Opportunity amid Danger — The Rise and Potential Fall of Index Investing

Opportunity amid Danger — The Rise and Potential Fall of Index Investing

This article may be long and quite technical, but it’s well worth your time and effort to read. It’s a capsule history of the rise and potential fall of index investing, viewed through the lens of companies such as Exxon, Pfizer, and Raytheon — which were recently kicked out of the Dow Jones Industrial Average Index.

Prior to about 1980, most investing was done by active investors who researched individual stocks and sectors and made recommendations or investment decisions on the basis of discounted cash flows, long-term growth prospects, and other fundamental factors.

The rise of passive index investing

Then, in 1980, the first index mutual fund (based on the S&P 500 Index) was offered by Vanguard Group. Investors were told they could not beat the market even with excellent research, and the best approach was simply to buy an index fund and go along for the ride.

Stocks do rise over the long term (despite occasional bear markets and sharp corrections) and mutual funds do offer lower fees and costs compared to active stock trading commissions. Over time, this argument won an army of followers and index mutual funds (and their close cousins, the ETFs) came to be a larger and larger part of most portfolios. Gradually, active investors disappeared, and passive index investing came to dominate the market.

This created feedback loops where certain stocks went up, indexers bought more to maintain the index weightings, and the stocks went up even more, and so on. This was great for tech stocks, but out-of-favour stocks — including giants like IBM, Exxon, and Schlumberger — fell by the wayside.

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The problem with passive index funds

The problem is that passive index funds depend on active traders to make markets and engage in price discovery by risking their own capital. The passive funds are like parasites living on the body of the active investor. When the active body dies, the parasite dies with it.

What happens when passive funds must dump stocks in a panic? Where are the active investors needed to make markets and provide liquidity? With active investors shoved aside, stocks will go no bid and the passive index funds will suffer enormous losses.

This danger also creates an opportunity…

If marginalised stocks begin to attract interest from passive investors looking to diversify, their small market caps can lead to huge price gains as trillions of dollars try to crowd into the new thing.

The author of the article suggests that old-line companies in energy, mining, and manufacturing are poised for huge gains when investors flee passive funds for higher returns in these non-tech sectors. The thesis is a strong one. Perhaps it’s time to invest in these non-index components before the expected price spikes begin.

Meanwhile, the layoffs are just beginning

In the US, unemployment skyrocketed in March and April during the worst stage of the COVID-19 pandemic and the lockdown that followed. The unemployment rate exceeded 13% in April, while total initial claims for unemployment benefits exceeded 59 million between March and August. This was the worst episode of unemployment since the Great Depression in the early 1930s.

Things improved from there. Unemployment fell to about 11% by July and even further in the latest unemployment figures. Does this mean the worst is over and the economy is recovering quickly? Not exactly.

Unemployment would have been much worse in April and May but for the Payroll Protection Plan enacted by Congress. This plan appropriated almost $1 trillion in easy-to-get loans for small- and medium-sized businesses. The loans would be forgiven if the proceeds were used to maintain payrolls for two and a half months or to pay rent. This program acted as a kind of bridge loan from May to July to keep employees on the payroll. It worked.

The second wave

But now those funds have run out and the lockdowns continue in many parts of the economy. Businesses that were expecting a reopening and a V-shaped recovery have found that the reopenings have been delayed by new lockdowns and the recovery is real, but weak. What we are starting to see is a second wave of layoffs as the Payroll Protection Plan money runs out and the economy does not recover.

This is also true in other industries such as airlines, cruise ships, and resorts that received their own congressional bailouts with other funds. Airlines received $25 billion of direct subsidies to prop up payrolls. That money has also run out and new funds have not been approved.

As described in this article, the second wave of layoffs has hit the airline industry hard, with 16,370 layoffs announced by United Airlines as of 1 October 2020. Similar layoffs are expected to be announced soon at Delta and American Airlines.

States and cities that operate on a 1 October fiscal year are also planning huge layoffs in the coming weeks as tax revenues dry up, and the costs of riots and looting begin to add up.

Where are the safe havens in this environment?

Putting all of this together reveals that unemployment may actually start to rise now after declining from May through August. The technical recession may already be over, but the long-term depression is just beginning.

Get ready for deflation, negative interest rates, and declines in most stock values, even as a handful of tech stocks prop up the major market indices. The safe havens in this kind of slow-growth, high-unemployment environment are cash, Treasury notes, and gold.

All the best,

Jim Rickards Signature

Jim Rickards,
Strategist, The Daily Reckoning Australia

PS: This content was originally published by Jim Rickards’ Strategic Intelligence Australia, a financial advisory newsletter designed to help you protect your wealth and potentially profit from unseen world events.