My favorite analogy for passive investing describes two men sitting at a bar. One is drunk and the other sober. When the night is over the sober man leads the other home to make sure he gets there safely. Historically, hedge funds and active investors pored over financials, looked at P/E ratios, and listened to earnings calls to decide when to invest. Passive investors just went long an index fund and hoped that the others did a good job leading prices to their logical equilibrium point. Thus the active investors could lead them home safely. Today, “the drunks” are leading the way as passive investors looking for low fees lead the way. What could go wrong?
On May 7th, 2021 a highly anticipated jobs report came out with expectations for a million jobs created with some even estimating as much as two million. The result, 266,000 thousand jobs created, the biggest miss in 23 years. CNBC was so stunned they thought there was a typo and had to verify from an official site. Naturally, the market rallied.
This is not the first time that the market rallied on bad news. It seems to be happening more and more. The simple explanation is that the equity market is dependent on Fed policies and low interest rates. Each sign of weakness is reason to believe that endless government dollars will pour into the market. If money truly could be created from thin air without consequences perhaps this could last but is that the case? More importantly, if bonds pay very little what choice do investors have?
Valuation doesn’t matter if investors rule out the possibility of declines in the first place. When risk aversion sets in though it does so with a vengeance. In time, people forget that the Fed tried raising rates in December 2018 only to see the worst final month since 1931. In fact, many probably forget that 2018 was a losing year in the market at all with the S&P down 6.2% for the year despite hitting an all time high on September 20th, 2018. The COVID induced drop and recovery followed the same pattern. Extreme panic followed by a recovery.
Belief is enough until it changes. Margin debit balances are at an all-time high again to match the heights the market recently. Now it just needs a catalyst.