Last Updated: September 30, 2019

A chart and an interview piqued my interest recently as the remarkable state of affairs in the global financial markets continues to play out. Consider:

1. $17 trillion of bonds trading at negative interest rates1, a phenomenon that should not exist except in moments of crisis.

2. A domestic stock market that is within hailing distance of all-time highs despite:

  • The risks of trade wars, which may indeed be masking the underlying weakness in China’s economy, the second largest in the world.
  • Numerous major geopolitical risks, such as Brexit and the EU, the tensions in the Middle East and the risk of oil delivery disruptions.
  • Exceedingly high stock valuations in the face of slowing growth in the U.S.
  • Substantial turmoil beneath the surface of the equity market as the duels rage on between active vs. passive, growth vs. value, large cap vs. small cap, domestic vs. international, defensive vs. momentum, just to name a few.

3. Notwithstanding all of the above, consider that the major rally of 2019 has only allowed the stock market (as measured by the S&P 500 Index) to finish the 12 month period ended September 30 with a modest gain of 4.2%, while the Bloomberg Barclays Aggregate Bond Index (a broad measure of the U.S. bond market) was up 10.2%.

The chart that drew my attention is shown above. It shows the rolling 20 year returns for bonds versus stocks.

Note that the “long bond,” the longest maturity U.S. Treasury bond, has generated a total return over the past 20 years that is 80 basis points (100 basis points [bps]=1%) per year more than the return of the S&P 500 Index. It is hard to imagine that a government bond issued by the United States, presumably one of the safest financial instruments to be found, has produced a greater return than the stock market, which by definition, because it is made up of stocks, is a riskier investment. It is almost as inconceivable as investment grade debt, such as government bonds, trading at negative yields. An investor, in other words, is paying the lender to take his money. And yet, both have happened, and both continue as fall arrives. How do we explain it, and more importantly, what do we do about it?

The one element that ties all the pieces together is the unprecedented effort by global central banks to lift economies on the sheer strength of money creation, or what is known as “QE” (Quantitative Easing). QE was supposed to be a temporary jolt to kick-start economies teetering on the edge of catastrophe back in 2009, following the global financial crisis. Instead, it has morphed into an on-going policy with no end in sight— and with no plan as to how to end it. The result—essentially what explains what is going on—is that pricing in bonds is being driven not by active buyers and sellers trying to do what economists refer to as “price discovery.” Instead, prices are being driven to a pre-ordained policy outcome, which may or may not be appropriate given economic conditions. Unlike the housing boom of the early 2000s which the monetary authorities merely aided and abetted, the decade-long rally in stocks and bonds is one that has been directly engineered by the central bankers.2

Why is “price discovery” so important? As Michael Burry, the investor played by Christian Bale in the Oscar-winning movie, “The Big Short,” put it in a recent Bloomberg News interview3, price discovery has been removed from the credit markets by the central banks and from the stock market by passive investment strategies. Without price discovery, “true” valuations cannot be determined, which means that serious distortions in capital flows can persist and still go largely unnoticed.

So what? You may ask. Why is this important?

For two reasons: First, investing on the basis of “factors”—that is, portfolio construction based on aspects of an investment, such as being characterized as growth or value, large or small (in terms of market capitalization), domestic or international, industry or sector, or even more ambiguously, defensive or cyclical—rests on the notion that price relationships between and among securities will persist indefinitely. In that sense, it is very backwardlooking. In contrast, security analysis, valuing a security based on the fundamental outlook for the enterprise represented by the security—its ability to prosper (or not), to meet its obligations (or not), to generate a profit (or not), and to pay dividends (or not)—is an exercise for looking ahead, and it is the essence, then, of price discovery.

Second, and this is a point that Burry makes exceptionally well, many indices are “replicated” not by buying each and every stock in its representative weight in a given ETF (Exchange Traded Fund), but by buying a small sampling of the stocks in the ETF that have correlated closely with the overall benchmark index as actually calculated. As a result, a large number of individual stock issues are being priced as if there were actual trades at the day’s prevailing prices when in fact, many of these issues that are not bought in the ETF are trading next to no volume. The “price discovery” that is going on is not so much related to the “true value” of the business but to the strength of the correlation between the price of a particular stock and the pricing of the ETF of which it is a part. This creates a potential liquidity crisis as the thinly traded stocks in the index will create a massive bottleneck when markets turn south. The use of an analogy may help illustrate this point. With the extraordinary growth in ETFs, and a market full of thinly traded stocks, in essence, the size of the auditorium (the ETF market) has grown exponentially but the size of the exit doors (stock liquidity) has remained the same. While investors think they can exit just as before, there is going to be a bottleneck in a crisis, which could well make stock pricing upon exit even worse.

One final aspect of ETF growth and the imperfect replication of various stock indices is that the valuation of some companies is distorted by the stock being included in multiple ETFs. For instance, Exxon is part of 290 different ETFs.4 It is hard to believe that Exxon’s share price can correlate perfectly with each and every one of the ETFs of which it is a part. It is, for example, part of nine ETFs that Lipper categorizes as “Growth” and 43 it characterizes as “Value.” The impact of a run on ETFs on a stock of this nature has the potential to be very powerful to the downside.

At the moment, the assumption of high and steady correlations has worked well. In part, this is due to the steady upward push to higher financial asset prices that is the product of QE. In part, it is due to the momentum of that trend that has been augmented by the drive towards passive investing. Passive investing is less costly to implement than an active strategy, but if the market is forever and always a one-way proposition—upward—the extra expense of building a portfolio through fundamental analysis can be viewed as unnecessary. If, for whatever reason, the assumption of high and steady correlations is threatened, one of the key tenets of passive investing will cease to prevail.

To be clear, to us this is not a question of “if” but “when.” The Theory of Unintended Consequences, which always plays out in ways no one can foresee, is doing its thing and will continue to play out in perverse ways. Trends in place for almost 10 years can take a while to come to a halt, let alone reverse, but no tree ever grows to the sky. For our part, we continue to analyze investments suitable for client portfolios in the fashion we have practiced for the 25 years SBH has been around (and for a number of us, longer than that with our predecessor firms). We will continue to pay attention to valuation and the risks that securities pose to our clients’ portfolios. If we may be permitted to extend the “investment vehicle” metaphor, one of the ways to keep the cost of a car or a passively-assembled investment portfolio down is to leave off a lot of the safety equipment. Trends and fads in investing have come and gone. Indexing has prevailed for quite a while, but it, too, will likely flame out, largely because it sows the seeds of its own downfall the more pervasive the practice becomes.

1Negative interest rates prevail in almost all of Europe and Japan. The central banks have bought so many bonds and driven the prices of bonds so high that the interest earned to maturity does not overcome the premium over par at which these bonds trade, thus producing a negative yield in investing in them.
2 Some periods of mania and mispricing can be driven by market participants. Think of the Tech boom in the late 90s. Corrections ultimately occur whoever is driving the bus, the public or the monetary authorities.
3“The Big Short’s Michael Burry Explains Why Index Funds Are Like Subprime CDOs,” Reed Stevenson, Bloomberg News, September 4, 2019.
4ETF membership & holdings data aggregated from CBOE Global Markets/ETF.com as of 9/30/2019.

The information contained herein is for informational purposes only without regard to any particular reader’s investment objectives, risk tolerances or financial situation and does not constitute investment advice, nor should it be considered a solicitation or offering to investors.