Who is Driving the Bus?

Only A Small Fraction of Daily Stock Market Trading Involves Fundamental Investors

Since so many investors are indexing, trading volumes in the market have declined. Furthermore, virtually all of that trading is conducted by algorithms or index funds. An analysis by J.P. Morgan showed that less than 10% of the daily trading of the market was from fundamental investors – those who look at company financials (income, balance sheet and cash flows), and decide when to buy or sell. And this analysis was conducted in 2017 when passive penetration was much lower than today!

In the report, Marko Kolanovic, global head of quantitative and derivatives research at JPMorgan, said, “fundamental discretionary traders account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago.”

So if the individuals doing the fundamental research on businesses are just a tiny minority of daily trading, how exactly are stock prices supposed to reflect real-world business performance?

To a large degree, they don’t.

Stock prices react to flows of money, plain and simple. In the active-dominated markets of the past, those flows were controlled by informed buyers and sellers who had a pretty good idea of the true worth of the shares they were trading. Today, however, passive is more than 100% of the flows into the market (since active funds are losing money as a group, their contribution is negative). And since inflows into passive have been primarily a one-way street since their inception, stock prices just go up and up, beyond many historical measures of valuation.

Indexing was never meant to be the dominant force in markets. It began as a niche strategy to utilize the work done by informed investors to set stock prices at values that reflected what the underlying businesses were worth. Now that indexing is the only game in town, passive funds are the ones setting the prices, not stock analysts.

So, where is this all headed?

Next Page – The Passive Indexing Trend Is An Unstoppable Freight Train