The US stock market has been in a relentless bull market. We’ve covered in depth one of the reasons—the monetary tsunami that is the Federal Reserve. But it is fair to say that the Fed isn’t the only reason for such a frothy market. There is another factor at play as well. That factor is the shift towards passive and ETF focused buying that began more than two decades ago and has come to dominate flows within the stock market.
These “passive” strategies use a rules based investment approach rather than actively discriminating between different equities. A result is that already expensive stocks become more expensive for reasons that have nothing at all to do with the underlying fundamentals.
For example, SPY is a popular index fund that tracks the S&P 500. By making just one purchase, you are able to gain access to all 500 stocks in the index. How’s that for diversification? The thing is, the SPX is a weighted index. Capital doesn’t flow equally into all 500 stocks that comprise the index. Instead, the stocks at the top of the index receive more capital than those at the bottom do.
Take Apple for instance. Due to its immense size, Apple finds itself at the top of the list, whereas you need to scroll way down the list to find Xerox. Because of the way it is constructed, a full $500 flows into Apple for every $1 that flows into Xerox.
There is nothing wrong with this approach, since an investor in SPY is expecting to match the S&P 500’s performance, what better way than to have the fund actually match the construct of the underlying index?
The problem that arises though, is that stocks with the highest market caps will receive the lion’s share of the money flowing into the fund. In other words, the expensive stocks will tend to become more expensive as it is purchased with no consideration to its existing price.
A consequence is that the market doesn’t mean revert the same way that it used to. As long as capital is flowing into passive funds, it is also flowing into the current high fliers that dominate the index.
Eventually, something will happen that will change the direction of capital flows. Then, the process will reverse and 500x’s as much money will flow out of Apple than it will for Xerox. But for now, capital is flowing steadily into index funds, which are bidding up the prices of stocks that would previously be viewed as expensive.
In conclusion, claims of a major top being at hand simply because of stock market valuation may be premature. While it is true that at some point the flows will reverse in a major bear market, that point isn’t right now.