I’m going to try to tie two related themes together today.  The first, and I have to admit I was surprised when I saw the research, is the incredible shrinking universe of stocks.  Think corporate share buybacks, mergers and acquisitions and fewer companies going public.  The second is the popularity of index investment products available via mutual funds, ETFs and in large managed accounts (e.g., pension plans simply allocate to index exposure whether it may be large cap, small cap, smart beta, etc.).

So here is what is concerning me.  Less supply of available stocks and more and more money in index-based products whose mandate is to buy all the stocks in its index.  No fundamental research required.  The good are bought along with the less well-run companies.  When the flows are positive, they all go up.

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A good friend asked me to do some digging, so I had my investment team take a look at the total amount of money in small cap ETFs and mutual funds.  I was surprised again; approximately 30% of the total money in small caps is in index-based fund products and that doesn’t include the large institutions.  That’s a wow.

The popular thinking is that owning a diversified index is better than picking individual stocks, and that’s been the case the last few years.  If you ask active managers, they’ll tell you they are feeling the squeeze and it is sure showing up in the flows — out of active MFs… into ETFs.

It is this high level of concentration that gets me thinking about other past investment crazes, such as tech in 2000, the “Nifty-Fifty” stocks in the 1970s and “portfolio insurance” in 1987.  Remember, that stuff was supposed to protect your downside.

So, with fewer stocks outstanding and the passive index investing popularity of today, I can’t help but wonder if we shouldn’t have our antennas up.  Then, this crossed my desk a few weeks ago:

In each market cycle, there is usually a new narrative to rationalize excesses in the late stages of a bull market. “Don’t worry about overvaluation in 1987,” it was said, because institutions had no need to sell due to a new concept called “portfolio insurance.”

The concept was well thought out, tested, and sold. I thought it had great validity. Nevertheless, when something becomes too popular and has a large crowd using it, it can malfunction and that likely played a large role in “the crash.”

Again, in 1972-1973, it was, “Don’t worry about overvaluation” if one just bought the “Nifty-Fifty” group of growth stocks that history had proven grew in both good times and bad. Some of these companies are no longer around! There was a similar story in 2000. We were in a “new era” of internet growth. “Don’t worry if stocks had no earnings.” It was “internet clicks” that were important to measure. The internet was indeed a new era, but most dot-com stocks went bust.

In 2007, it was “Yes, housing is pricey,” and nearly anyone could obtain a mortgage loan. However, real estate only went in one direction – upward! Also, don’t worry about mortgage debt – no major bank/broker had gone broke in decades. Besides, as everyone knows, real estate is “local.”

In 2017, I fear the bubble is mainly in passive investing. It has done so well for so long that John Bogle’s great idea has been bought by nearly everyone.

Low fee passive funds that just buy and hold an index fund have largely creamed the high fee active funds the last few years. Not only have index funds outperformed, but the crowd has noticed. Most all of the positive flows are going into passive funds as seen by comparing the flows into mostly active equity mutual funds with passive ETFs.

“Don’t worry about fundamentals, or values; don’t worry about market timing; just buy the market and hold!” Even if there is a small correction, the market has always come back!

Ned Davis sums up his viewpoint, “Sounds “bubbly” to me.”  Words of wisdom from one of the world’s great investment minds.

With the smaller inventory of available stocks and positive capital flows to index-based products, the supply/demand dynamics are quite favorable.  The stock market goes up.  And this may continue for a few more years.  The problem comes on the other side of this trade – when there are more sellers than buyers. With so much concentration in index products and fewer shares outstanding, a rush to the exits will result in a downside that will likely be more pronounced.

Those risks will materialize in the next recession or a systemic shock to the system (i.e., Europe, China, Japan, a global banking crisis or a number of other risks that are higher today due to the global debt problem.)  So stick to the trend and if you do nothing else, put a 200-day moving average stop-loss trigger on all of your long equity positions (or hedge).

With that said, I do love passive low fee index-based products – especially ETFs.  They are great investment tools and, if used correctly, can add great value.  Frankly, there is a way to target so many different asset class exposures and there is generally an asset class that is going up when most equities are going down.

The equity bull market is more than eight years old.  Valuations are the second highest in history.  The positive tailwind from the Fed is no longer at our backs.  They are raising rates and in 10 of the last 13 Fed rate-rising cycles since WWII, recession followed.  In the three that there was no recession, we were in the third year of recovery, not the eighth.  And what does this passive bubble do to asset classes correlations?  We likely won’t be getting that MPT diversification across asset classes that the academics say we will get.

Risk remains high.  With fewer shares and positive flows continuing into equities, if you are an active investor, it feels to me like 1998 when all the value managers were totally unloved.  All the flows went to technology stocks and funds.  It was later called the great tech bubble and the “great tech wreck.”  Now active is unloved.  The current passive trend may continue for longer than I might expect.  For now, the overall equity market trend remains bullish and as they say, “let the trend be your friend.”

Grab a coffee and find your favorite chair and read on.  I share some bullet points from a Credit Suisse research piece, “The Incredible Shrinking Universe of Stocks.”  Supply and demand.  More buyers than sellers.  For now, anyway.

We’ll also take a look at rising inflation pressures (that could trump the Trump bump) and I share with you one of my favorite inflation watch indicators – currently showing high inflationary pressures.  A run up in inflation will kick the Fed into high gear.  Keep that too “On Your Radar.”

Read on… and have a great weekend!

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Included in this week’s On My Radar:

  • “The Incredible Shrinking Universe of Stocks”
  • Charts that Matter
  • Trade Signals – Extreme Pessimism Reading S/T Bullish for Equities; Primary Trend Remains Bullish
  • Personal Note

“The Incredible Shrinking Universe of

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