The mainstream media and industry focus on passive versus active is setting investors up for another “tulip bulb” market mania event that could destroy more investor wealth and capital than the Financial Crisis. The idea that active management’s only purpose is to constantly outperform indexes all the time is not only wrong minded but is also a dangerous storyboard that could capsize the investing public and industry professionals.
To keep up with the constant feedback loop created by the news cycle, the mainstream media has reduced the concept of active investing to outperforming an index by the minute, hour, day, week, month, quarter, year and longer periods. The mainstream media touts studies that show that most managers don’t outperform passive indexes all the time. This drives them to the conclusion that investors should only invest in passive low-cost index products and has created a strong investor preference for passive indexing. The trend is well confirmed with capital flows from active to passive which is accelerating as the bull market has extended for years.1
Active managers who benchmark against an index will typically have a goal of outperforming the benchmark but over long periods of time. Some managers may focus on outperforming an index on a risk-adjusted return basis, while other managers are index agnostic with the goal to actively manage risk to capital to improve capital performance with the lowest risk possible over an investor’s lifetime. This more complex backdrop of varying active product goals do not neatly fit into the mainstream media’s sixty-second storyboard, so it is rarely discussed.
The Lurking Danger in Passive Indexing
Passive indexes generally outperform active management during bull markets and especially when volatility is low and markets drift higher like they have since the markets bottomed in 2009. The bull market recovery has been supported by Fed monetary policy and has been carefully managed to create “Wealth Effect” spending by consumers. To promote spending, the Fed has intentionally created asset bubbles and managed markets to keep volatility low and asset prices high.
Passive index products consistently look good in bull market trends as markets move higher. They are designed to replicate an index and, therefore, have a symmetrical return profile. Unfortunately, the same symmetry that investors like so much on the way up is what causes them the most financial harm on the way down. In bear markets, passive products can fall just as much as the index, often as much as 50% or more, as the markets did during the crashes of 2000 and 2008.2 It’s time for investors to pause long enough to remember the catastrophic losses the indexes incurred during the aftermath of the Dot.com bubble bursting and the real estate bubble collapse.
Investors Beware of Increased Liquidity-Trap Risk
We think the main reason for this liquidity trap is because access to financial information has been democratized since about 2000. Financial information and data have been instantly disseminated for free via the world-wide-web to investors. In turn, this has synchronized investor behavioral biases making markets more susceptible to major shifts in investor psychology. When investors down shift — from the excessive optimism that exists now — to pessimism, the ensuing move to sell overpriced assets may cause another liquidity trap event. The concentration in passive index products points to the possibility that future bear market cycles will be faster developing, deeper, and more damaging than previous cycles. The Financial Crisis handed investors huge losses across virtually all asset classes as sell side liquidity overwhelmed buyers. Virtually all asset classes sold off as investors sought to reduce risk. In 2008, the liquidity crunch started with the crowded trades in credit default swaps. As mortgage-backed securities started to unwind, market makers backed away from providing a liquid two-sided market. Investors rushed for the exits and selling pressures swamped markets in mortgage and caused the financial system to fracture.
The Fed Signals a Major Shift in Monetary Policy
The easy monetary policies that led to building the asset bubbles are behind us. The most influential central bank in the world, the U.S. Federal Reserve Bank, has been removing monetary policy accommodation and has embarked on an ill-conceived rate hike cycle. Up until recently, Fed Chair Janet Yellen has been very circumspect about raising rates too quickly and promised to wait until the data indicated the economy was achieving a healthier growth rate and inflation pressures were becoming worrisome. Unfortunately, the March hike shows the Fed has become compromised by emotion and fear rather than staying data dependent. They increased rates on concern that proposed fiscal stimulus and tax cuts might cause the economy to overheat and inflation to overshoot.
The Fed Has Become a Serious Risk Factor to the Bull Market
The Fed has a long history of raising rates too much and at the wrong time. Their most recent move is a classic Fed policy misstep. The economy was growing at a 2.6% rate in 2015 and the Fed, who was under public and political pressure to normalize interest rates, hiked rates by a quarter of one percent.3 They rationalized the small hike by thinking the economy could handle a small rate increase after holding rates near zero for seven years. Unfortunately, the small rate hike caused GDP to slow appreciably to 1.6% in 2016.3 Still, under intense pressure to normalize, the Fed decided to increase rates again by a quarter of a percent in December of 2016. This time the hike was justified by the Fed, eyeing full employment statistics and a small uptick in wages.
Typically, it takes about six months for the Fed to be able to see the full effects of a rate hike, so it was shocking to see them hike again in March. This time the hike had everything to do with their concern over the possible effects of proposed policy — that may or may not be put into place over the next 12-24 months. Let’s look at the facts surrounding the initial rate hikes:
- The economy is still weak and has posted the slowest growth rate in history during this recovery.4
- The 2015 rate hike caused the economy to slow by 38% from 2.6% in 2015 to 1.6% in 2016.3
- The economy is projected to slow again in 2017 with first quarter forecasts at just 1.00% GDP growth, and this is before the effects of the rate hikes have worked their way into the system.5
This is why it is so inconceivable to me that the Fed would put continued economic growth in jeopardy by hiking twice in three months. I thought they would be smarter this time around, but I remind myself that they have routinely hiked rates too far and too fast, thereby slowing economic growth and leading to recessions. We see their shift in policy to be a major short-term risk factor to the current bull market trend. These rate hikes could torpedo the markets before the much-needed pro-growth policies get the chance to develop.
Is it Time to Hedge Your Fully Invested Bets?
Recently, we had become much more positive on the potential for the aging bull market to get a second wind because of the pro-growth tax and fiscal policy promised by the new administration. Post election, there has been a major shift in investor optimism that has included increased asset flows into equities. When you combine optimism and capital flows with positive earnings and revenue trends, it’s easy to be constructive in equity markets. But with consecutive Fed rate hikes and the potential for more rate hikes in the future, a prudent investor needs to start hedging their bets.
We fear the dangerous combination of constant media messaging and an elongated bull market that has reinforced the argument for low-cost and passive indexing is creating one of the most crowded trades in history. We believe when markets finally correct, the crowded index trade will unwind causing investors to run for the exits as if fleeing from a burning building. The resulting melee could cause another liquidity crisis even more severe than the 2008 Financial Crisis. Luckily, WBI’s quantitative management system is on the tightest risk control setting in our 25-year history. Tight risk controls give us confidence that we can maintain our fully invested position while having the potential to reduce risk quickly if markets do start to unwind.
Past performance does not guarantee future results. The views presented are those of Don Schreiber, Jr. and should not be construed as investment advice. All economic and performance information is historical and not indicative of future results. This is not an oﬀer to buy or sell any security. No security or strategy, including those referred to directly or indirectly in this document, is suitable for all accounts or proﬁtable all of the time and there is always the possibility of loss. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, please consult with WBI or the professional advisor of your choosing. This information is compiled from sources believed to be reliable, accuracy cannot be guaranteed. Information pertaining to WBI’s advisory operations, services, and fees is set forth in WBI’s disclosure statement in Part 2A of Form ADV, a copy of which is available upon request.
1Wigglesworth, Robin, and Stephen Foley. “Active Asset Managers Knocked by Shift to Passive Strategies.” Financial Times. The Financial Times Ltd., 11 Apr. 2016.
2“11 Historic Bear Markets.” NBCNews.com. NBCUniversal News Group, 24 June 2010.
3U.S. Department of Commerce. Bureau of Economic Analysis. Gross Domestic Product: Fourth Quarter and Annual 2016 (Second Estimate). 28 February 2017.
4Schreiber, Don. “The Zombie Economic Recovery.” WBI. 28 October 2016.
5Federal Reserve Bank of Atlanta. GDP Now. 24 March 2017.
Tulip Bulb Mania: Holland 1593-1634. Tulips and their bulbs were a highly valued commodity that people traded for land, homes, and other valuables until the market crash from 1634-1637 when the value equated to a common vegetable.
Risk-Adjusted Return: adjusts return by subtracting for how much risk the investment took.
Liquidity Trap: When a market dislocation occurs due to emotional investor behavior during periods of overvaluation and volatility causing less liquidity and significant disruptions to price continuity.