I agree with @cchernoff, the thesis that the rise of passive management is somehow responsible for the increase in equity valuations is superficially appealing but sadly only half-baked.
Equity markets and other asset classes function as a kind of fourth dimensional wormhole, enabling today's savings to fund tomorrow's consumption. At a macro level, the key valuation driver is the cumulative stock of savings seeking to traverse this wormhole vs. the supply of assets available to transport this stock of savings into the future. At best, the behavior of intermediaries like active and passive managers might affect the valuation path, but they do not determine the destination. And in terms of path dependency, were active managers skillful in navigating this path due to their valuation-informed market timing expertise, assets would be flowing in the opposite direction, and we would all be worshiping Warren Buffet for his market timing skills.
Hey Mike great piece. This work that you’re doing is incredibly important. Keep it up!
While not denying any of the points you’re making, I wonder to what extent equities today “deserve” higher multiples than in the past thanks in part due to higher profitability for US corporations? Corporate margins are in double digit territory which is much higher than decades past. Hard to see them mean-reverting without significant policy shifts (particularly in areas such as antitrust).
Or perhaps do I have it backwards - are higher equity valuations creating conditions for higher corporate margins? (It would seem reasonable that higher valuations leads to more political power which leads to policies that further advance the agenda of corporations).
I would love your thoughts regarding owning various commodities or a basket in coming years vs equities in a long term portfolio. Might BCOM be a better choice ahead than SPY?
Excellent piece as always, Mike. Maybe asking too much, but would you have color on these dynamics in other regions, e.g., Germany, UK, Australia? Maybe the US markets are more out of whack than others given the big push and lobbying behind target date funds, retirement products, and passive ETPs in general - thanks, Moritz
It's a very good piece re-capitulating a familiar theme of yours . The model , however , remains that of a closed system and there are longer term external factors which could materially affect this model , among them:
- Market venue arbitrage . ARM Holdings will list in NY . CRH will move its listing . These are explicitly affected by desires to achieve a higher valuation in the US than in London. In the aggregate this could be a material increase in supply.
-High and rising equity valuations could increase supply via increased use of share -based compensation.
-At some point debt becomes really unattractive versus a higher equity component in capital structure s, ergo increased supply.
-At some level of higher equity/debt valuations the logic of private equity reverses and private equity , especially of larger companies , should disgorge into public markets .
-To the extent the operation of income real estate is a business and tracks many of the macro influences affecting corporate operating results there should be similar valuation increases and decreased use of debt in income real estate as well.
I do not claim to have any insight as to the elasticity of these phenomena at what sort of valuation and spread relationships ; but the agency incentive to bring them into play will clearly be there .
My only problem with this analysis is that it seems to have an overly idealized model of the world prior to passive investment.
Just because 401K money or other money for investment was going into "active" strategies does not mean that that world was all that different from our world today. If the active money was still going to active bond funds and active stock funds at about the same percentages that the retirement glidepaths of today then there should be no difference.
If active managers are given funds and can only put them into stocks, then they will go into stocks and as a whole they will go into the stock market at a market-cap weight definitionally.
Do you have any evidence that your equilibrium model really describes the prior situation (PEs went basically up and to the right from the 1930s-1960s. Using the blip during the 1970s seems disingenuous of the historical trend)?
Finally, in world with only two assets that generate returns, (stocks and bonds), moving between them cannot cause their future expected returns to go up, what the "real" problem is is that the world has more savings than ever before and those savings want to go into return-generating assets, when demand for assets goes up returns on those assets go down. Being active between them doesn't affect anything. More active management would not cause future bond and stock returns to go up, they would just plow the money into their limited options and grouse about PEs. So no different from today.
The difference is not just passive but target date funds. People have been told to believe that all they need to do is put money into target date funds and forget it. We now start new 401(k) investors ("The Nudge") into these vehicles. Unless they take action, there they stay - forever. By design - because it's "better" for them.
I've a q regarding your following comment: "If active managers are given funds and can only put them into stocks, then they will go into stocks and as a whole they will go into the stock market at a market-cap weight definitionally."
As I understand the avg the historic market valuation 16X P/E ratio (Mike referred to) is from S&P 500 companies so, if the active managers (historically) weren't investing in S&P500 companies, the funds historically wouldn't have gone in stocks at a "market-cap weight" way.
Likely I'm missing something silly so appreciate any clarification. Thanks
Thank you for your insights and answers to our comments.
My two big "attacks" (read qualms) against your thesis are:
1. How exactly is today different from yesterday? People are more "passive" so what? How different are the dynamics of money going into passive MFs vs. going into 1000s of active MFs that likely together = market.
2. I worry that without cash / excess savings in the picture, your PE multiple argument falls on its face, PE and bond yields can be seen as the supply of future consumption so if the demand for it is high (lots of savings) it doesn't matter if your algorithm says be price sensitive. If stocks and bonds are expensive TINA.
Somehow every manager claims they will hold cash when the market is expensive, but when you look at their long-term average results ... it equals the market.
I guess I am too much an empiricist to hold by your suggested model, and would like proof that passive investing actually changed the landscape.
@Raj, by definition the market must be held at market-cap weight. If active managers were a large part of the market, then they will necessarily have to hold companies (at least on the whole) close to market cap weight.
Been following your thoughts on "passive" for a while. I wonder under which circumstances that gravy train might start moving the other way...I imagine there must be some threshold level of unemployment where "the passive investor" asks for cash and the simple allocation algorithm runs in reverse.
Of the remaining active funds, I wonder how many are mirroring their passive benchmark with some individual stock picks at the edges? The "I don't want to be fired" active strategy.
Michael, I understand the problem with passive investing that you have eloquently demonstrated. My question is about tactical investing where investors are using the various "sectors" (consumer staples, energy, etc.) and rebalancing monthly or quarterly. I see several people advocating that this doesn't fall under passive investing. You are still pretty much in equities so I don't see how this is much different.
I agree with @cchernoff, the thesis that the rise of passive management is somehow responsible for the increase in equity valuations is superficially appealing but sadly only half-baked.
Equity markets and other asset classes function as a kind of fourth dimensional wormhole, enabling today's savings to fund tomorrow's consumption. At a macro level, the key valuation driver is the cumulative stock of savings seeking to traverse this wormhole vs. the supply of assets available to transport this stock of savings into the future. At best, the behavior of intermediaries like active and passive managers might affect the valuation path, but they do not determine the destination. And in terms of path dependency, were active managers skillful in navigating this path due to their valuation-informed market timing expertise, assets would be flowing in the opposite direction, and we would all be worshiping Warren Buffet for his market timing skills.
Hey Mike great piece. This work that you’re doing is incredibly important. Keep it up!
While not denying any of the points you’re making, I wonder to what extent equities today “deserve” higher multiples than in the past thanks in part due to higher profitability for US corporations? Corporate margins are in double digit territory which is much higher than decades past. Hard to see them mean-reverting without significant policy shifts (particularly in areas such as antitrust).
Or perhaps do I have it backwards - are higher equity valuations creating conditions for higher corporate margins? (It would seem reasonable that higher valuations leads to more political power which leads to policies that further advance the agenda of corporations).
I would love your thoughts regarding owning various commodities or a basket in coming years vs equities in a long term portfolio. Might BCOM be a better choice ahead than SPY?
Excellent piece as always, Mike. Maybe asking too much, but would you have color on these dynamics in other regions, e.g., Germany, UK, Australia? Maybe the US markets are more out of whack than others given the big push and lobbying behind target date funds, retirement products, and passive ETPs in general - thanks, Moritz
It's a very good piece re-capitulating a familiar theme of yours . The model , however , remains that of a closed system and there are longer term external factors which could materially affect this model , among them:
- Market venue arbitrage . ARM Holdings will list in NY . CRH will move its listing . These are explicitly affected by desires to achieve a higher valuation in the US than in London. In the aggregate this could be a material increase in supply.
-High and rising equity valuations could increase supply via increased use of share -based compensation.
-At some point debt becomes really unattractive versus a higher equity component in capital structure s, ergo increased supply.
-At some level of higher equity/debt valuations the logic of private equity reverses and private equity , especially of larger companies , should disgorge into public markets .
-To the extent the operation of income real estate is a business and tracks many of the macro influences affecting corporate operating results there should be similar valuation increases and decreased use of debt in income real estate as well.
I do not claim to have any insight as to the elasticity of these phenomena at what sort of valuation and spread relationships ; but the agency incentive to bring them into play will clearly be there .
Really great conversation @profplum99!
My only problem with this analysis is that it seems to have an overly idealized model of the world prior to passive investment.
Just because 401K money or other money for investment was going into "active" strategies does not mean that that world was all that different from our world today. If the active money was still going to active bond funds and active stock funds at about the same percentages that the retirement glidepaths of today then there should be no difference.
If active managers are given funds and can only put them into stocks, then they will go into stocks and as a whole they will go into the stock market at a market-cap weight definitionally.
Do you have any evidence that your equilibrium model really describes the prior situation (PEs went basically up and to the right from the 1930s-1960s. Using the blip during the 1970s seems disingenuous of the historical trend)?
Finally, in world with only two assets that generate returns, (stocks and bonds), moving between them cannot cause their future expected returns to go up, what the "real" problem is is that the world has more savings than ever before and those savings want to go into return-generating assets, when demand for assets goes up returns on those assets go down. Being active between them doesn't affect anything. More active management would not cause future bond and stock returns to go up, they would just plow the money into their limited options and grouse about PEs. So no different from today.
The difference is not just passive but target date funds. People have been told to believe that all they need to do is put money into target date funds and forget it. We now start new 401(k) investors ("The Nudge") into these vehicles. Unless they take action, there they stay - forever. By design - because it's "better" for them.
Nice comment @cchernoff
I've a q regarding your following comment: "If active managers are given funds and can only put them into stocks, then they will go into stocks and as a whole they will go into the stock market at a market-cap weight definitionally."
As I understand the avg the historic market valuation 16X P/E ratio (Mike referred to) is from S&P 500 companies so, if the active managers (historically) weren't investing in S&P500 companies, the funds historically wouldn't have gone in stocks at a "market-cap weight" way.
Likely I'm missing something silly so appreciate any clarification. Thanks
Active managers can hold cash
The market <> all funds
I’ll add a discussion of cash in a future piece, but when I entered the industry it was not uncommon for active funds to hold significant cash
Thank you for your insights and answers to our comments.
My two big "attacks" (read qualms) against your thesis are:
1. How exactly is today different from yesterday? People are more "passive" so what? How different are the dynamics of money going into passive MFs vs. going into 1000s of active MFs that likely together = market.
2. I worry that without cash / excess savings in the picture, your PE multiple argument falls on its face, PE and bond yields can be seen as the supply of future consumption so if the demand for it is high (lots of savings) it doesn't matter if your algorithm says be price sensitive. If stocks and bonds are expensive TINA.
@Michael W. Green Sure they can, but did they?
Somehow every manager claims they will hold cash when the market is expensive, but when you look at their long-term average results ... it equals the market.
I guess I am too much an empiricist to hold by your suggested model, and would like proof that passive investing actually changed the landscape.
@Raj, by definition the market must be held at market-cap weight. If active managers were a large part of the market, then they will necessarily have to hold companies (at least on the whole) close to market cap weight.
Been following your thoughts on "passive" for a while. I wonder under which circumstances that gravy train might start moving the other way...I imagine there must be some threshold level of unemployment where "the passive investor" asks for cash and the simple allocation algorithm runs in reverse.
Of the remaining active funds, I wonder how many are mirroring their passive benchmark with some individual stock picks at the edges? The "I don't want to be fired" active strategy.
Michael, I understand the problem with passive investing that you have eloquently demonstrated. My question is about tactical investing where investors are using the various "sectors" (consumer staples, energy, etc.) and rebalancing monthly or quarterly. I see several people advocating that this doesn't fall under passive investing. You are still pretty much in equities so I don't see how this is much different.
So generally agree with flow premise, but my next question inevitably has me looking for the answer..
Does the target date/passive flow premise, like USD hegemony flow premise, structurally make it a harder to make money in active?
If so, why fight it or is the eventual day or so called reckoning inevitable and if so, the million dollar question is when, hard to determine..
Thanks for this article Michael. Hope you're not distracted and finish your thoughts next time. Enjoyable and really thought provoking.
The song Runaway Train comes to mind. No negative feedback loop to mean revert. Casey Jones you better watch your speed.