Relentless Price-Insensitive Buying

Businessman, Internet, Continents

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We have focused on the monetary tsunami set in motion by central banks, but there is another force contributing to the record-high valuations in the US stock market. That force is the shift towards passive and ETF-focused investing that began more than two decades ago and has come to dominate flows within the stock market.

So-called “passive” strategies use rules-based investing, often to track an index by holding all of its constituent components or a representative sample of those components. There is no discretion on the part of the asset manager. For example, money going into an S&P500 index fund will be allocated to all of the stocks in the S&P500 according to their weight in the index, meaning that the stocks with the highest market capitalizations will receive the lion’s share of the money flowing into such a fund.

Due to passive investing, the more expensive a stock becomes the more investment it will attract and the more expensive it will become. For example, in the S&P500 Index the current weighting of Apple is 500-times greater than that of Xerox, so when money flows into an S&P500 index fund the proportion that gets allocated to the purchase of Apple shares will be automatically 500-times greater than the proportion that gets allocated to the purchase of Xerox shares. Therefore, rather than a relatively high valuation stemming from past outperformance being an impediment to future relative strength, it will tend to create additional relative strength.

This wouldn’t be a major issue if passive investing constituted a small part of the market, but the strategy has grown to be by far the most important source of demand for stocks in the US. This means that the largest net buyer of US equities each month is price-insensitive (value blind).

Summing up the above, every month a large amount of money flows into funds that allocate with no consideration of value.

Furthermore, many “active” fund managers now trade ETFs rather than individual stocks and many of these ETFs are rules-based. For example, rather than go to the trouble of selecting/monitoring the stocks of individual oil companies, these days an active manager who is bullish on oil is likely to buy shares of the Energy Select Sector ETF (XLE). This ETF tracks a market-cap-weighted index of US energy companies in the S&P 500, so the more expensive an oil company becomes the greater will be its weighting in XLE and the larger the amount of money that will be allocated to it whenever the demand for the ETF pushes the ETF’s price above its net asset value.

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