Market Factors: Index investing might be riskier than it looks

Secret meetings in the snack sector, new research suggesting risks for index investors, the struggling global consumer and a look ahead to two important economic data points are all covered in today’s edition.

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Passive investing

The ‘amplification loop’ increasing risks for index investors

There is no credible financial study that disproves the idea that passive, broad index-based investing is the best market strategy for the vast majority of investors. A new academic study, however, implies that passive investing may become a victim of its own success.

Passive Investing and the Rise of Mega-Firms was written by Michigan State professor Hao Jiang, London School of Economics’ Dimitri Vayanos and Lu Zheng from the University of California-Irvine. The study concludes that passive investing “[raises] disproportionately the stock prices of the economy’s largest firms, and especially those large firms that the market overvalues.”

In simple terms, passive index buying results in large cap stock buying that is not price sensitive. Active managers’ attempts to correct eventual valuation excesses through short selling are ineffective because of passive investor inflows that keep pushing the stock price higher. These active managers are then forced to cover their short positions, which pushes stock prices higher, which means they get a bigger share of passive investor inflows. The study calls this “an amplification loop.”

Passive assets invested in U.S. stocks have climbed from US$23-billion in 1993 to US$8.4-trillion at the end of 2021, according to the paper, exacerbating the trend. The result is that the biggest stocks get bigger and more expensive. With active managers powerless to put speed bumps in the way of valuation expansion, investors should start speculating as to how far things can go.

In case I need to restate this: No one can consistently pick market tops, so I am not arguing that disaster is imminent. More volatility, on the other hand, would not be a big surprise.

The rise of passive investing is a massive change in market structure. There is a history in finance of new, good ideas being used until something breaks. As examples, portfolio insurance was blamed for the 1987 market panic and credit default swaps drove a lot of the excesses of the Global Financial Crisis that started in 2007. It is not inevitable that passive investing will cause a problem, but it is important to look for one as part of risk management.

Apple Inc., Nvidia Corp., Microsoft Corp., Alphabet, Meta Platforms Inc., Tesla Inc. and Amazon.com make up 31 per cent of the S&P 500 market capitalization. Their average trailing price to earnings ratio is 54.7 times although that number is skewed by Tesla’s 116.4 times valuation. Whether this is a bubble and the extent to which passive investing is inflating valuations are matters of conjecture.

Again, passive investing is a good idea, all the research says so. But as far as I know, no research has taken into account the findings of the three academics about passive assets distorting large cap valuations.

The longer the percentage of assets in passive portfolios climbs, the more likely we are to find out the risks.

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Trends

Global consumer starting to look tapped out

There are reasons to be concerned about the U.S. and global consumer. Wells Fargo analyst Christopher Harvey collected downbeat management comments from a number of consumer-focused companies, including McDonalds Corp., Nike Inc., Delta Air Lines Inc., Lamb Weston Holdings Inc. (they provide potatoes for French fries for fast food restaurants) and swimming enabler Pool Corp. McDonalds noted that “lower-income consumers are dropping out of the market” because of price hikes.

Tuesday morning, alcohol giant Diageo PLC – owners of the Guinness, Johnnie Walker, Tanqueray, Smirnoff and Crown Royal brands among many others – dropped 10 per cent after reporting weaker than expected quarterly profits. CEO Debra Crew reported “a very extraordinary consumer environment” with inflation slashing spending power.

Domestically, the retail sales data for May was terrible, down 1.3 per cent when a much smaller 0.5 per cent decline was forecast.

Diversions

Here’s some food for thought

CBC published Ozempic is changing the way people eat. Snack companies are paying close attention in early July. The report noted that Nestle was developing meals specifically for consumers taking Ozempic.

I have no guesses on how snack companies will adjust to appetite suppressing drugs but it did remind me of one of the most delightful news features I’ve ever read - The Extraordinary Science of Addictive Junk Food in the New York Times.

The story is ten years old but it has everything – secret and acrimonious meetings of snack company executives, how chemists design food to appeal to our evolution-derived tastebuds, how one yoghurt brand gained market share by having “twice as much sugar per serving as marshmallow cereal Lucky Charms,” and the industry’s fear they would be branded the new tobacco for the health side effects of their products.

The Essentials

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Globe Investor highlights

It was just last week that money market traders were putting equal odds on the Bank of Canada cutting rates for a third time come September. But over the last few days, they’ve become increasingly convinced more monetary easing is coming soon - which would be most welcomed by investors in interest rate sensitive stocks. As Darcy Keith reports, economists have been left guessing as to why the market probabilities for a cut have gone up.

It isn’t just U.S. small caps that are on a roll of late - they are in Canada as well. But Robert Tattersall notes there’s a big difference between the two markets when it comes to smaller-capitalization stocks.

The Financial Times recently reported that “public markets are undervaluing clean energy companies.” That means they could be acquisition targets. Hugh Smith of the London Stock Exchange Group uses some pretty advanced screening to look for U.S. renewable stocks that are the mostly likely candidates.

Which U.S. political party is best for the economy and markets? Tom Czitron crunched some numbers to find out.

What’s up next

Domestic GDP data was released today for May. An anemic 1.0 per cent year over year was expected and we got a slightly less anemic 1.1 per cent

The U.S. Non-Farm Payroll data on Friday remains important as I mentioned Monday. Consensus points to 141,000 new jobs.

The other one is the ISM Manufacturing report on Thursday where a contractionary 48.8 reading is forecast. I learned from Francois Trahan, ex-strategist at UBS and founder of Trahan Macro Research, that even though the United States is a services dominated economy, manufacturing data is more sensitive to changes in the economic cycle and a better indicator of future corporate profit growth. The New Orders component of the survey is the most forward-looking segment and worth paying attention to on its own.

Mr. Trahan’s Intern’s Guide To Macro’s Influence On Equity Markets is one of the few research reports I return to at least annually.

See our full economic and earnings calendar here (You can bookmark the page - it gets updated weekly)