Who’s Crazy Enough To Buy Stocks Heading Into Recession? Passive Investing Strategies!

Who’s Crazy Enough To Buy Stocks Heading Into Recession? Passive Investing Strategies!

Mike Green asks the rhetorical question, ‘Who is crazy enough to buy stocks when we are headed for recession?’ Unsurprisingly, the answer is passive investing strategies that buy stocks blindly as long as they receive cash from their investors.

In this video interview with his Tier1 Alpha team, Mr. Green discusses several key concepts related to the passive forces driving the market:

Who’s Crazy Enough To Buy Stocks Heading Into Recession? Passive Investing Strategies!

  • How index funds and ETFs are making the stock market much more inelastic, meaning that a change in supply in demand moves stock prices much more than expected.
  • Business schools and academics still teach that markets are very elastic, meaning that it is easy for large funds to establish a position without moving the price. This is key for passive funds, which are the largest players in the U.S. stock market. They rely on the fact that their constant buying does not move prices much. This is no longer true as passive funds have become enormous.
  • The Efficient Market Hypothesis assumes that no one player had a big impact on stock prices.
  • The old theories estimated that $1 invested in the market would cause a one cent change in market capitalization.
  • However, now a dollar creates anywhere from $3 to $17 in market capitalization! [See the brilliant study by Xavier Gabaix (Harvard University) and Ralph S. J. Koijen (University of Chicago, Booth School of Business) for much more on the The Inelastic Markets Hypothesis]
  • This research has only come out in the last 3 years.
  • Essentially, the models they are teaching in business school are more than 500 times off and this violates CAPM (the capital asset pricing model). It is a huge change in our understanding of how financial markets work.
  • The large investment flows based on systematic algorithms at passive funds are having enormous effects on stock prices.
  • However, nothing will change until we have a major crisis because everyone is making money.
  • So investors are not making a conscious decision to buy at these high valuation levels with a recession looming. They are simply taking the advice of luminaries like Cliff Asness and Warren Buffett that indexing is the superior strategy. It is the index funds are blindly purchasing stocks.
  • Discussion on target date funds – Roughly 85 cents of every dollar invested in a 401(k) is in a target date fund.
  • These funds did not even exist prior to 2003.
  • QDIA – Qualified Default Investment Alternatives made target date funds the default investment in 401(k) accounts. Previously, workers who did not choose investment options in their 401(k) accounts had their money invested in a money market or cash option.
  • With QDIA, their money was automatically invested in target date funds. They did not have to opt in or choose the funds themselves.
  • This has helped accelerate the death of active managers, since 85 cents of every dollar of 401(k) money now flows into passive strategies.
  • Based on Tier1 Alpha’s research, $60 billion per month is being injected into target date funds. A significant amount of that is invested into the stock market.
  • Therefore, the major link between cash flowing into the stock market is employment because this money is deducted from workers’ paychecks.
  • This amount is approximately $60 billion a month. Therefore $720 billion per year invested into target date funds. This is a net number because 401(k) withdrawals are happening as well.
  • These passive inflows are more than 100% of the money coming into the market. The Boomers redeeming are more heavily weighted to active managers, so they are essentially firing these old-school active managers when they withdraw their money.
  • So the investors trying to be thoughtful about company valuations and the future of businesses are being fired and in their place are index funds and other passive investing strategies that allocate money simply by market capitalization.
  • We’ve actually seen even more money flow into index funds than we expected as people who grew up with passive investing reach age 55 and are eligible for catch-up contributions.
  • The average age of a Vanguard customer was 38 in 2017 and today it is north of 50.
  • So, according to the inelasticity observations Gabaix and Koijen (and Mr. Green’s work as well), this approximately $60 billion worth of buying per month creates, on a 5X multiple, $300 billion worth of price appreciation in the market.
  • That is almost 1% per month market appreciation just coming from 401(k) contributions!
  • Mike’s team at Tier1 Alpha monitors the macro economy as well, but sometimes it does not impact flows and flows are the most important thing that drives the market.
  • They’ve seen situations where the macro deteriorates for 6 months and does not impact the flows, so the market continues to rise.
  • Equity flows could also be impacted by older investors rotating out of stocks into fixed income. This is a function of aging and the target date funds make this shift automatically (and very predictably) as time passes.
  • When recessions hit, it is the 50+ year-olds that lose jobs, sometimes never get them back, and that will hurt 401(k) flows. We have not seen that play out in this cycle yet. It is something Mr. Green and his team is watching very carefully and monitoring the flows into passive investing strategies.

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