The Giant Mindless Robot Driving Stocks Is Starting to Falter | Mike Green

There are some signs that we are starting to see a bit of a slowdown. Prior to the April run, we saw some diminishment of 401k flows. My hunch is that part of what is ultimately happening here is that boomers are actually working slightly longer and millennials and younger, the Gen Z, are having trouble finding jobs. That's creating some disruption in the process. But the simple reality is those 55 and over hiring is up dramatically. Employment rates are down in part because of things like AI, the return of manufacturing or the need to return to manufacturing.

Well, that would certainly be the implications of something like AI.

You've been fortunate. It's a little over 14 billion now.

We are definitely holding our own.

Well, a combination of retirement flows and some driven by rebalancing as well as systematic strategies like vol targeting, CTAs, etc., actually led April to be the — like off-the-charts record inflows versus anything we've ever seen. That's exacerbated by flows into things like levered ETFs where if you properly track the price impact of those because they are effectively taking one of your dollars and buying two or more of the underlying and doing it in the same transaction, it has an even more levered — basically the square root of two — impact on the flow components as well. So this has just been — April in particular was just an extraordinary period. May has slowed and the performance of the market has basically matched that over that time period. And so when we look at what happened in April, it was just a mechanical bid that came through that forced extraordinary short covering and amplified exactly the sort of stuff we would expect to see amplified in a passive inflow. The largest companies, the most volatile companies are those who basically took off and ran with the most aggressive components.

And the war.

So, you know, this is unfortunately really an extraordinary testament to the type of stuff that I've been highlighting and writing about for the last several years. With that said, there are some signs that we are starting to see a bit of a slowdown. Prior to the April run, excuse me, we saw some diminishment of 401k flows. My hunch is that part of what is ultimately happening here is that boomers are actually working slightly longer and millennials and younger, the Gen Z, are having trouble finding jobs. That's creating some disruption in the process. But the simple reality is those 55 and over hiring is up dramatically. Employment rates are down in part because of things like AI, the return of manufacturing or the need to return to manufacturing.

Well, that would certainly be the implications of something like AI. And I've talked about this fairly extensively. There was a phenomenal paper released by the Riksbank, the central bank of Sweden, earlier this year that took advantage of the natural experiment of the Riksbank being among the first central banks to hike interest rates in 2021. And the question that they tried to evaluate is: is the decline in hiring tied to the increase in interest rates and the contractionary effect that that has on many types of purchases, or was it tied to AI? And what they found was that the vast majority of job loss that occurred over the '22-'23 period was tied to the increase in interest rates. But within companies, they found an entirely different phenomenon, which is what we refer to as the low-fire, low-hire environment we're experiencing.

There's been a dramatic increase in value for those who are older and have what's called domain-specific knowledge. They know how to do their jobs. And there's been a tremendous diminishment in the value of people who need to be trained. And so what we've actually seen is, crazily enough, an 84% increase in the hiring rates of those 55 and up and a 25% decline in the hiring rates of those 29 and younger. This has really only been replicated or preceded by one period in history that I can point to, which was the early stages of, you know, kind of the first parts of the Industrial Revolution. As we transitioned from the Industrial Revolution largely being about power generation, coal used to power things like textile mills and looming facilities, and we began to move into the actual manufacturing and automation of manufacturing.

A lot of your listeners will be familiar — I know you spent time in Northern California — you know, with the popularity of Victorian houses in that era. The reason Victorian houses were popular was because new manufacturing techniques dramatically lowered the cost of things like filigree, wood trim, etc. That was done because we automated that process in the early stages of the Industrial Revolution, in the early parts of basically the 1830s is kind of the easiest way to think about it. That process was very similar to this one. It created an explosion of demand for trained artisans, those who knew how to do this because they were required to design the jigs that would ultimately be used in the automated factory. But it simultaneously destroyed the apprenticeship business. And so historically, we had always had guilds with masters and apprentices. Apprentices were brought in, paid minimal wages. Basically, they worked for food. They were taught the trade and then they became masters in turn. The Industrial Revolution broke that process and destroyed the pipeline of apprenticeship to mastery and created conditions of highly cyclical, highly damaging cycles of unemployment. Just to give reference to it, while we often think about the elevated unemployment in the Great Depression where it hit 25%, in New York City and Philadelphia, which were manufacturing centers, in the Panic of 1837, unemployment hit 63%. So, you know, this has precedent and I agree with you. I don't think it's going to be anywhere near that extreme. I want to be very, very clear. But I just want to parameterize where we have seen this type of behavior before. Today, those senior employees are being used to train the AIs instead of the young workers. And that is because we are genuinely questioning: will there be a need for them?

Well, the simple answer is that I don't know. Right? So I want to be very clear on that. But when you think about the proportion of our activities that flow through into the market-based economy versus the early parts of the 19th century, discretionary income that actually transacted at market-based prices was very low as a fraction of total spending. You likely grew your own food unless you happened to be in New York City. And so could we see this sort of phenomenon in urban environments in which service jobs like, you know, fast food cashiers rapidly gets replaced by automation, or cooking or delivery via trucks, etc.? These are all very large employment bases. It's entirely plausible that many of those jobs go away and there is no alternative for those workers. But that's a very strong statement and it's not one I'm prepared to make right now.

Yeah, I'm definitely keeping an eye open for it. And again, part of what I want to convey is that, you know, this creates understandable anxiety as this narrative increasingly permeates through our society that, you know, you are replaceable, you are a horse. You know, it's a really terrible message to convey to people because at the end of the day, they aren't horses. You know, we are mammals and I want to be very clear on that — that, you know, there's more similarities between us and a horse than people might take on first glance. But that fear that effectively we're going to become domesticated animals, that ultimately we exist to serve the whims of our masters, is not really an accurate representation of what an economy should be.

Yeah, I think that's right. And so we have to consider both the demographic component of it — of the retiring boomers, the vast majority of them will be retired over the next decade — as well as the simple reality that we are now creating underemployment conditions for the next generation means that those 401k flows are increasingly at risk.

Yeah. I mean, that I think is the unfortunate component. As always, I think there are opportunities that are created and we'll probably talk about one of them. You know, what I'm always looking for is areas of the market that have been neglected. And, you know, if you listen to the advice that I've given, I think people oftentimes, you know, they either think that I'm a crazy bull because I'm like, look, this is going to continue and markets are going to continue to levitate and go higher. But understand that's not telling you about health, right? That doesn't make me bearish. That's actually me telling you like, hey, this casino is going full bore and not only are they, you know, plying you with alcohol, but they're dropping cocaine on the tables. The simple reality is that that is, you know, the components of a truly epic bubble, which is part of what I think we're actually in. The other side of that though is that means that investment has to be directed away from another area. It's crowding into the speculative areas of the market in part because people are so afraid, right? They're afraid they're going to lose their job, therefore they have to earn 20% every year in their savings in order to achieve their perceived objectives. The simple reality is that's increasingly untrue and it's really untrue for the older generation. There's extraordinary opportunities that are being created by components of passive that create neglect. We'll talk about those. But that means that we also can't all get out at the same time, right? People have to decide they're going to do something different. And that in and of itself creates the feedback loop where if more people wake up to this opportunity and recognize that they're now investing to keep up with the Joneses as compared to what their individual needs might be, that they, you know, if they wait, they're going to join the crowd that tries to get out at the same time. And that could very well impair their financial future.

Unfortunately, like, let's reverse engineer that, right? So, you've heard me use the math that suggests the multiplier on passive flows is now in the range of about 22 times. 10 trillion worth of market cap appreciation would translate to roughly, you know, $450 billion worth of inflows. Our math suggests there was $400 billion worth of mechanical inflows. So like, you know, it's doing exactly what we would expect it to do in response to those flows. And those flows were generated by 401ks, particularly target date funds systematically rebalancing on a threshold basis. Because of the relative outperformance of bonds into the April lows, that created conditions where bonds needed to be sold and equities needed to be bought. That was one source of inflow. That inflow, as it began to drive markets higher, forces CTAs to cover their short position. As the market continues, CTAs flip from a short position to near a full allocation long position. Vol targeting strategies reinvest on the collapse in volatility that occurs as that begins to settle down. And then we also have things like risk parity and others that are smaller players in this. But at the end of the day, like, we can mechanically identify these flows that came into the markets and it has nothing to do with the war. It has nothing to do with economic outlook. Everything I literally just described to you has no discretionary component to it.

Well, you know, the simple answer is that we should, right? But it's not a very satisfying narrative, right? It's much more fun to look at the S&P as a price level without, you know, attaching the traditional narrative to it. It's more fun.

It's one of the reasons that when I appear in financial commentary or I'm asked, you know, what's going on? People will ask me — and this is a regular conversation, right? I will get a phone call from a press outlet saying, you know, do you have any comments on why markets are up today? And my answer is, well, we have positive inflows. What would you expect? And their response is, well, yeah, but what about earnings? What about oil? What about Trump? You know, etc., etc. And the answer is it doesn't matter. Like, I mean, to the extent that oil can actually — you know, the surging oil prices can cause investors to change their allocations or the marginal discretionary investor to say, I'm going to buy more oil-related stuff, like, sure, that has an impact. I want to be very, very clear. But the reality we saw in April was not actually about that.

I don't think there's much debate about that. Most people assume I'm crazy.

Yeah. I mean, I will send you a copy of our flow analysis from Tier One Alpha that highlights this. I could probably just share it on my screen. Give me a second to pull it up. But like, you know, the minute you see this, you're like, 'Oh, okay.' It all unfortunately makes a ton of sense. It doesn't make it feel good, right? And it does, as you said, highlight the framework and it is the same framework, unfortunately, that then suggests, you know, this does not end well. But that's, you know, that's a point still to be proven.

So we are increasingly focusing on the predictive models that identify things like the movements of CTA, vol control, risk parity, 401k rebalancing, etc. And so we do have some insights around that. There remains a discretionary component to it and there remains uncertainty as to forward-looking metrics like what is going to happen to employment or as we're starting to see from companies under stress, they're reducing their voluntary matching of 401k benefits and contributions. Those are things that are just candidly outside of the purview of what we attempt to do, which, you know, does create challenges. But at this point, like, it's kind of crazy when I talk with my team, we're getting very close to being able to explain north of 50% of the move of stocks like Microsoft, Nvidia, etc., simply on the basis of these flows.

Yeah, unfortunately the predictive models are things that are in development. So we're starting to write about it. We're starting to incorporate it into our outlooks, but the reality is that there are not yet products out there that are working off of the predictive framework. I hope to change that over the next six months.

Yes.

Exactly. Let me just share very quickly that chart of flows.

So this is actually looking at it going back over time. This is again just an isolated segment of the flows. It does not include things like the short covering that emerged from hedge funds, which we have strong evidence for as well. That's another data set that we're starting to build in. But you can actually see over here to the right, we've never seen anything like this. We exceeded about $350 billion of inflows in basically the blink of an eye.

Right. And the vast majority of that actually came through things like CTAs, etc. Now, you'll notice that we've separated out SPY, V, etc. These tend to be additional contributions over and above the 401k component. This is that part that is very, very hard to basically forecast. I can't tell what's going to happen on the discretionary side. Or at least I can't directly tell what's going to happen on the discretionary side. But, you know, when you ask me about April and the crazy rally and what's happening to flows, you can see both components. The flows slowly turning negative and ultimately pushing us into the correction that we experienced followed by the extraordinary reversal in the opposite direction.

Actually, we were kind of in the opposite camp. So at our commentary at Tier One, which we write, you know, on a daily and then weekly basis, in terms of much fuller note, you know, we kept emphasizing that what we were seeing were indications that yes, flows had turned negative, but almost every part of it was suggesting that the markets had already crashed. And so, you know, our quantitative models were saying risk off and we had to respect that. But at the same time, all of our commentary was focused on everything we are seeing says that this is basically over and, you know, it can get worse. There is the potential for it to get worse. We didn't see the 401k flows, etc., decline in a meaningful fashion. But, you know, this had all the indications of a market that had already crashed and as we disaggregated the flows, that became very clear that that's what had occurred and the reversal of that is again what we experienced in April.

I think there's more evidence for the second statement than the first one. You know, there is a feedback loop that is created as markets continue to march higher. There's stronger and stronger evidence for an alternative interpretation, which is, hey, markets just go up, right? They always go up or the Fed has our back or they're not going to — and by the way, the Fed did absolutely nothing but speak hawkishly over this time period. So, I'm not quite sure where that narrative comes from.

Yeah. Although the impact of that I think is strongly debatable among other things, but, you know, I will accept that, that's totally fine. So let's assume that it's QE, right? Well, then the evidence is very clear. You should just be in equities 100% all the time and any opportunity you get with the market drawdown is an opportunity to pile in. Now again, I'll emphasize we didn't actually see that much discretionary movement. Most of this was systematic in structure. And so I do think that there is, you know, an idiosyncratic component to this akin to sailing on the open ocean and encountering a rogue wave. Is it going to happen again? Sure, it absolutely can happen again, but it does require a special confluence of events.

Yeah. So this is actually the subject of a paper that I just released with Hari Krishnan, who wrote the book 'The Second Leg Down', and Stefan Sturm, who is a professor of mathematics at Worcester Polytechnic. You know, we basically created an analysis in which we used a closed-form mathematical solution to show that if you exceed about 65% passive share — and just to parameterize that, we're about 53, 54 right now, gaining about 4% a year — above 65%, there is not enough discretionary capital left that is really capable to respond to the volatility signatures that begin to emerge past that level and it becomes like the XIV trade that you've heard me talk about before. It basically becomes a guarantee that a volatility event will occur that can't be offset by discretionary flows. And so that was what I was looking for in the XIV. If you remember the statistics that I shared with you on that, about 70% of the daily trading volume was tied to the inverse VIX ETF complex. That allowed us to get to the point that we were able to articulate fairly cleanly that this event was not just a possibility, but a probability, a high probability event. My analysis was it was roughly 95% certainty that within a two-year period from when I began to analyze the XIV that an event would occur that would drive the product to zero in a single day. It happened six months later. So, you know, you can decide I was too conservative and that's, you know, candidly probably right. But that same phenomenon exists now not for a $2.5 billion ETF but for a $73 trillion market. And that is a source of genuine fear.

No, I want to be clear on that. So we estimate that somewhere in the neighborhood of about 60% of all trading activity is tied up in the passive complex, whether that's the creation-redemption process for ETFs or mutual fund rebalancing or, you know, that type of process. Now is approaching rapidly those levels, but discretionary trading is still significant both on the retail side and on the asset manager side. The real crazy part there is how those ratios have flipped. So if I go back to 1995, which is give or take when I started my career, about 80% of trading activity involved discretionary active managers. Today we would estimate that number is down around 7 to 8%. In 1995, retail traders, what are typically referred to as noise traders, were about 10% of the market. Today they're about 20 to 25% of the market and so they have grown significantly. The irony, of course, is it means that experiences like the GameStop saga in which, you know, retail traders convinced themselves that they could really give it to the hedge funds — they're kind of right. They're three times our size, right? They are much bigger in aggregate than we are. I illustrate this in my upcoming book with, you know, the classic illustration of a shark being pursued by a school of fish that is formed in the shape, you know, of a bigger shark, right? And that unfortunately, I think, is a key component of what we're actually seeing.

Well, it's rising and not so slowly. So, passive is gaining about 4% a year. So, you know, the math would suggest we're about two and a half years out. Once it gets inside kind of that two-year window, there's tools that are available to start playing it. And, you know, I hate to say I look forward to that opportunity. I think that there will be trades to be done around that.

I mean, it would be presumptive to say yes to that, right? I mean, I would hope that I'm able to take advantage of it. At the same time, I acknowledge that, you know, predicting stochastic events by definition is stochastic, right? It could happen four years out. So...

Yeah, I think unfortunately that's the case. And as that settles in, like the easy math — the math behind it is that what we have experienced through a combination of two factors: the introduction of defined contribution relative to defined benefit and the introduction of passive to facilitate investing in that defined contribution framework, are two once-in-a-lifetime phenomena that are unlikely to repeat themselves. Both of those have a valuation increase impact. The shift to defined contribution, as we'll talk about later, requires people to save dramatically more because you're now self-insuring instead of mutually insuring against an uncertain retirement. The implementation of passive is more subtle in its components, but it basically drives capital into the largest companies and the most volatile companies. That in turn perverts the cost of capital analysis, leads to all sorts of bizarre shenanigans like we're watching happen in the technology industry right now where much of the profitability has become circular and inflated by equity valuations. And so, you know, we are creating conditions where that eventually has to be reversed under demographic features and the higher volatility that emerges. And that's the unpleasant experience. That would be like going — I want to be clear, I hate to use these examples because they sound pre-programmed, right? But, you know, that is the experience of investing in the 1920s versus investing in the 1930s. And that's something I think people are very poorly positioned to evaluate.

Well, as I said, you know, the plan is to introduce products that begin to take advantage of and exploit this phenomenon. A lot of my research in the last six months, seven months has actually been directly on this subject of what can you do now that the peak of the hill is effectively within sight. It is — I want to be very, very clear. There's two answers to that. If you think the peak of the hill is in sight but still not here, there's one type of strategy that you want to pursue. If you think that the peak of the hill is here, which I don't think, I want to be very clear on that, right? Then there's an entirely different type of strategy. And so facilitating those two is kind of a one-two step. I'm working on products that allow people to express both. I look forward to sharing with you the information around that as it occurs. I have started to roll it into products that I manage. I have started to roll it into the design of new products around this stuff. But, you know, it is speculative. I want to be very clear. It is my view supported by the evidence and I'm always happy to share that with people about what is likely to occur, but it's a human making a forecast and you are subject to error on that. So like, you know, it's just not that simple. I want to be...

We do have investment options. And I want to be clear that I think many of the investment options that we offer at Simplify are primarily focused around the idea of how to use derivatives to increase income while reducing some elements of risk. You need to obviously consult your financial advisor. You need to consider that. But at the end of the day, we do have products that are designed to facilitate the transition from asset hoarding into income. And I think it's really critical for people to understand that that is the transition that is likely to matter over the next cycle. We have basically created conditions through the defined contribution shift that require people to save an extraordinary amount of money in the hopes that that money will last them through their retirement. That has perverse effects. We can talk about those in detail. But at the end of the day, you do need to figure out how to convert that into income. You can either choose to hope that markets will still be bid and you can sell your equities slowly to obtain that income or you can begin the process of transitioning it into various forms of strategies that automatically sell, create synthetic selling, or put you right into fixed income, which has the characteristics of converting capital into income on a continuous basis. And candidly, I wish there were better choices and this is one of the areas that I'm spending some time trying to figure out. I wish there were better choices in things like annuities that allow you to have some comfort about spending down principal as well as simply tapping into the income. I think that's really going to become a critical tool as we move forward in changing our retirement planning to a more thoughtful process. But I don't anticipate that happening in this administration or another administration. And candidly, it's one of the reasons I speak so publicly about this stuff because my hunch is there's going to be another Pecora Commission just like we saw in the early 1930s. And I want to make sure that the evidence is out there so that those who are at fault and can be blamed for this aren't able to say, 'Well, how could we possibly have known?'

I do very much and actually would suggest that that's one of my frustrations right now is seeing Americans that have accumulated an extraordinary pool of assets keep those assets in something that I think is far riskier than they fully understand. And they're seeing the historical behavior that is driven by the combination of a switch to passive investing and the inflows associated with defined contribution plans and not understanding that that is a temporary phenomenon and they are missing the opportunity that has emerged in places like fixed income, in particular. You and I have talked about long-dated TIPS, for example, offering now a 2.7% sort of return for 30 years. People don't understand how incredible that is, right? You know, we can...