Implosion of the Index

An implosion is when something collapses under it’s own weight. At the risk of being a doomsday contrarian, I’ll propose a pre-mortem scenario worth thinking about.  Act according to your own insights.  This is not a recommendation but an exercise I’ve challenged myself to consider.

The ETF indexes failed.  How did it happen?

There is widely held knowledge that most people stink at picking individual stock investments but regularly over-value their assessment of their own skill.  If you do not allocate the time how will you improve skill?  Even more evidence suggests that even those that have allocated professional levels of time are still regularly failing, so why try? Thus began a wise recommendation to pursue a whole market, low cost index. With this approach at least you are assured to be average… which is still really good over long holding periods.

With this truth in hand, advisors have poured more than 35% of the total daily trade volume into indexes in the last twenty years. JP Morgan’s estimates are higher still. They estimate that 60% or more are high frequency trades, quant trade algorithms and “passive” investors. Warren Buffett has even recommended that most people should be in a low cost equity index. So, what’s wrong with going passive, and accepting the average?

Back to the pre-mortem:

An entire mob of cars can go from a comfortable 50 mph to 75mph and be happy… all running bumper to bumper, in apparent harmony.  Although the speed has increased linearly, the risks have escalated exponentially. When a tire blows several slam on their brakes and bump into each other.  Those behind sense fear and brake even harder.  The ripple cascades throughout the entire group and everything comes to a standstill, or worse.  An entire freeway can screech to a grinding halt caused by a single flat tire… a foolish mob can cause much worse at high speeds.

I’ll propose that the market index is akin to a recommendation to “run with traffic.” It’s likely to get you there at about the same time with low risk and low costs. However, it also assumes that the traffic load is not too congested and drivers behave normally.  It also assumes traffic is moving. Running with stopped traffic is certainly not be the best approach!

In this metaphor, if the number of cars had been just slightly lighter, with more space between cars, the jam may not have occurred. The drivers would have been more able to adapt independently.  A swerve here, a brake there, return to speed, and no butterfly effect. However, a simple tire problem may lead to catastrophic results when acceptance of running with the crowd turns into a race to maximum results by pushing the crowd.  The consequences can become overwhelming. The same crowd-averaging, mob-mentality can occur in the market when the upward, happy speed momentum pulls too many brake-happy/fearful into the fray.  The honest truth is that the majority does not have to be fearful if the fearful brake hard enough and the speed and congestion are high, the patient can sustain real fall out.

All the “passive” trade volume becomes increasingly fragile with each percentage point increase in the total that is run through ETFs… particularly those “smart” ones that automate their trades. With more high frequency trading we also have the speed to do now what we only day dreamed of earlier. Thus, a stop loss market order may sound like a good idea to a programmer, but it spells trouble when the sellers using the approach far out number the buy-at-market buyers… there is a big assumption at work here that “someone” will step in. My impression is that they are following a very safe distance behind… perhaps even as far back as the next off ramp!  Those dummies!

A logical way to address this is to simply stay in the market. Most index advisors recommend this above all else. Stay in the fray. However, this is easier said than done. Particularly, when the other part of the pitch is that the index is highly liquid.  We have yet to test liquidity in any really significant way.

An investor is someone that trades liquidity today for earnings in the future. This is foundational to business. It starts from the founder(s) of the company and compounds all the way up to the index buyer and momentum trader. In the absence of an underlying valuation, an index may well become a mob who does not understand the liquidity trade they are inherently making.  You are on the freeway in a mob and have agreed to stay in regardless of what transpires.  How is that liquid?

I call out “passive” in quotes above because the perceived lack of a decision by the index holder is actually a decision to trust the advisor. The advisor often makes a decision to trust the ETF or quant. The quant believes everything will continue in a predictable manner. If something goes haywire, then at least the quant warned the ETF wholesaler. The reality is a decision to be long equities is being made. Warren Buffett has a mindset that is long equities over very long holding periods.  This is consistent with an index. Buy the index and sit on it… regardless of what transpires.  The bet is on the economy at large.

The concern over indexing arrived for me personally when one of our individual stock selections entered an index. It went up ridiculously fast. Most people would celebrate, I did a little jig.  And then, I thought, “What the heck?  Why am I okay with frosting on my meat and potatoes?” Although an unearned upward pop in the price feels nice it’s fundamentally more akin to our little company joining the freeway.  Our speed and our risks have exponentially increased. I’m not so sure we should celebrate the index as broadly as we have.

 

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