The Passive Zombie Army Will Keep Stocks Marching Higher – For Now

(Source: Pixabay, author)

For the past few months, I’ve been active on Seeking Alpha in the exchange and market data industry, covering specific stocks and the sector as a whole. Today I’m dipping my toe into the macro conversation after, in the course of my normal sector-specific research, I came across an interesting and powerful thesis driving stocks as a whole. I’ve heard this thesis debated on SA before, but not in as clear or compelling of a way to cause me to change my market outlook.

It’s not earnings projections.

It’s not COVID-19.

It’s not even central bank intervention.

This thesis revolves almost entirely around the seismic shift towards passive, index investing and the exponential impact this shift has on all investors. Before hearing the below argument laid out clearly, I was net bearish on the stock market, albeit scratching my head in frustration as to why markets kept going up in the face of truly apocalyptic fundamentals. I’ve since reluctantly pivoted to a bull in the short term, but am no less worried about the long-term state of financial markets and the economy as a whole. The foundation for this thesis comes from Mike Green of Logica Funds, who is very active on the podcast and YouTube financial circuit, particularly via Real Vision. I strongly encourage you to take a look at his content and understand the crux of his argument, but I’m going to summarize below.

Fund Flows, Not Valuations, Drive Today’s Market

As most (if not all) of us know by now, passive index investing has taken the market by storm. The combination of low expense ratios, high liquidity, and returns that crush active management has created a tidal wave of market adoption into passive equity products:

(Source: Financial Times)

In addition to the inherent benefits of passive products, the avenue to gain exposure to these instruments as a whole has been made much easier in recent years. 401K plans through Vanguard and other asset managers promote target date funds as their flagship product, and in many cases employers automatically enroll new retirement accounts in passive, target date funds when employees are hired. As a result, more than 90% of equity market inflows made by millennials today are through passive vehicles, according to data collected by the Financial Times.

What does this mean for the equity market? It’s helpful to review the rules by which the average active fund and the average passive fund operate to understand further. An active fund generally operates with the below philosophy in mind:

(Source: author)

I know this is a gross generalization, but the core philosophy holds that active managers can choose not to invest money when valuations are too high, or sell stocks they currently own that they deem are too expensive.

In contrast, a passive fund is generally governed by this idea:

(Source: author)

Notice the lack of reference to any semblance of valuation among the rules of a passive equity fund. If I have a retirement account set up and am contributing part of my paycheck to buy a passive equity fund, I am creating a rule to buy stocks no matter the price or valuation of the underlying shares. Valuations mean nothing to me – I get cash every pay period, so I buy stocks. The end. Millions of retirement accounts operate under this general rule today, creating an effective army of “zombie buyers” – market participants who buy the same securities at the same time every month with no discretion to the price of what they’re buying. As more millennials enter the workforce and start to contribute towards retirement, I believe this passive, zombie army will only grow over time, transferring more assets from value-sensitive investors to value- insensitive ones. We’re already seeing this phenomenon take shape – in 2019 we saw equity market scales tip, as passively-managed AUM surpassed actively-managed AUM for the first time in history, a truly staggering milestone:

(Source: Bloomberg)

Another side effect of more passive market share is a lower effective float among underlying companies in the index, which contributes to higher levels of volatility. As a primer, a stock’s float is defined as the number of shares outstanding minus restricted stock and shares owned by insiders, seen as a reference to shares available for everyday investors to trade. In 2017, Goldman Sachs coined the term “passive-adjusted float” as shares outstanding ex insider shares and passively-held shares, seen below:

(Source: Goldman Sachs)

Why is it acceptable to exclude passive shares from a stock’s float? Because these shares are very likely to be held for long periods of time in retirement accounts and, as argued above, are not price sensitive. Buy-and-hold investors do what their name suggests – they hold. At extreme ends of the spectrum, if all shares of a stock were held by passive buy-and-holders, and someone new wanted to buy the stock, there would be no one to sell to them. There would be no stock left to buy. As passive inflows grow, I think we’re going to see equity market volatility become more pronounced as prices will be determined in a market with ever-shrinking shares left to trade and ever-shrinking liquidity. This is where flows take precedent over valuation, and why I think they’re the key metric to watch when predicting where this market is going.

Short and Long Term Flow Predictions

Now that I’ve laid out the argument for why flows matter more than valuations in the current environment, I want to talk about the short and long term drivers of these flows – mainly, demographics.

In the short term – over the next 1-2 years – I think flow favors the bulls. The passive tidal wave is showing no signs of fading soon, and millennials fully entering the workforce with close to 100% exposure to passive products will keep inflows strong. If inflows stay strong, I think equity markets can continue to march higher. I know – I can hear value investors screaming at me through the screen – valuations are crazy at these levels, and future returns seem doomed at these prices. There are plenty of articles that lay this out extremely well. However, when a majority of buyers in the market are insensitive to valuations, these valuations start to take a back seat to basic supply and demand. There are less and less free-floating, non-passive shares outstanding for marginal buyers to purchase, and this will inherently cause prices to rise, potentially dramatically.

Long-term – 3 years or more out – I’m still quite bearish on the market, both from a valuation perspective and, more importantly, a flows perspective. The baby boomer generation – people born in the US between 1944 and 1964 – are starting to turn 70.5, the age when required minimum distributions from 401Ks start to kick in. The recent SECURE Act passage pushes this age back to 72, but the time is quickly coming when baby boomers will start net selling stocks to pay for retirement. The reason this is a very negative development for the markets is boomers are currently extremely overweight equities. Below chart from Vanguard lays this out more clearly – a normal target date fund would have ~40% exposure to equities around retirement age. Boomers are currently averaging 60-70% equity exposure, very similar to the millennial’s average exposure today. This exposure, however, is on a much larger base, as boomers hold most of the national wealth today given time compounding:

(Source: Vanguard)

(Source: Washington Post)

My concern is that in the next 2-4 years we’re going to start to see net equity inflows turn into net outflows, as baby boomer required distribution selling outweighs smaller contributions from the relatively poorer millennial generation. When the marginal buyer turns into a marginal seller, especially when a stock’s effective float has shrunk amid more passive share, we could see prices drop extremely rapidly.

Conclusion

Here’s the part where I add a caveat – I, along with everyone else on Wall Street and Main Street, have no idea what is going to happen. I was a bear when coronavirus hit and normal valuation metrics screamed financial doom. I didn’t understand why markets rebounded so quickly and powerfully, even with help from global central banks. The more research I did, the more I am now gravitating towards passive indexation taking over normal valuation methods and flows truly determining prices. I think in the short term, prices can keep rising above what anyone expects or has seen before as passive buyers pay higher and higher prices for a smaller percentage of underlying float. I will point out, however, that passive indexing is a relatively new phenomenon, and we haven’t seen markets with this much passive exposure at any other point in history. Managers like Mike Green are giving detailed warnings about the effect this can have on financial markets, and I largely agree with him. I’m investing with a long bias for now, but am concerned what prices will do when baby boomers are forced to sell their large equity holdings into an illiquid stock market.

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Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article should not be taken as investment or financial advice and is for informational purposes only. Consult a financial advisor before making investment decisions. This article discusses public information sourced from SEC filings and publicly available reports. Future performance could differ from what is estimated in the article.