The Big Picture
“Thoughts arrive like butterflies” – Eddie Vedder of the rock band Pearl Jam
I have had many conversations over these past years discussing the underlying themes that have driven the markets for the last decade. It has led to some good discussions, points, friendly debates, and plenty of thoughts arriving like butterflies.
Market flows, or the capital invested into the stock market over time, are one of the 3 significant underlying themes of this cycle. The laws of supply and demand are pretty simple. The supplies of stocks have been coming down, especially among the high-demand names, while the demand for stocks increasing. Result? A bull market that persists to levels well beyond historical norms.
The Game… has changed…
There are some who are perplexed when I at times refer to the markets as a game. What is a game exactly?
A form of play or sport (we’ll go with play). Especially competitive, (check). Governed by rules and decided by skill, strength, or luck (all correct).
Strength is the point here with flows. Flows are a measure of strength. Are the flows strong, or increasing? Are they slowing? Are they weak? Or are flows negative and coming out of the market?
Even more to the flow point. The dynamic of fund flows has changed significantly since the GFC (Great Financial Crisis). Keep in mind that this event marked a multi-decade shift in thematic drivers for markets and investing (i.e. changed the game).
Have a Plan and a Process!
From the Trenches
“Even a dead fish can go with the flow.” – Jim Hightower
Going against the flow has not been a good market strategy these past years. Ask any value manager!
According to Bank of America studies, over the past five months more money has flowed into stock funds than in the past 12 years combined. For some, this is an indicator that all is well and the best place for hard-earned dollars are equities. Given the recovery from COVID this point has some merit. For others, it is just another indicator that markets have come too far too fast and there must be a catastrophe on the horizon!
Some other interesting points relating to flows:
Over the past decade, there has been an overwhelming shift to passive investment vehicles which essentially duplicate and index, sector, or investment style. Passive flows have totaled $3.8 Trillion (Morningstar) and now make up 41% of total market share. It is likely only a matter of time before passive is the leading market approach.
Over the past decade, there has been $5.3 Trillion in stock buybacks. Buybacks are controversial. A buyback is a form of returning capital to shareholders by reducing the number of shares outstanding and managing the capital structure. The controversy is the buyback may be an attempt to manipulate the stock price higher, benefiting management, as well as all shareholders. Buybacks also reduce the number of shares available in the market, effecting the impact of flows.
Margin debt, or money borrowed by investors from a broker, reached an all time high of nearly $900 billion in June (Bloomberg). Margin debt as an indicator is mixed at best; with no significance on a bullish or bearish trend in markets. However we do witness margin debt increase the higher the market climbs and the longer the market cycle continues. Coinciding with higher market valuations. Overall agreeing with the principal that investors tend to buy the most stock at the highest valuations.
“The public buys the most at the top and the least at the bottom.”
I think there are a few key points to be made here.
- The overwhelming approach to purchasing equities has shifted from active selection, to passive selection primarily based on size, or capitalization. I.e. the most flows go to larger companies, with no consideration on price.
- This shift has drastically changed the landscape in favor of larger growth companies over other investment styles. This is one reason we are seeing valuations significantly above long-term averages.
- Flows, or liquidity, may be a primary driver here. Where money is flowing is a significant factor for market performance. In other words, flows themselves have become a leading factor over other factors such as valuation or fundamentals.
Bottom Line: Security selection has drastically changed over the past decade. I have referred to this approach as a game of musical chairs. Don’t forget what happens if you’re the one left without a chair!
“One man’s constant is another man’s variable.” -Alan Perlis
For many years I have listened to investors discuss how we must revert to historical norms. I understand the argument. However a lot of time may continue to pass trying to convince the market that you are right!
Play the game in front of you…
We spend a lot of time thinking and writing about the changing variables that affect markets. Once we identify them, we can better understand the environment they create and may navigate with better success.
A secular change occurred as a result of the GFC (A secular cycle is a longer period of time and may be made up of several shorter market cycles). Much has changed in the manner in which the markets function and behave since that event.
This has caused significant consternation among many investors!
During every secular cycle there are a few primary drivers or underlying themes that the markets respond to. Over this cycle we have identified a few significant drivers:
- Central Bank intervention and stimulus programs.
- Extended period of very low interest rates.
- Investment approach shifting to passive and capitalization weighted fund flows.
In my opinion these are by far the most prevalent. And I have ranted about all of the above for some time! A constant inquiry I receive from investors revolves around the following:
- “This is unsustainable!”
- “We must be due for a crash!”
- “Hyper-inflation is near!”
All of the above are valid concerns but all are also lacking some needed details. I have heard all of the above for a better part of a decade! Unfortunately these absolutes do little to address the concerns nor do they provide solutions. These concerns adjusted:
- Given the underlying themes driving the market what are the potential risks that would bring an end to the sustainability of the current environment?
- What are the signals and factors that may indicate a potential market decline? Also what strategies can be deployed to address that potential situation?
- What assets or strategies benefit from inflation? Also what strategies mitigate the negative effects of significant inflation?
Bottom Line: Stating absolutes does nothing without a plan or process to address the concerns. The market for the propagation of fear is as old as time. There are no solutions in promoting fear.
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