Expect More Pain, Much More Pain

If you think you can hide out in ETFs or high growth stocks and weather the downturn, please think again.

In case you failed to notice, investment sentiment has changed. The stock market struggles to go up on good news. Investors wonder if the Fed still has their back.

Some think they can weather the storm by diversifying into ETFs or by owning high quality growth stocks. In reality, the co-dependence between big tech and passive and algorithmic investing will cause far more pain than most anticipate.

Throughout the near-decade-long bull run, tech giants and passive and algorithmic investing ascended hand-in-hand. The more a small group of tech companies dominated market returns, the less active investors could outperform tech-heavy indexes. And the more capital herded to passive and quant strategies, the less firm-by-firm price discovery could restrain tech stock inflation. It was a virtual feedback loop and the consequence is historic capital concentration in the tech sector.

Companies in the NYSE FANG+ Index are valued at a multiple that’s almost three times that of the broader gauge, a greater divergence than at the top of the dot-com bubble. According to a Morgan Stanley analysis, “the e-commerce bubble” — which includes FANG plus Twitter and Ebay — has inflated 617% since the financial crisis, making it the third largest bubble of the past 40 years behind only tech in 2000 and U.S. housing in 2008.

The topline stats are staggering regardless of how often they’re repeated. From the 2009 low to the recent highs, the S&P 500 advanced 331%. Meanwhile, Facebook advanced 413% (from its 2013 IPO), Amazon surged 2,102%, Apple 1,123%, Netflix 5,349%, and Google 586%. Combining those names with Microsoft and Nvidia, just eight tech stocks now account for over 15% of the entire S&P 500 index, and a staggering 48% of the Nasdaq 100.

The S&P 500 Growth Index has a 41.3% weighting to technology. The Russell 1000 Growth Index carries similar exposure, at 39%. At the average of the two, this represents a 60% overweight versus the S&P 500’s 25% exposure to technology stocks.

This brings us to passive investing’s great illusion: diversification. As Jared Dillian, former head of Lehman Brothers’ ETF desk, explained to Bloomberg in November: “Retail investors who are buying ETFs or indexed funds are being sold on the idea that they’re diversified. What [they] don’t realize is that the trade is very crowded — like 20 million-other-people crowded.”

As Morgan Stanley warned in a report released last week: “[The sectors] now occupy top rankings within the momentum trade that are ‘grossly’ out of proportion with their share of the market”:

​Hiding Out in ETF? High Quality Growth?

Investors are about to re-learn a "Nifty-Fifty" lesson that they should have memorized in 2000 and again in 2007.

Lesson Unlearned

The lesson is good companies do not necessarily make for good investments.

For sure, Apple, Amazon, and Google are excellent companies. That is why they are on nearly everyone's "must own" list.

The problem with must own lists is they never (and I doubt that is "never" is much of an overstatement) take into consideration valuation.

Mean Reversion

Earnings mean reversion is coming up. It's guaranteed. Timing is not guaranteed.

What appears to be reasonable based on silly forward estimates is an enormous value trap.

Meanwhile, "Stopped Clock" taunts pile in, just as they did in 2005, 2006, and November of 2007.

It Remains Impossible

It was impossible (in aggregate) for investors to heed such warnings in 2000, 2007, and it is also impossible now.

Individual persons can indeed take action, but given there is a buyer for every seller, it is mathematically impossible for the masses to do anything but ride this mess down as happened previously.

Mike "Mish" Shedlock

@killben .... you are preaching to the choir, I agree with all your are saying. CB have painted the world into a corner and just kicked the can down the road. But there is a difference between being a permabear and a skeptic. 2006 was a great time to be a skeptic. But the problem with a permabears is the word "perma". They did not recognize the value in assets from 2009-2012, as they thought bad times would be "forever" and that everything would go to "zero". I'm more of a real estate & distressed debt buyer then stock market guy. 2009-2012 was a PHENOMENAL time to buy rental property and distressed mortgage debt for pennies on the dollar. Permabears missed this buying opportunity because as always, they thought back in 2009, 2010, 2011, 2012, etc... that another depression was "right around the corner" or hyperinflation, or some other calamity, etc... Neither which materialized....YET... of course it still might of course. I have friends that never picked up any rental property when prices were dirt cheap 2009-2012 because they though prices would only go lower. So its easy to be a permabear say for decades that "bad times are right around the corner". It's much harder to make the turn, and buy assets at bottoms whenever hates them, and thinks the world is headed into a endless depression.

@MntGoat, I agree with you on buying when there is blood on the streets which many cannot do. That is why only few end up rich. That said, the point remains that there was a recovery in Mar 2009 only after FASB rule change (did you envisage this at the time of buying?) and the CBs doing QE And then QE after QE every year thereon for some time (did you envisage this?). If you envisaged all this and bought then great buying indeed. If not, then if the CBs had not intervened to the extent they did this levitation of asset prices would not have happened and your friends might well have been proved right and the bottom in prices would not have been in. The CBs simply got away by saying that it would have been worse.

@killben .... I didn't envision any of the CB asset inflation...I don't buy for appreciation or greater fool theory...I buy stuff that cash flows day one with a margin of safety at a discount to replacement value. All the appreciation the FED created was gravy, I had no clue I would get. It's good to be a permabear at the end of cycles (which we must be close to now)...but the hard part is to buy when people think the world is coming to end (which they did in 2008 when Lehman went BK). If I had a crystal ball I would have bought A LOT MORE then I did. But of course I didn't and I have a lot of permabear blood in me which restrained my buying efforts.

@MntGoat " buy stuff that cash flows day one with a margin of safety at a discount to replacement value. " ... one can learn from you! sincerely said!! I would the courage of conviction helps.

"which we must be close to now" ... the problem is we cannot be sure of this also the way the CBs have managed for nearly a decade now. Close could be this year or 5 years hence.

Also this...

"which they did in 2008 when Lehman went BK"

without FASB and endless QE, would this have been proved right?

@killben ...."which we must be close to now" ..." the problem is we cannot be sure of this also the way the CBs have managed for nearly a decade now. Close could be this year or 5 years hence". ---------> What's REALLY different now vs. say 2010-2016 is the FED is now in tightening mode not loosening mode. This bull market has never been tested by a prolonged FED tightening phase, which it is being tested by now. And I think throughout history FED tightening phases have almost always led to recessions. And yes if we hit a bad stock crash and/or recession, the FED will likely reverse course....and I have no clue what that will entail for everything.

While you ultimately are bound to be correct, the lessons from Venezuela, Argentina and every other fully financialized dystopia, has still been that those who own stocks, bonds, housing etc., still come out ahead of those who sit in cash, relatively speaking. Simply because the Fed and government has the power to look out for their own. Hence will do so. Making up ever more obviously contrived excuses for ever more obviously crass theft, as the productive base they are dependent on preying on erodes.

Pretty much every single person who has ever been invited to speak in front of Congress, and/or been invited to the White House, or has ever written an opinion in a magazine read by politicians and Fed governors, owe somewhere between a very large and all of their wealth and social status, to pumped up asset prices. Just like in Venezuela, right up until there was simply nothing left whatsoever to steal for fuel on the asset pumping bonfire.

But while eventually the Venezuelan asset-pump freeriders did get a bit of a comeuppance, the important lesson is that this didn’t even begin to happen, before those dependent on cash rather than “assets” were literally starving to death for lack of available food. There is precious little reason to believe our local Chavez’ and Maduros, nor the theft rackets they head up, will go any easier on their designated livestock. Nor that the local livestock; dumbed down, overweight, hapless and indoctrinated as they are; will display any more Somalian like resolve to force the oppressors’ hand.

@Stuki - Completely agree with you. I don't see why there is so much doom and gloom about the US economy. The Fed can easily reverse course and print even more money if it sees any of the dire predictions coming true.
After all, there is still the option to buy all of the listed stocks in the US market (other central banks are doing it, why not the Fed)? Asset prices can also go up a lot more - many PE funds will view reduction in property prices as an attractive investment opportunity (at least by recent historical standards)...
How long can the Fed continue this policy without the general public losing faith? No one can predict the future but I'd bet it'd be a lot longer than the next 5-10 years - even Japan is seeing a very slow decline instead of an instant collapse. Totally agree with Mish that some other economies are in even worse situation than the US - any sign of trouble and investors will flock back to the USD's relative safety...
Mish - What is your view on higher marginal tax rates as a way of income redistribution from the ultra-rich to the general population? Although, politicians don't have a great track record of investing money in the right places, it'd still be better than the current income concentration.