WASHINGTON. Stocks opened down again Monday morning, adding to Friday’s dismal market collapse. We rarely make predictions here. But at this point we can fairly predict there’ll be no Santa Claus Rally to end the year. Instead, our current grueling bear market continues to eat any profitable positions that remain. Cash, even at current substandard money market or bank rates, is king for now.
Are index funds the answer in a seriously grueling bear market decline?
It’s interesting to note that while we had some success moving our investment strategy toward holding more index ETFs and less individual stocks, we’ve failed to prevail against the current bear market.
This is something we’ve long feared as various index funds and ETFs, large and small, specialized or general, gained popularity with investors. Namely, in any decline, massive investor sales of index funds and ETFs disproportionately drive down the prices of all stocks in the index.
Certainly, any number of individual stocks in an index fund or ETF may take a hit from time to time. But the whole idea behind these investments is to buttress the index or ETF) with a large number of stocks. This has the effect of diminishing any individual stock’s bad performance. You could say this strategy smooths the curve. Hence, such funds / ETFs are, statistically, viewed as “safer” than individual stocks.
But most of the popular index funds / ETFs are weighted heavily and disproportionately in favor of larger capitalization stocks. In other words, funds and ETFs based on given indexes rely on the larger-cap stocks for much of their trajectory, both up and down.
The downside of investor enthusiasm for index funds and index ETFs
Some smaller stocks in an index may perform better than the heavily weighted large cap stocks driving the index. But if those large-cap stocks damage the index with a couple of bad quarters, ETF holders start dumping those index fund / ETF shares.
That, in turn, forces these index funds and / or ETF shares to dump their holdings proportionately. This holds truer whether other indexed stocks are doing better than the bad stocks or not. This results in a situation where those better earning stocks can be effectively penalized by the bigger bad stocks. As the indexes are sold off because of the bad stocks, the decently performing smaller stocks get crushed. They are penalized for a bad quarter they never had. It all contributes to this fall’s miserable bear market scenario.
An investing guru’s take on indexing
CNBC offered a short, thoughtful piece online his morning that provided some useful insight into our growing bear market problem from an industry expert.
“DoubleLine Capital CEO Jeffrey Gundlach took a shot at passive investment strategies such as index funds on Monday, declaring the investing strategy a “mania” that is causing widespread problems in global stock markets.
“‘I’m not at all a fan of passive investing. In fact, I think passive investing … has reached mania status as we went into the peak of the global stock market,’ Gundlach said, speaking with CNBC’s Scott Wapner on ‘Halftime Report’ in Los —Angeles.
“‘I think in fact that passive investing and robo advisers … are going to exacerbate problems in the market because it’s hurting behavior,’ Gundlach added.
“Gundlach’s DoubleLine actively manages clients money and has more than $120 billion in assets under management, according to the firm’s website.
‘I wouldn’t advise anyone to be a passive investor,’ Gundlach said. ‘My strongest advice is to not invest in passive U.S. equity funds.’
“The investor made correct predictions for 2018, including a drop in stocks on rising yields and declines in Facebook and bitcoin.”
Cap-weighted indexes: A prominent villain in Wall Street’s ongoing stock market decline?
Large-cap weighted indexes have always posed at least a theoretical risk for stocks in general. Typically, weighted indexes represent all stocks in an index. Rejuggling George Orwell’s famous statement on equality, we might say that in cap-weighted index funds or ETFs, “All stocks are equal. But some are more equal than others.”
The problem arises when those “more equal” index shares have a really bad quarter or two. Their heavy weighting in a given index can bring the whole index — and associated ETFs and index funds — down in one violent crash. Subsequently, as the index fund or ETF dumps its holdings, it dumps all of them proportionately. Thus, companies still doing well in a bad environment can get severely penalized by the bad companies.
This phenomenon is slowly invalidating two traditional ways to evaluate stocks: price earnings ratios and technical analysis (charting). Both systems have their pluses and minuses. One represents a stock’s value. The other represents a stock’s movement in relation to value (and the economy). Both are based on verifiable reality.
Feast or famine? Or, irrational exuberance vs a relentless, grueling bear market
What’s going on now, however, is feast or famine. Since Election 2018, investors have feasted on the profits they’ve earned. Most prominently, most invested in large-cap stocks in the IT industry sector. But now as they’ve turned on them, investors continue to sell these shares at a rapid clip. In this mindless dumping, investors indavertently bring down this entire sector as if no tech company were profitable at all. The bear market in these shares quickly spread to the financial sector and beyond.
Many passive individual and institutional investors hold (or dump) these large-cap company shares through buying or selling representative ETFs. The managers of these ETFs heavily weight their product toward large-cap holdings.
When investors massively dump ETF shares, ETF managers must proportionally dump shares of all the other stocks in the index. That unfairly cuts the share price of these companies. That holds true even when such companies prove consistently profitable. That significantly contributes to this fall’s ongoing investor festival of pain. Economic speculation aside, that’s why we’re in the midst of this grueling bear market.
Next installment: How three large stocks in one ETF can effectively damage all the other stocks in that ETF.