EC The Difference Between Good Economics And Bad

This long-term “parental” panic pattern results in a variety of adverse consequences. The worst of them may be the extreme surge in passive investing. As we wrote in a Passive Fingerprints are all over This Crazy Market, the influence of passive investing on the current market is extreme.

Other Factors

In 2014 Steve Bregman at Horizon Analytics, enlightened us to what he calls the ETF (exchange-traded fund) divide. His argument highlights the passive, indiscriminate nature of ETF investors. The monumental shift away from discretionary (active) value-oriented strategies was well underway but not yet diagnosed in a way that Bregman astutely observed.

Since then, the wave of passive investing has become a tsunami. Passive, or index strategies, attract massive capital at the expense of discretionary or active mutual fund managers.

That re-allocation means two things:

  1. Money is leaving active managers who regularly hold 5% cash on average and is going into passive ETFs which hold less than 0.10% cash
  2. Active managers have historically been the cops on the beat patrolling overvalued stocks and selling them when those conditions are clear. Those cops are being systematically “defunded,” and there is no consideration of “value” in the passive index world.

Seismic Shift

Why are these issues so important?

First, when $3 or 4 trillion dollars move from funds managed with 5% cashto funds with near-zero cash, $150 to $200 billion of “new money” leads to an explosive upside effect on individual stocks targeted in passive funds.

Good bad economics, The Difference Between Good Economics And Bad

Second, when money is removed from discretionary hands and reallocated to index funds, there is no consideration for price, ever. When a passive S&P 500 or NASDAQ 100 fund receives one dollar to invest, it immediately invests in all of the underlying stocks. It does so at whatever price is available. The top decile, ranked by market cap, perpetually benefits the most as the inflows occur. The bottom decile also benefits via overvaluation, but to a lesser extent.

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Edward Simon 2 months ago Member's comment

Lately, there has been an increase in chatter on the net about returning to value investing, or at least that "value" stocks are currently presenting themselves as good investing opportunities because of their relatively low prices. Do you think this is a trend that will gain traction?

Bruce Wilds 2 months ago Contributor's comment

It is only massive and unsustainable deficit spending that continues driving our economy forward. The bottom-line is that we are in the midst of a "false economy" and it is only by the grace of this huge deficit spending that we are not languishing at the bottom of a deep economic pit.

Today late cycle indicators are on the rise, moderating growth, tightening credit, declining earnings, the peak of consumer confidence, rising inflation and more. Deficit spending is not a silver bullet without consequences and with each step forward we get closer to the end of the road.

This is why investors would be wise not to accept America's recent GDP as verification the economy is hitting on all cylinders. The article below argues government spending is a poor substitute for the free market in allocating capital to where it is most effective and it is not economic growth but simply a method of borrowing from the future.

Beating Buffett 2 months ago Member's comment


Moon Kil Woong 2 months ago Contributor's comment

However, I am fiscally conservative. The US messed up pumping the economy for all the years it was expanding. For that, there is no excuse and is the definition of poor planning and economically destitute behavior. We need to learn or put more constraints on central bank actions when we aren't in crisis or in an economic downturn.

Republicans and Democrats are to blame and Congress should take back their power from the central bank, the Presidency, and manage the fiscal aspect of their Constitutional duty better. Simply put, the fault and error of the Treasury has been committed years ago and is the opposite of anything resembling fiscal constraint or good economics. You don't stimulate and carry low interests rates in an expanding economy. Revoke their degrees and make them attend basic economics courses again please.