Why These Constant Market Highs Have Me a Little Concerned

This is a syndicated repost courtesy of Money Morning – We Make Investing Profitable. To view original, click here. Reposted with permission.

Maybe Vanguard Funds’ John Bogle knew he was about to ignite one of the hottest investing crazes of all time when, on Aug. 31, 1976, he launched the world’s first index mutual funds.

Then again, maybe he didn’t.

But what’s clear is the decades-old “how to invest your own money” philosophy has never been more popular.

In fact, it’s so hot it may be the reason stock markets are hitting serial new highs… and why volatility, as measured by the VIX, is at historic lows. Genius!

The thing is, it’s also likely going to cause the next insane spike in volatility and serve as the impetus for the next market crash. Insanity!

Either way, no one – even active investors – can afford to keep ignoring what’s happening…

The Market Means Different Things to Passive Investors

The core philosophy of passive investing is that individual investors can’t beat the market, so they should just buy the market.

The thinking, in other words, is “don’t bother trying to become a stock picker and go looking for needles in a haystack. Just own the haystack, since all the needles you’re looking for are in there.”

Of course, there are different measures of the “thing” we call the stock market.

When the average person in the street thinks “market,” he or she is probably thinking of the Dow Jones Industrial Average, a 100-year-old index of 30 big-cap stocks.

Now, when a market pro thinks “market,” they’ve likely got the industry benchmark in mind: the S&P 500, Standard & Poor’s index of 505 (that’s right, there are 505 stocks in the S&P 500) big-cap stocks.

And of course there’s also the Nasdaq Composite Index, an index of around 3,000 stocks, led by 100 tech-centric stocks.

Besides the “Big Three” benchmark indexes, there are plenty of other market indexes and sub-market indexes, too. Those are industry-related and other, smaller benchmarks of groups of stocks. They all are supposedly representative of the market or specific sectors.

The good news for passive investors is there are hundreds of mutual funds and even more exchange-traded funds (ETFs) that investors can buy and sell that track just about all of anything you’d like to call “the market.”

But the recent passive investing mega-trend exploded with the advent of ETFs. Index ETFs are the biggest, most successful products to come out of Wall Street since mutual funds.

They are rapidly gaining ground on mutual funds as the go-to place to park money and as tradable instruments to bet on the market (or any sector of any market), either going up or going down.

Mostly, however, individual investors are pouring money into index funds that own stocks, betting markets are going up.

And, of course, they are going up. And here’s a big reason why.

The Inflows Here Are Off the Charts

The quantity of money going into passive investing strategies and instruments is staggering.

In the first five months of 2017, a little more than $388 billion has gone into passive investment vehicles. At that pace, the annual flow into the strategy will exceed $800 billion, doubling the take in 2015 and easily exceeding the $506 billion invested in passive funds in 2016, which was itself record year.

The reason the stock market has been going up no matter how you measure it is because there’s so much money being invested in “the market.” Plenty of analysts, myself included, say the markets are making serial new highs because the flow of passive money is scooping up so many indexed mutual funds and index ETFs.

Indexes are all up because when investors buy index funds, the sponsors of ETFs and fund families have to buy all the stocks in the indexes that investors are parking money in.

You read that right: They have to buy all the stocks in an index, in the same proportion, with the same weighting each stock has in the index it’s in.

That means the stocks with big weightings get more money put into them, which means they move the whole index higher because they account for so much of their index’s weight. That can be self-fulfilling, or circuitous, meaning the more money that goes into passive investing vehicles, the more the indexes we measure the markets by go higher and higher.

That could be the genius: If buying the market raises the market, then it makes sense for everyone to keep buying – to keep plowing money into passive investing vehicles.

Or, it could be insanity. Because of money flowing into Vanguard’s passive indexed funds, the fund family has a greater than 5% position in 491 of the 505 stocks that make up the S&P 500.

That’s kind of insane.

Many of the stocks that investors might otherwise pass on, or short, are getting money allocated to them as well. All boats are rising with the tide of money flowing into passive investing; even “bad stock” boats are being floated.

That’s kind of insane.

The growth of passive investing, lifting indexes steadily for the past several years, has reduced volatility to record-low levels, as if there’s no reason for the market to exhibit volatility anymore.

That’s kind of insane.

Excessive amounts of money are flowing into the big-cap weighted stocks, which by themselves move indexes higher and are overbought, according to many analysts (myself included), which in turn contributes to their overweighting in indexes. This is influencing analysts’ (myself not included) and investors’ perceptions of the market to a point where no one really understands their effect on stock valuation metrics…

…Which is more than kind of crazy.

There’s more – because there’s way more esoteric stuff to talk about when it comes to the insane things that the passive investing mega-trend is manifesting.

All the money that’s pouring into all the stocks, especially the big caps leading indexes higher, is causing them to be less liquid as the float (the number of shares of these stocks that trade in the open market) is reduced dramatically because they are being “parked” in funds, which is worrisome. And it may be insanely dangerous.

It’s all good when stocks are going up, and passive investing strategies drive markets higher. In fact, it makes a lot of investors look like geniuses.

But the trend – what’s happening underneath all this growth – is crazy worrisome. It borders on insanity, and it’s accelerating.

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