In this week’s Perspectives, fund manager David Jane considers if the current stock market structure is leading to a false sense of wellbeing – and potentially a fully automated stock market bubble.
In his 2019 book Fully Automated Luxury Communism, Aaron Bastani argued that technology could create a world of super abundance leading to widespread prosperity. In my view this nirvana is unlikely even in a world of super abundance, simply because human nature will intervene. In this week’s note we argue that the current stock market structure is creating the appearance of ‘fully automated wealth creation’. This is potentially leading to a false sense of wellbeing when the true level of wealth creation is far below the apparent growth of valuations.
In previous notes we have referenced the memetic, or narrative driven, nature of the current stock market. It has decoupled from fundamentally based valuation metrics some time ago. What is driving stock markets now appears to be a fully automated bubble process that sends large companies, particularly the fashionable well known tech names, ever higher. Until it stops.
Bubbles are a feature of financial markets and have existed throughout history. They require a couple of factors to occur. Firstly, there must be a novel undeniable fact. Consider the great technological advancements of the past, such as railways or the mobile phone. Secondly, they can only occur in periods of abundant liquidity. Clearly those conditions exist today. It is undeniable that the AI revolution will transform the business environment in ways not yet understood. Financial conditions are undoubtedly loose, with the Fed cutting interest rates despite rising inflation and a strong underlying economy.
There is a difference this time which sets the current conditions apart. In all previous bubbles the majority of participants were willing participants, actively buying into the story and the market. In this period, much of the buying is automated. The underlying investors having no idea what they are buying into.
There is a considerable move away from active management into passives based on another undeniable truth – on average, active managers must underperform because of transaction costs and higher fees. Hence, most buying that takes place makes no consideration of any concept of the value of what they are buying. The situation is in fact more extreme than that. Each time an investor moves from active to passive they inevitably sell international shares and small and mid-caps and buy large-cap US shares. Given the popularity of the Nasdaq, the bias is towards these big tech companies.
The chart shows the Vanguard S&P 500 UCITS ETF fund flows and the P/E valuation on the same index. As trackers take an increasing share, valuations go higher.
As trackers take an accelerating shares of flows valuations increase
Source: Bloomberg data, 31.5.2018 – 19.12.2024. Past performance is not a reliable indicator of future returns.
Compounding this is the fact that the largest companies, rather than paying dividends, typically have share buyback programs. Given the timing of index rebalances and buybacks, the number of shares notionally in the index is always above the number of shares available to buy.
This leads us to the concept of a fully automated stock market bubble. The passives must continuously buy the largest stocks due to regular inflows and their market share gains. The companies continuously buy back their own shares. They both do this irrespective of the price they are paying. Outflows from active managers means that small and mid-caps are continuously sold. Fed liquidity keeps the game going.
When you combine all of this with the concept that central bankers and politicians see the stock market increasingly as a tool of monetary policy or at least as an important signal of confidence, you have the potential for things to get very out of hand.
Our place is not to judge the current market structure but to understand and act accordingly. We have to be aware that the market is being driven by these factors and to be alert to the consequences should this change. Historically such manias tend to end with a combination of tighter liquidity conditions and the absence of new buyers. The auto-bid from buybacks and passives is not going away, unless profitability of the large-caps declines materially. The trigger will more likely be liquidity drying up. With the Fed now suggesting a more hawkish stance as move into 2025, the market has already taken a step back. It’s too early to say if we have seen the end to this trend but vigilance is required.
RISKS
The value of stock market investments will fluctuate, which will cause fund prices to fall as well as rise and investors may not get back the original amount invested.
Forecasts are not a reliable indicator of future returns.
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