clients to offset the difference. This means that The Big Three have almost never needed to place their stock holdings on the market for sale, as they pay redeeming investors with some of the new investors’ cash. This cannot go on forever.

Think about forces at play for a minute. Here we have very large players, receiving hundreds of billions of dollars a year. They are basically in the process of cornering the market for many companies, by removing their shares from the normal market give and take. It does not matter if a stock’s price goes up 100%, 200%, or 1,000%, the index funds will not sell [Think we are exaggerating? Call up a chart of the biggest index fund holdings and 1,000% gains, meaning a 11X increase in price, over the past decade are the norm. See AMZN, AAPL, MSFT stock charts].

This causes stock prices to exhibit significant inelasticity, meaning that since a significant supply of shares is not available to meet demand (since it is “locked up” at the index funds), the price must increase significantly to compensate. Stock prices have been artificially boosted by factors unrelated to the performance of the underlying companies: supply has been removed from the market at the same time huge demand is focused on the largest companies from index fund purchases.

The result is a continually rising market, as long as the cash keeps flowing.

Next Page – Who is Driving the Bus?