Why Passive Investing Has Broken The Price in Markets | Michael Green

When you buy the S&P 500 to Nvidia or Microsoft or Apple, the size of those orders is actually skewing the market behavior even further, causing those companies to rise relative to the rest of the universe. That then changes investment behavior because if you're the CEO of Microsoft or the CEO of Apple, you're receiving confirmation from the market that your cost of capital is very low, that what you're doing is absolutely the right thing to do. In fact, there's no company doing anything better than what you're doing. That creates, unfortunately, the incentive to then invest as if this market capitalization and this valuation is earned, which is part of the reason why we've seen such an incredible surge in investment in areas like data centers, etc. You increasingly hear an open discussion of will these investments actually generate a return? Most people are increasingly saying probably not.

Thank you. I'm glad to be back.

Well, as we talked about last time, I think we're increasingly seeing a bifurcated economy, what many refer to as the K-shaped economy, in which some firms are doing exceptionally well, particularly in terms of their stock prices. Other firms are doing less well. And basically, the further you remove yourself from publicly traded equities, the more the world starts to look increasingly dicey. Whether those are levered companies held in private equity firms, those are increasingly experiencing financial distress. Some components of that are captured in loan markets, but the vast majority of it is not being properly captured. If you look at businesses that are not publicly traded, are not owned by financial owners, small business in the United States, it's actually struggling tremendously.

And again, in many ways, last time we talked about some of the intricacies of the CPI and how that can influence the reporting, the way that we manage our reporting system in the United States, trying to capture the dynamism of the United States, new business formations, etc. That's doing our politicians and our policymakers a disservice. We've tried to smooth those components, introducing measures that are candidly just kind of made up, that are influencing our perception on the jobs market in the United States, how small businesses are doing, etc. If you have small business owners in your audience, I would suggest that the vast majority of them are experiencing increasing distress. Whether that is availability of financing, whether that is shortages of customers, reduced sales that are coming through, competition that's coming from larger competitors. This is particularly true in services businesses like HVAC, plumbing, etc., where there's a huge disconnect that's emerging between what you as an individual pay for plumbing services and what's received by people actually going into plumbing to work. That's being driven by horizontal consolidation from areas like private equity, etc. That's isolating the profit streams more and more in the same way that we're somewhat seeing in financial markets where it's growing increasingly concentrated in terms of the financial performance and the behaviors of that.

The United States is increasingly characterized as an economy with a growing component of monopolization and concentration across all industries, where industry giants are increasingly determining outcomes as compared to the vast majority of participants. Again, in many ways echoing that K-shaped economy that many listeners are experiencing on an individual basis. We're seeing that play out in financial markets as well. So big public companies are doing well.

Big public companies, by and large, are doing well. And that's a byproduct of a number of components, but the single biggest component to it is dramatically reduced regulation of antitrust. That's created pricing umbrellas. It's created pricing power where it historically didn't exist. We're seeing that across everything ranging from real estate and rentals, where information asymmetries are able to effectively exert monopolistic-like behavior, which is the bane of existence of capitalism. Adam Smith identified this in 1776 with The Wealth of Nations, that anytime you bring businesses together, there's a natural desire to collude to raise the relative profitability of capital in business that unfortunately destroys price information. It destroys competition, which is really what we rely on in a capitalist society to maximize the overall outcomes for all individual participants.

Their businesses are actually not doing as well. So we are increasingly seeing bankruptcies accelerate and rise in small and moderately sized businesses. I realize this is going to sound like a very large number, but if you look at the behavior of bankruptcies for companies with over $50 million in assets, those are hitting levels that we only experienced in the early stages of 2008.

We're seeing areas like downtown regions of various American cities being hollowed out by the loss of retail establishments, etc. Anyone walking through the streets of New York will see a shocking number of vacancies. That's going to be even more true in many small towns. Those businesses are at a structural disadvantage in many ways because in 2006 we changed the retirement systems in the United States to increasingly drive investment into public markets. It was what was called the Pension Protection Act of 2006. It established a change in the way that 401ks work. 401ks being the vast majority of the retirement assets that are generated from employment in the United States, as additional sources like IRAs, etc., and they also have some of these rules applied to it. But the Pension Protection Act in particular changed our 401k system from one in which you had to choose to participate, what was called an opt-in system, to one in which you had to choose not to participate, what's called an opt-out system. This had the effect of crowding people into strategies that invest exclusively in public markets, things like the S&P 500 or a total market fund.

And it actually went a step further than that. It established what was called the qualified default investment alternative. If you're going to automatically default somebody into an investment program, you have to designate what types of investments they are going to be defaulted into. That QDIA status in 2006 was effectively assigned to index funds. And from that point, we've seen an accelerated growth of index investing across the US spectrum. If you're investing in the S&P 500, that means exclusively you are investing in companies that clear a certain profitability and capitalization threshold. You're not putting any investment into local businesses. You're not putting investment into local communities or smaller companies, etc. Even if you're expanding that to invest in small caps in the United States, things like the Russell 2000, even there the cutoff is large enough that effectively any business owner that you know on an individual basis, their business is likely dwarfed by these publicly traded companies. And in many cases, most of those business owners are increasingly looking to areas like horizontal acquisitions, consolidation within an industry as a mechanism to realize some of the wealth that they've created in their businesses. But that just drives further consolidation.

Yeah. So the quick answer is that this is the largest pool of assets that effectively exists on the planet. 401ks and IRAs in the United States combined at this point are about $28 trillion in assets. That's both equity exposure and fixed income exposure. So things like treasury bonds, corporate debt, etc. But increasingly those funds are being allocated into investment strategies that simply buy in proportion to market capitalization with no real consideration of what is the forward-looking opportunity for profitability from those companies. That crowding into these investment strategies, in my work, is largely responsible for the dramatic increase in valuation that we've seen. And the flow of funds has a disproportionate impact on the largest companies, driving down their relative cost of capital, their cost of financing themselves, and their availability of capital to make investments or to acquire other businesses that has been lowered radically relative to all other companies. And so as a result, these companies are just increasingly advantaged, creating competitive disadvantages for most businesses by number in trying to compete with them for the American consumer.

Passive investing absolutely impacts valuations. And it's as simple as understanding what passive investing is supposed to be versus what it actually is. So the label of passive investing, this idea that index investing, since it's buying things in proportion to their existing market capitalization, shouldn't have any impact on financial markets. Right? The idea is effectively you're a free ride.

It's not even so much that you're diversifying, it's just that you're doing the same thing that everybody else is already doing is at least the theory behind it. Now, one of the things I would emphasize is by definition, if you are investing in an index, you are excluding a world of investments that are not in those indices. So, if I invest in the total market index, I'm buying roughly 3,500 publicly traded companies. Am I putting any money into the local stationery store, local grocery store? No. But those are assets that are not being properly captured. And so as a result, those companies actually trade at a relative discount, which in turn has helped to facilitate the growth of private equity, which has been built around rolling up or consolidating those companies. But we are withholding funds from areas of the market that should otherwise be receiving investment because we've established a preferred way of investing by government mandate.

It's going to the stock market and the bond market. It doesn't go to your local businesses. It can't be reinvested in that way, or it's very, very difficult to make investments in that manner. Most people candidly look at the allocations that they receive under the Pension Protection Act, that qualified default investment alternative, or QDIA, today is a target date fund. And if you looked at your 401k, I'm sure most of your listeners are employed, they're working for companies. If they look at their 401k plan, they'll see that there's typically around 10 choices: the 2065 target date fund, the 2055 target date fund, the 2045 target date fund, the 2035 target date fund, etc. Right? Basically, the only question that's being asked is when do you plan to retire? Otherwise, we presume you're going to invest like everybody else does. That creates crowding within strategies, and it really unfortunately hits at the core of what passive investing is supposed to be versus what it actually is.

Passive investing is supposed to, in a theoretical framework, capture all investment opportunities: small businesses, large businesses, etc. Now, that's impossible to do. So, we automatically know that we're working within a reduced universe. The second component is that we assume that markets are what's called highly elastic. In other words, they can absorb the flow of funds. And there's some theoretical justification for this because for every buyer, there's a seller. And as a result, when money flows into the market, it shouldn't have that much of an impact if it's allocated on a market capitalization basis, basically in proportion to what everybody else is already doing. The problem is that's not what actually happens. And so in the last five to six years, we've actually discovered through improved mathematics and through improved use of analysis that the impact of these flows is anything but passive. It actually has a concentrating effect. It drives the value of the largest companies higher more than the smallest companies.

That sounds perverse when you think about it, but the reason why is because the impact on price of putting in an order is not tied to the market capitalization of the company. It's tied to how much it trades and how volatile that trading is. Those are the two factors that really play through. And so when you're sending an increasingly large order size when you buy the S&P 500 to Nvidia or Microsoft or Apple, the size of those orders is actually skewing the market behavior even further, causing those companies to rise relative to the rest of the universe. That then changes investment behavior because if you're the CEO of Microsoft or the CEO of Apple, you're receiving confirmation from the market that your cost of capital is very low, that what you're doing is absolutely the right thing to do. In fact, there's no company doing anything better than what you're doing. That creates, unfortunately, the incentive to then invest as if this market capitalization and this valuation is earned, which is part of the reason why we've seen such an incredible surge in investment in areas like data centers, etc. You increasingly hear an open discussion of will these investments actually generate a return. Most people are increasingly saying probably not, right?

We're actually seeing indications from Google already that things like AI will ultimately become free services supported by advertising in the same manner that search is a zero-cost, quote-unquote zero-cost activity where you don't have to sign up for tons of subscriptions, etc. You simply do work by watching ads and you're then compensated with free search services. We're seeing the direction head in the same way on things like data centers and AI services. Perversely, that means that most of this money is being, quote-unquote, wasted, but the market is telling us that it's a fantastic place to invest and a fantastic time to invest. And I would argue that that's largely a byproduct of how we choose to invest, how it's been mandated by the government in a liability-protected manner.

Part of my communication with my investors and others is through my Substack. I actually did an analysis on this in which I tried to look at various tools for valuing these businesses in a traditional framework, on a discounted cash flow analysis or on a return of capital type framework. And unfortunately, the data suggests that these companies are anywhere from, you know, two to five times overvalued overall, which would imply an 85% drawdown at the extreme. And unfortunately, that makes a lot of sense if you think about a company like Apple. It really hasn't grown its income for give or take three or four years. Its last growth of income was associated with the COVID surplus and stimulus. It's trading at the highest valuations it's ever traded at in history, suggesting significant future growth opportunities. But this is a company that really has no future growth opportunities. They've outsourced their AI to Google. They have seen very few of their new product developments post-iPhone become meaningful components of their overall revenue. Even things like iPads, etc., are relatively small in their business. Accessories like Beats headphones, etc., have failed to live up to the promise or expectations. Terrible things like their, you know, Vision headset, etc., have been largely failures. This is a company that should be trading at a low multiple. Instead, it's trading at a remarkably high multiple. And again, I would assign that to the way that we choose to invest, which automatically sends investment retirement funds. A sizable fraction of those are sent to Apple.

Well, a really simple example of that is if it actually turns out to be competitive with search, right? So, search is a defined source of profits. My behaviors as a leading user of technology, a rapid adopter of technology, is seeing my use of search collapse relative to my use of LLMs, what we call AI. And I think that's likely to continue if it basically is just a replacement for search or it's a replacement for other software services that we receive, things like Microsoft Office or email accounts or webpage design or all sorts of things that we're finding that AI is taking the place of in many ways. Then the pool of aggregate profits doesn't meaningfully grow while the investments have been huge, and so the return by definition there is relatively low. That's what seems to be happening, but we can't possibly know the future.

It really depends on how it affects the macroeconomic environment. If we see cutbacks in these investments, which would be similar to what we saw in the buildout of the telecom sector or the dot-com components in 2000, then we would see job loss associated with companies cutting short those expectations, reducing that investment. And that in turn would likely lead to macroeconomic deterioration and a potential correction in the stock market that's not tied to forward-looking components, but simply reflects fewer people paying into the system because there's fewer jobs that are out there.

I don't have a strong view in terms of whether AI is going to take a whole bunch of jobs or not. What I know is actually happening is that AI is creating the narrative that allows an increasing number of companies to defer hiring. We're not going to know if we need these people if AI ends up working. And likewise, it's also leading to people not replacing employees who are leaving because they're envisioning a world in which there's much higher productivity and so they need fewer employees to do the same amount of work. We're not yet at a point in which the prices of providing those goods and services has collapsed, driving a quantity increase that in turn would create the next sort of boom that comes after it. We saw that in the internet when prices collapsed for data services post-2000. Today we take for granted that we should have cheap and available bandwidth that allows us to do all sorts of things using telephones and computers that candidly we couldn't have imagined before, including things like distributing this broadcast over the internet. That's something that, you know, 25 years ago would have been prohibitively expensive. Today it's effectively zero cost.