Something Is Very Wrong With the Stock Market | Michael Green

Passive investing was anything but passive. We assume the economy is fine because stock markets are moving to new all-time highs or near all-time highs, while many members of this economy look at their world and say, 'I certainly don't feel like I'm at an all-time high.' It is actually a valid complaint from the younger generation that the older generation is effectively rug-pulling them. There's no bailout for them. But the reality is that to those individuals, we're saying you're going to have to get by with less. When you ask how long a K-shaped economy can go on, well, in the tail end of the Roman Republic into the Roman Empire and into the Middle Ages, it went on for give or take 1,100 years. It's also entirely probable that an authoritarian emerges. I am very concerned about the leadership in AI, which largely views their role as replacing human beings. It does have to end eventually. It just can be really, really wild before we get there.

Thank you for having me, Aaron.

Well, my dog wanted to chime in there, but the quick answer is actually I think the passive flows account for more than 100% of the price improvement that we're now seeing in markets. I actually think that most of the evidence is in the absence of this type of directed flow, we're seeing on net stock markets decline. In the areas of the markets where we see less impact from passive, for example, the smaller stocks or the smaller stocks in the S&P, they aren't experiencing the same outcomes that we're seeing for the largest stocks. And part of that is because there is a fundamental mismatch in liquidity between the largest stocks and the order sizes that are coming through in passive vehicles which scale those order sizes to their relative market caps. Volume or dollar trading liquidity does not scale linearly with market capitalization. It scales what's called sublinearly. In other words, the largest stocks are less liquid relative to their market capitalizations than the smallest stocks are. That means that an investment style like market cap weighting that is placing orders in proportion to market capitalization is going to disproportionately force the largest stocks up. And that's really what we see in the indices. It's been the case by and large for several years. This is not decrying that there's no impact on the smallest stocks. It's just less. And so there is actually a bifurcation just like you were describing in the economy that's occurring within the stocks that are well represented within the S&P 500 or the NASDAQ 100 and stocks that are much less well represented. For example, the stocks in the Russell 2000, particularly those at the lower end of the Russell 2000 where you have the competing force of active managers who may have selected those stocks for very fundamental reasons and they are on net actually experiencing redemptions. That means that there is much less demand for the smaller stock shares than there is for the larger stock shares. And this is unfortunately creating the conditions that I think are now powering much of policy, where we assume the economy is fine because stock markets are moving to new all-time highs or near all-time highs, while many members of this economy look at their world and say, 'I certainly don't feel like I'm at an all-time high.'

It is. It's extraordinarily negative. And it actually is far worse when you move beyond the public markets. In 1978, when we switched our retirement system from a defined benefit system to a defined contribution system, and we then made basically a special election that you would be able to invest in publicly traded companies, not in privately traded companies or not in your small local bodega, for example. Instead, we would provide a tax-advantaged investment flow into the largest companies. We inadvertently, because we didn't understand this at the time, and candidly many people still resist it today, but we didn't understand that by doing so we were actually providing a sizable benefit for the largest companies that has grown over time as I was describing. And today the vast majority of financing is actually flowing to the very largest companies in our economy while many of the smaller companies struggle under exceptionally high costs of funds, in particular equity is extraordinarily expensive. It contributes to the lack of entrepreneurship. And that lack of entrepreneurship is then further embattled by the failure to enforce antitrust provisions. If you come up with a good idea that impacts Apple, they're simply going to copy you and they're going to basically say, 'What are you going to do? Sue us?' And that has played out over and over and over again. And unfortunately, it has led to the decline in entrepreneurship that we're seeing in this economy.

Well, if we were to see this as the world losing confidence in America, then we would expect to see several components play through. The bond market has the capability to separate the pricing for inflationary fears, i.e., debasement. That is not what is driving the interest rate. The bond market also has the ability to price the uncertainty that the US will even pay its debt, what's called default risk, that should be reflected in what's called the credit default swaps of the United States. Those are actually falling, not rising. What is increasing in the interest rate is what's called the real interest rate. That is the net component of the nominal rate less the inflationary component. That's the portion that's rising. So most people think this is about inflation or they think it is about energy prices or they think it is about the faith and credit of the United States, and those components of the market are not sending any form of alarm bells. What is happening is a fundamental mispricing or repricing of the curve across Western societies regardless of their indebtedness. So Australia, with debt to GDP at 25%, is experiencing the same problems that the United States is experiencing at 130%, and Japan is experiencing north of that. Countries that are not part of the global bond indices, like China, for example, are not seeing this impact at all.

And so one of the very first things we should do is ask what are the common features of the markets that are selling off. They are all represented as the majority of their marginal buying activity is now coming out of market cap weighted bond indices, which perversely have a similar effect to what we were describing in equities, but there it's a function of price. So a bond that is trading at a premium to par in a market cap weighted index will be overrepresented in that index. A bond that is trading at a discount to par will be underweighted. That means that there has become a pro-cyclical duration exposure within the bond indices. In other words, when the Federal Reserve is cutting interest rates, the long end will rally most because of its duration sensitivity and will experience the largest net increase in buying from a passive bond index. A hike in interest rates, on the flip side, will most negatively affect the longest duration and the lowest coupon bonds. And those bonds in the United States and elsewhere around the world are now trading below 50 cents on the dollar in many situations. Perversely, that means that when you put your money in to buy and you see these high interest rates in an index like the Bloomberg Aggregate, represented by a total bond market index like the BND ETF, you are underinvesting in exactly the securities that reflect the selloff that you are highlighting. And unfortunately, that is going to continue to be the case until the Federal Reserve begins to understand that markets no longer are actually telling us information about the riskiness of the United States or the inflationary pressures, and instead it's really reflecting the way that we have chosen to invest in these products.

No, I am not worried about the debt. I'm worried about the implications of how we react to the information that we're receiving on the debt. So, by hiking interest rates, we're raising the cost of financing those same small businesses that we were talking about before. And we're dramatically raising the cost of financing households through things like mortgages and auto loans, which are really the primary sources of financing that are tapped, particularly from your generation. My generation has hopefully earned enough money at that point that we're not really relying on credit in the same way. Instead, we have surplus funds that we're receiving the benefit of the higher interest rates in the form of higher income.

That's the thing that I find so frustrating is that the social concerns are correct, right? It is actually a valid complaint from the younger generation that the older generation is effectively rug-pulling them and saying, you know, we like earning high interest rates on our deposits. We like receiving high income on our bonds. Perversely, many in the older generation don't understand that when, again, they buy a bond index, they are under-buying the bonds that are most deeply depressed, but they still are quite happy with the income that they are receiving at this point. And if you're an older person and you're forced to borrow, you're running through the same challenges that the younger generation is. And likewise, the older generation is incredibly concerned because they hear the narrative and they say, 'Oh my gosh, my money may run out. My money may become worthless. Therefore, I can't buy bonds. I'm going to buy stocks,' keeping the stock prices elevated as well. And so we've created this, you know, hall of mirrors as to the real economy that unfortunately is increasingly being used by our policymakers as they, you know, abrogate their responsibility to do thoughtful work.

Well, before PEs contract is really going to be a function of do we actually force or experience forced liquidation of the assets that have been accumulated. And because so much of the stock market and so much of the stock market wealth is held by those with extraordinary wealth, the question is legitimate: when will we actually see that much selling? We don't know. We've never been here before. When you ask how long a K-shaped economy can go on, well, in the tail end of the Roman Republic into the Roman Empire and into the Middle Ages, it went on for give or take 1,100 years. So, you know, that strikes me as a reasonably long time period. It also could be solved in a matter of months if we were to decide that we were going to actually make the hard choices and treat the information we're receiving from the markets as an error in our investment strategies as compared to an insight into the functioning of our economy.

Well, the key difference is that what has happened is because we hiked interest rates, boomers had to save relatively aggressively in a low interest rate environment. That meant that they accumulated a stockpile of assets that was further enhanced by the pandemic when we basically said to anyone who had a business, 'Oh, we recognize that you're short of funds, so we're going to lend you money called the Paycheck Protection Program so that you can continue to pay your employees.' That pushed funds out into the economy that turned into something like $4 trillion of increase in liquid assets in money market funds that largely sits with the boomer generation because the end point is the business that ultimately collects the funds associated with that. We're not seeing a lot of pressure to sell yet from the boomers precisely because a withdrawal rate out of a target date fund or a retirement vehicle can now largely be met through a combination of higher interest rates or the proliferation of income strategies that have begun to materialize.

It will eventually happen, right? It is critical to understand that ultimately investments are always going to be a function of incomes. Those can be generated off of investments themselves and we are seeing evidence of that. But by and large when you think about something like a Buffett indicator, which is the ratio of stock market wealth to GDP, that's really just an asset value to income measure. It's the same phenomenon that we're discussing here. Eventually the assets become so large on an inflated basis that people decide to take profits, or taking profits overwhelms the inflows coming from incomes, that starts the process of a correction. We then improperly interpret that correction as a sign about the investment prospects of those companies and that process takes on a sentiment character to it in which further selling occurs and you lose your job because the stock price is falling and the CFO decides the right way to fix it is by cutting payroll. That's my hunch for how this plays out. But again, we are in largely uncharted territory. We cannot draw direct analogies to prior periods. If we look at a period like the 1920s in which there was similar speculation in single stocks and closed-end funds and unit trusts that have characteristics not dissimilar to today's passive world, it's important to remember that less than 10% of the US population even owned stocks going into the 1929 crash. Today that number is around 65%. It's our entire retirement system. And so if we were to experience an incredible decline, we would almost certainly see policymakers reverse themselves and again flood the system with liquidity, creating conditions under which we would again expect earnings to increase. And if those earnings are then deployed in the form of buybacks as we have seen for the last five years, that would simply exacerbate and continue to drive the process further. So, it's not as simple as saying, you know, it has to end eventually. It does have to end eventually. It just can be really, really wild before we get there.

So the answer is both, and it really is a form of the Keynesian beauty contest, right? So in the 1930s, John Maynard Keynes articulated the philosophy of investing in the stock market and that it's not what you're interested in, it's not who you think is the most beautiful woman, it's who everybody else thinks is the most beautiful woman. And that's really what you're trying to do when you try to understand and predict flows. If you look at an asset class that has been underinvested in and has been ignored, that becomes an area with high potential flow impact. On the flip side of the equation, if you look at areas that have experienced extraordinary investment, but that extraordinary investment is coming through in a mechanical process in which people somehow or another assume that the fundamentals no longer are what's driving the underlying performance. For example, bonds in the period of 2018 to 2019, when they offered zero coupon, were not good investments, and yet people continued to invest in them simply because bonds were supposed to be part of their diversified portfolio. Now that we look at bonds offering really attractive yields, interestingly enough, people are largely ignoring them because of the mechanical way that we believe that we are investing in them. We assume we're buying bonds. We assume we're buying attractive bonds. But for the most part, we're simply buying the front end of the curve where bond prices are highest relative to the rest of the market.