Passive investing next market bubble?

[NW-Bound]

OK. Good.

I do compare myself to the benchmark to make sure that I am not too far off the main stream. And if I do, I'd better have a very strong reason and conviction.

It's the same as comparing my personal political beliefs to that of the masses, to make sure I am not really in a crazy corner by myself.

 

[NW-Bound]

I do not index. I do stay quite diversified, although with concentration on some sectors.

I like to have a bit of everything, and enjoy watching them race each other. Imagine a slot car race, but with hundreds of tracks.

And they are not cars, but snails slowly crawling along. One day, snail A gets ahead by 1%. The next day, snail B goes backward by 2%. What the heck?

That's how I spend my time.

 

[NW-Bound]

Some people think of active investing as something as exciting as a football game.

No, for me I think it is more like a chess game, if not snail racing. At most, a frog hopping contest.

And as I mentioned slot car racing which I have not done in 50 years, I just looked on Youtube to see how it is done now. Way too fast for me and most people here.

 

[GravitySucks]

^^
^^
Wow. I loved building and racing slot cars when I was a kid. 1/16 and HO.
They weren't that fast though!

 

[SnowballCamper]

If index investing means following an algorithm to select stocks, there could be a common bias among the algorithms (e.g. sufficient market capitalization). One could do the research to discover what this bias might be, and then come up with a hedge against it.

Burry points out, "This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue."

But at this time, there is still more than half the market actively managed, and thus using information to determine price.

There must be some percentage of the market that uses information to trade and thus, set prices (otherwise it would not be a market). Note that an algorithm uses information to select stocks as is the case with many "Index" funds.

As for the "massive capital flows" If they're going to the entire investment universe (e.g. they are distributed across the total market) then the risk seems to be more for inflation. The article warns us about a bubble, but doesn't give any information (or even speculate) as to why the pricing mechanism is/will be wrong.

There is always a market bubble on the horizon...
And hence, just another investment porn article.

 

[NW-Bound]

A bubble is when there is a mispricing of 2x to 10x or more.

I do not care about indexing, but do not see a mispricing of that level either at this present time. I hope that I am not wrong.

 

[OldShooter]

If index investing means following an algorithm to select stocks, there could be a common bias among the algorithms (e.g. sufficient market capitalization). One could do the research to discover what this bias might be, and then come up with a hedge against it. ...

Personally, I try to avoid the word "indexing" in favor of "passive investing." The reason for this is that the hucksters have hijacked the word "indexing." A passive investor does what Eugene Fama advises: "We have to hold the market portfolio." IOW, everything. For many passive investors "everything" is limited to the US market. For others of us, "everything" means the whole world. There is also a group for whom the S&P 500 is close enough to "everything" to be satisfactory. Only in this latter case is there a "bias" -- US large cap.

Most funds with "index" in their names, especially ETFs, are not IMO passive at all. They are just sector funds with an advertised bias. But since there are hundreds of these, it seems logical to believe that in aggregate they hold the whole market so I'm not sure how you make any money knowing about them.

@NW-Bound, how do you know if there is currently a mispricing and what its magnitude is? I can see where you might know when looking in the rear view mirror but that is not very useful information.

 

[dirtbiker]

I tend to think we're in a bubble or close to it. I'm at an all time low in equities and all time high in cash equivalents right now. I'm not completely out of the market, but I'm not buying new equities for the time being. I'm doing what Warren Buffet is, and letting my cash pile grow. I could be wrong, and if so, I've still got equity investments that will grow. But if I'm right, I've got enough outside of equities that I can scoop up plenty of good stocks at rock bottom prices.

I'm in the minority hoping for a bear market soon for a good buying opportunity and an opportunity to get back to buying equities.

 

[NW-Bound]

@NW-Bound, how do you know if there is currently a mispricing and what its magnitude is? I can see where you might know when looking in the rear view mirror but that is not very useful information.

That was my point. A factor of 2x can be normal, and justifiable in a certain economic set of circumstances. A factor of 10x or higher should be more identifiable. The dotcoms were mispriced. Beany Babies were mispriced. I believe bitcoins are mispriced.

I have recounted the story of Bogle sounding the alarm back in 2005 or so, when he noted that the financial stocks took up too big a percentage of the stock market. His point was that they were middle men, and when the middle men became more important than the producers, that was not a good omen.

Yet, at that point financial stocks had fine P/E. They raked in mucho profit from subprime mortgage dealing. That level of profit was simply not sustainable, but people did not question that. Yes, you make a lot of money, but how? Did you print it?

PS. What are the measures to know if something is out of the ordinary? We have all the traditional criteria, such as P/E, P/S, book value, PEG, etc... People either do not look at them, or if they do, simply wave their hands and say that things are different now, or finding new reasons. Sometimes the latter is true. Often, it is not.

If we do not question anything, of course we will not see anything.

 

[dixonge]

... in fact when you buy the S&P, you buy more of the high flyers than the undervalued ones.

I have been putting most everything into RSP, mostly to avoid over-reliance on the biggies (Facebook, Amazon, Google, etc.). However, even though it is based on the equal-weight S&P 500, it isn't truly equal weight.

Truly equal weight would involve each stock comprising .2% of the fund.
Top holdings are 0.35 percent.
Lowest holdings are 0.06 percent.

On top of that, 10% of the fund is in something else besides the S&P 500 (I'm guessing some form of fixed income).

Having said that, it's a helluva lot more equal than the S&P itself and most ETF's. So I guess I'm good...

 

[OldShooter]

That was my point. A factor of 2x can be normal, and justifiable in a certain economic set of circumstances. A factor of 10x or higher should be more identifiable. The dotcoms were mispriced. Beany Babies were mispriced. I believe bitcoins are mispriced.

I have recounted the story of Bogle sounding the alarm back in 2005 or so, when he noted that the financial stocks took up too big a percentage of the stock market. His point was that they were middle men, and when the middle men became more important than the producers, that was not a good omen.

Yet, at that point financial stocks had fine P/E. They raked in mucho profit from subprime mortgage dealing. That level of profit was simply not sustainable, but people did not question that. Yes, you make a lot of money, but how? Did you print it?

PS. What are the measures to know if something is out of the ordinary? We have all the traditional criteria, such as P/E, P/S, book value, PEG, etc... People either do not look at them, or if they do, simply wave their hands and say that things are different now, or finding new reasons. Sometimes the latter is true. Often, it is not.

If we do not question anything, of course we will not see anything.

But ... but ... you didn't answer my question. How do you calculate what the factor is? If you don't know that you can't determine whether there is a bubble.

Here is a piece of the Fama/Thaler discussion from that video I linked:

Thaler: ... For a long period, house prices were roughly 20 times rental prices. Then, starting around 2000, they went up a lot, then they went back down after the financial crisis.

Fama: What’s the bubble? The up? The down? The subsequent up?*

Thaler: We agree that it’s impossible to know for sure whether something’s a bubble.

*Recall that subsequent to "the bubble" housing prices recovered to levels that were/are higher than their values during "the bubble." That rebound wasn't considered to be a bubble, however.
​

If these guys can't identify bubbles, I am pretty sure that I can't either.

 

[NW-Bound]

Has anyone asked Farma about the dot-coms, the Beany Babies, the bitcoins? These are contemporary events, and not even the old stories about the South Sea bubble, the Tulip mania, etc...

He probably says "That's the way it is. That's how market works".

If he really says that, then I have learned all I can from this man. No matter what happens, he would shrug and say that nobody possibly knows.

 

[OldShooter]

So you're not going to answer? During the event how do you calculate the factor?

 

[NW-Bound]

I thought I answered it already.

From my earlier post:

... A factor of 2x can be normal, and justifiable in a certain economic set of circumstances. A factor of 10x or higher should be more identifiable. The dotcoms were mispriced. Beany Babies were mispriced. I believe bitcoins are mispriced.

PS. What are the measures to know if something is out of the ordinary? We have all the traditional criteria, such as P/E, P/S, book value, PEG, etc... People either do not look at them, or if they do, simply wave their hands and say that things are different now, or finding new reasons. Sometimes the latter is true. Often, it is not.

If we do not question anything, of course we will not see anything.

Could it be true that Fama does not believe any of the traditional financial measures?

Hmmm... Interesting.

 

[NW-Bound]

By the way, it is peculiar that because Fama himself cannot tell what is a bubble or not, he says that nobody else can either.

And I am talking about huge bubbles in the recent past, like the dotcom and the subprime bubble.

I can eat quite spicy food compared to most people, but there's no way I can eat an entire habanero. I was extremely flabbergasted the time I saw an episode on Food TV, where a group of hot pepper aficionados got together to eat habaneros. They ate them raw, and popping them like we eating popcorn.

So, I learn not to judge people based on my own ability.

PS. About the dotcom and the subprime bubbles, I knew it was very wrong. These bubbles were so big, a lot of people knew, not just myself. And we were no Nobel laureates.

What I did not know was the bubbles were that big!

I just did not know the fallout could spread so wide, and did not know how to protect myself.

 

[NW-Bound]

OK, I am obviously not a fan of Fama, so do not read everything that he writes. But I found this after a very brief search.

... Fama is convinced that financial bubbles don’t exist, and until the dot-com era he was able to keep most of his colleagues in academic finance from even using the word “bubble.” Here’s what he told Kestenbaum: “If you interpret the word ‘bubble’ to mean, ‘I can predict when prices are gonna go down,’ you can’t do it.”

Fama is surely right that nobody can reliably predict exactly when prices are gonna go down. But he’s way off base when he implies that this is a widely accepted definition of “bubble.” In fact, hardly anybody interprets the word to mean this.

So, in Fama's definition, if you cannot tell exactly when a bubble is going to bust, so that you can make a lot of money by shorting it, then it is not a bubble.

Hah! If I know to stay away, to not buy dot coms, to not buy a lot of houses to flip, that is not enough? I have to be able to be as prescient as Templeton who shorted the dotcoms at the right time to make a lot of money, or as Burry who made huge profits off the CDO/CDS, in order to be able to say that the dotcoms and subprimes were bubbles?

This man is very strange. And of course, he is using his own definition of the word "bubble".

Just because you don't know exactly when a temporarily insane person will stop acting crazy, that does not mean he is not crazy.

 

[Theo]

It goes back to "irrational exuberance". Because bubbles are irrational, you cannot reliably predict when they will end. That is part of what makes them so dangerous.

 

[Oz investor]

What seems to be implied is that these funds are not actually "buying" the shares (low volumes traded in many of the index components) but pretending to buy the shares through instruments like derivatives. If that's the case, then the fund shareholder doesn't actually own anything except the financial instruments used to emulate buying and selling shares. If this interpretation is correct (please correct me if I'm wrong), then the stock market is a very dangerous place to invest.

More likely, these funds do own shares, but also play with derivatives to smooth out buying and selling. That's less risky, but is in no way a simple buy and hold strategy.

ETA: Even more likely is the idea that only a few of the stocks in each index are "in play," and the others are not. Then the funds are not representative of the index, but just some components of the index, and everyone in the index fund business only buys and sells those stocks.

None of these interpretations makes me want to be in the stock market...

from my research into various ETFs ... SOME ETFs ( not all ) use extensively financial instruments instead of direct share-holdings , and some have limited usage of derivatives while i also notice SOME ETF providers ( like Vanguard and Blackrock ) now MIGHT lend the shares out to short-term traders

such research has made me rigously research any ETF i buy into so i have a very good grasp of the product i am buying

i still hold various ETFs ( of various types ) but they are probably just over 10% of the portfolio .. i use ETFs as 'insurance ' covering areas and stocks i do not hold individually .

smoothing out ..yes in some cases but it seems mainly to increase profit margins ( in a world of reducing fees )

 

[NW-Bound]

I think people often abuse the term "bubble", and that adds to the confusion. A bubble is not something that happens often. But quite frequently, things become "overvalued".

Of course, one then asks "overvalued with respect to what?". And the answer is "with respect to the traditional yard sticks".

And we find that the yard sticks may have to be recalibrated every so often. Something might have changed that it makes sense to do so. For example, the P/E of the S&P has been higher than the historical average, and that has persisted for 25 years.

Can something that last 25 years be called a bubble? Perhaps this is now the new normal. Or is it still too early to tell? Shiller and Bogle suspected that the P/E will revert. I don't think they called this a bubble. Certainly not Bogle.

But outrageous stuff like the dotcoms, the Beanie babies, the subprime CDO/CDS, they are bubbles. No doubt about it. Just like the late Templeton said when he shorted the dotcoms, and I will quote once more here.

“This is the only time in my 88 years when I saw technology stocks go to 100 times earnings; or, when there were no earnings, 20 times sales. It was insane, and I took advantage of the temporary insanity. - John Templeton”

 

[Oz investor]

I think lots of people panic and sell everything indiscriminately in their scramble to “get out” when crashes happen - indexes or not.

And speculating individual investors as well as professional investors get hit with margin calls and have to sell whatever is still up, so good stocks get taken down with bad. We see this during any market disruption. Index funds didn’t change this.

many of the sellers are ' forced sellers , in crashes , margin loans , derivatives , and just general debt on assets of dwindling underlying value ( making your lenders very nervous , of how much they will get if they bankrupt you )

i see index funds as a possible magnifier of the downturn , but probably not the actual cause of the downturn .

but not to be neglected is the 'herd factor ' in a rush for the exits , where those not actually in debt thumb-screws flee for 'safety ' ( whatever that is this crisis )

i also wonder if during the next crisis if ( financial ) liquidity will dry up ( and a 'run ' on the banks )

 

[RobLJ]

I, in general, believe in the efficient market. However, I made an exception in 2000 in the dotcom when the S&P/large tech shot up to what I believed was an unsustainable (over the long term) PE of 34 or 35. I took gains and diverted those gains to midcap value which (I recall, I may be wrong) had a PE of about 13 or 14. Sure enough, the S&P continued to shoot up for almost 2 years, until the crash. Had it continued to shoot up, who knows whether I would have maintained that allocation. I think so; but maybe not. I began diversifying to other cap areas and to foreign at this point, and in the recovery.


So Fama is both right (who can call the timing of a bubble deflating) and wrong (there are no way of identifying bubbles). Bubbles are quite rare, however, but we have had two in my investment lifetime. There may be another, but I doubt I will able to identify it profitably.


The same held true in 2006 when I became concerned about housing, then about housing-related debt. Conveniently, I was nearing 50 and perhaps just wanted an excuse to reallocate away from a 90-10 allocation; in any case, it served me well. I went heavy into Treasuries as I was selling mutual stock gains over a two year period. Fortunately, I suppose, the crash took longer than I expected to occur (and it was worse than I had expected, while the recovery was much quicker than I expected).

Those are the only big calls I have been willing to make against the efficient market. I do reallocate gains into market areas that are lagging, but that is rebalancing.

Also, now that I am withdrawing from my funds, I do sometimes (no more than once a year) scrape 1/3 or 1/2 of the years gains from hot funds for the next few years' withdrawals. I'm about at the end of my lucrative part-time online gig, so I've been trying to build up a cash/short bond pool for the next 2.5 year withdrawals, until DW is sufficiently old for IRA withdrawals without penalty. So I don't mind giving up potential gains to ensure I don't have to withdraw for two years from stocks or even longer bonds at the bottom of a big downturn. In a few years, it won't matter since I'll have a much larger pool to dip the bucket into, and two more years later I will qualify for regular rather than early SS. So the next 4 years is the danger period, before coasting into SS for first me, than DW.

 

[Drewskers]

Anyone worried about Michael Burry's opinions would do well to equip themselves with the factual information in the following articles, which will go a long way towards allaying concerns about the scenario he's painting:



Michael Burry Trashes Index Funds – Are We Screwed?


https://www.etf.com/sections/index-investor-corner/big-short-whiffs-indexing

 

[Born2Fish]

I visited my nephew near Amelia Island Plantation, FL just before the real estate bubble burst.

One of his neighbors was having a get-together in his garage. I talked with him a while and he confided that he had 3 different properties like his house on golf courses scattered around FL. He had been buying properties with minimum down and financing while flipping the properties. He told me that he had gained 10% appreciation in the 3 months that he owned the house we were in next to my nephew.

There was nothing about the locations, amenities, or proximity to high growth cities to support such "appreciation".

Several months later the bubble burst. A lot of people went under.

I think that the current stock market has climbed to very lofty levels. GSPC rate of return from March 20, 2000 until Sept 20, 2019 was only 3.5% annually. The rate of return from the bottom of the housing bear market until today has been around 7.7% annually.

I don't understand the Fed's recent interest rate adjustments.

I have taken gains on high flyer stocks over the past few weeks.

I have several others that seem lofty but am hanging on for the divs.

I am now 52/48 allocation and don't see anything I want to buy.