Money is leaving active management and pouring into passive vehicles like ETFs. What will cause it all to come down? You get three guesses, and the first two don't count.

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One of the biggest problems for bears—the ones who predict a 25% to 50% drop in the equity markets—is the structural change in U.S. equity markets over the last decade.

While the newsletter business was full of calls about Nvidia (NVDA), Palantir (PLTR), and Tesla (TSLA)—which we highlighted as oversold in September before the election—the markets did what they often do on repeat.

Last year, investors poured another $1 trillion into the exchange traded fund world, bringing the passive investment total in ETFs to a stunning $10.6 trillion. Here’s the chart from ETFGI data via Chartr and Sherwood News.

All the while, investors pulled $450 billion out of actively managed stock funds, outpacing the outflows of $413 billion the year prior, according to EPFR. The markets are on autopilot -- at least 80% of it when we combine the passive investment world and the managers trying to replicate their benchmarks.

Lower costs are attracting those outflows. So, too, is performance.

More passive investing isn’t necessarily bad for the market, but it does impact price discovery. The reality is that the stocks in the ETF will only exit those funds one of two ways. First, the fund closes. That’s unlikely.

ETF managers like Blackrock and Vanguard are happy to slap that stock into an ETF and then lend it to short sellers to do whatever they want. Those shares will generate a nice 1% to 2% return for the money managers as they give investors what they want: The ability to set the whole thing on autopilot.

The second way is that there is forced selling. Forced selling occurs when investors must sell assets due to margin calls, redemptions, or fund rules, often driving prices lower regardless of fundamentals.

So, what are the notable periods of forced selling seen since 2008? It’s all the usual suspects:

• 2008 Financial Crisis: Margin calls and deleveraging experienced in the housing and credit markets.
• 2011 European Debt Crisis: Sovereign debt concerns led to widespread liquidations.
• 2015-2016 Energy Crisis: The oil price collapse triggered forced selling in energy-linked assets.
• Late 2018: Fed rate hikes and trade tensions sparked a sharp market downturn.
• March 2020 (COVID-19 Crash): Liquidity crunch and panic selling occurred amid global shutdowns.
• 2022 Bond Market Selloff: Rising rates and inflation caused heavy outflows from fixed-income and equity markets.

It’s All About Liquidity

That returns us to the very important argument to end all arguments: It all comes down to liquidity in the system. If liquidity drains at an extreme level, then watch out. But when you hear someone warn of a crisis, remind them that every crisis is a liquidity event.

See the 2008 GFC, the 2011 European crisis, the 2015/16 China crisis, the 2018 bond frenzy, the 2020 COVID-19 crisis, the 2022 GILT crisis, and even the selloff we saw in late 2023 due to rising U.S. bond prices (which impacted borrowing collateral).

This is why American International Group (AIG) stock plunges during these events, as the stock is a proxy for default risk.

Be patient. If we do get a major downturn toward the end of 2026 and into 2027, you’re going to get a once-every-five-year opportunity to buy American International and ride central bank easing into outrageous gains.

Here’s the performance of the stock from 2010 until 2024. You’ll notice a liquidity event that aligns with their lows, but also a central bank pivot that runs the stock higher each time.

(Click on image to enlarge)

• In 2011, the ECB’s maneuver and the U.S. debt ceiling shifted to turn the tide.
• In 2015/16, the “Shanghai Accord” didn’t happen, according to Janet Yellen.
• In 2018, it was the pivot by the Fed to QE4 and rate cuts.
• In 2020, it was every central bank printing money and slashing rates to 0%.
• In 2022, the Bank of England pivoted away from the GILT crisis.
• In 2023, the Treasury Department's suppression of the 10-year bond largely started after the 5% surge.

This is how markets work, it all comes down to central bank pivots. And when China does take action, it will be more of the same.

I still find it confusing that Goldman Sachs is putting so much faith into “moderate earnings growth rates” for the year ahead, when the last 16 years have reliably shown that the market depends on liquidity, momentum, insider buying (and buybacks), and central banking pivots.

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