Passive funds and computerized trading are a toxic mix at record valuations

A decade of QE-flows along with follow-the-leader-price-indiscriminate buying led by computerized trading has made an epic mess of so-called investment markets.

Central banks, banks and other ‘market-makers’ did not have the tools and ability to prevent meltdowns of 50 to 70% in the last two bear markets, and they have a lot less now.  The next storm is coming, and very few are prepared for it.  See The risks grow that the passive and algorithmic transformation of equity markets could lead to a crisis:

According to estimates released by J.P. Morgan in late June, passive strategies now control 60% of U.S. equity assets while quant funds control 20% — a staggering 80% combined. Passive titans Blackrock and Vanguard now oversee $12 trillion, up from less than $8 trillion just five years ago. And based on a recent report by Thomson Reuters, algorithmic trading systems are now responsible for 75% of global trading volume.

This development has never been tested by a recession. And evidence continues to mount suggesting the algorithmic and passive transformation of markets will only accelerate and deepen pain.

Trying to reduce risk and weather this storm holding dividend-paying “low-volatility” stocks and funds is a flawed concept.  After a decade of ultra-low rates, there is more price-risk in these instruments than we’ve seen in many decades:

“Low-volatility stocks are trading at almost three standard deviations above the mean. That means low-vol is more expensive than it has been nearly 99% of the time, relative to the mean, since 1990,” according to the Leuthold Group.

With our firm being one of the few who did not lose but made money, during the 2008 meltdown, in November 2008, I was asked to speak at the CFA Institute conference in Atlanta, Georgia.  The audience was a room of highly stressed financial analysts and asset managers. Most had lost huge chunks of money under management over the preceding year and were facing job loss worries and lawsuits.  Many confided they were in an existential crisis.  My topic was “When to hold ‘EM and when to fold ‘EM:  Policy discipline in Volatile Markets.”

Since most amateur and professional money managers are programmed and/or mandated never to fold but only to hold, their ‘skill’ rises and falls in lockstep with each market cycle. And, in the end, they fail miserably at building lasting value.

The best way to weather a hurricane is not to stay out in it and hope for the best, but to take shelter with stored provisions and a plan before it starts.  Wait for it to pass and then search the rubble for high things brought low.  At that point, capital risk will be a fraction of the present, return prospects above-historic averages, and a multitude of assets on clearance sale–the polar opposite of right now.

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