The Bubble’s Passive Accomplice

Andrew Stuttaford

Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: passive funds and bubbles, snacking from home, vanishing green jobs, regulating social media, and the value of SPACs (or not). To sign up for the Capital Note, follow this link.

Bubbling Away
Yes, of course there is a bubble (or, more accurately, there are bubbles), and by now, you should not need GameStop, SPACs, or the market-moving powers of Elon Musk to remind you of that fact.

At the core of it is, I continue to think, unsurprisingly and unoriginally, the mispricing of risk that flows from ultra-low interest rates, rates distorted, to no small extent, by what the Fed is doing. And there are no signs for now that that is going to change anytime soon.

CNBC (from Wednesday):

Federal Reserve Chairman Jerome Powell on Wednesday painted a dour picture on the state of U.S. employment, saying continued aggressive policy support is needed to fix the myriad issues still facing workers.

Addressing the issue will require a “patiently accommodative monetary policy that embraces the lessons of the past” regarding the benefits that low interest rates bring to the labor market, the central bank chief told the Economic Club of New York.

Even though the economy has reclaimed more than 12 million jobs since the early days of the Covid pandemic, Powell said the U.S. is “a long way” from where it needs to be in terms of employment.

“As long as the music is playing, you’ve got to get up and dance,” as someone once said. It is not unreasonable to think that, under current conditions, investors will continue to dance into one asset class or another.

Robb Report (my emphasis added):

The economy may be in a precarious spot, but the collectible card market is apparently booming. The latest proof: Two Michael Jordan rookie cards set records at auction this past weekend.

On Saturday, Goldin Auctions sold two mint condition examples of His Airness’s 1986 Fleer rookie card for $738,000 each. Breaking a record set less than a month prior, the astounding hammer prices mean that the value of Jordan’s first professional basketball card has multiplied by more than 15 times since the start of the Covid-19 pandemic.

The Wall Street Journal:

U.S. home prices are rising at an accelerating pace, new data show, as the strongest housing boom in more than a decade is boosting home values from major metro areas to small cities and vacation spots.

The median sales price for existing homes in each of more than 180 metro areas tracked by the National Association of Realtors rose in the fourth quarter from a year earlier, the association said Thursday. That is the second consecutive quarter that every metro area tracked by NAR posted an annual price increase, marking the first time this milestone has been achieved in back-to-back quarters.

The latest data underscores how the home-price rally, which over the years has played out in distinct pockets such as Idaho or across parts of the Sun Belt, has become much more widespread and continues to gain momentum. In the fourth quarter, 161 metro areas posted double-digit-percentage price increases, up from 115 metro areas with double-digit gains in the third quarter.

But you get the picture.

In an article for the Financial Times, Carson Block, the founder of Muddy Waters Capital, discusses another possible explanation for what’s going on:

One factor that made the GameStop squeeze so profound was passive ownership. About one quarter of the available shares were owned by passive investors. These funds run on autopilot. As new money comes in, it is allocated to keep a constant balance among a specific combination of individual stocks or other assets. As GameStop’s price rose to ridiculous heights, those passive funds were almost certainly buying to maintain their balance.

These same phenomena are a big part of the Tesla stock story. Ever-rising share prices that have no basis in fundamentals have birthed yet another meme, “Stonks!”, which is feeding frenzied retail speculation.

The distortion of prices caused by the growth of passive has only recently been fully understood, thanks to the work by Michael Green of Logica Funds and a growing number of academics.

Green estimates that when an incremental dollar is put to work with an active manager, it has an average effect on aggregate market capitalisation of $2.50. The multiplier occurs because the number of shares available is smaller than the total number of shares outstanding, and a buyer must often pay a premium to induce a shareholder to sell. However, Green estimates that when a passive fund receives an additional dollar, the automatic decision to maintain balance by buying in proportion to market capitalisation results in an increase in market cap of more than $17!

Passive funds have a much greater impact on prices because active investors can be patient in deploying their capital and are sensitive to the prices they pay. Passive funds have little discretion whether and at what price to buy — they must buy if they have inflows. Perversely, passive funds’ demand for a stock generally grows as the price increases because the weighting of the stock in the indices they track increases. So long as such funds have inflows, they do not sell.

Leverage linked to low interest rates turbocharges these unhealthy dynamics. Balanced funds are forced to buy stocks because their bonds have risen in value. Pensions and endowments are forced into equities to replace lost yield. Stonks’ increased values are used for collateral for loans to buy more stonks. Cheap money leading to excessive speculation contributed to the 1990s dotcom bubble, the 2000s housing bubble, and now the stonk bubble.

The real risk to markets is that passive flows go negative (if widespread lay-offs lead workers and employers to cut their 401K contributions). If that were to happen, passive fund selling would quickly overwhelm the market. Such a crash could resemble 1929-1932 in magnitude but at 2021 speed . . .

Unfortunately, Block may well be right. Quite what can be done about this, I don’t know. Block points to the need to find a way to “deleverage our markets and economies,” but that is easier said than done, as I am sure he would acknowledge. The disgraceful old option of inflating the leverage away would be likely to lead to market chaos and, with federal debt so high, a fiscal crisis. And where that might lead, well, we don’t want to know.

Block also raises the issue of whether such funds should be treated “as systemically important financial institutions,” to which the obvious answer is, at least in theory, yes, but, as a practical matter, it’s hard to imagine the sort of safety measures that might be built in. Block also mentions “looking at funds through the lens of antitrust issues,” an idea to which I, as no great fan of antitrust, view with some skepticism. A constellation of smaller passive funds would logically lead to much the same consequences as a handful of very big ones. That said, the outsize influence of some of the largest fund groups (whether active or passive or both) is certainly something to be discussed.

But on another day.

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The Capital Record
We recently launched our new series of podcasts, the Capital Record last week. Follow the link to see how to subscribe (it’s free!). The Capital Record, which will appear weekly, is designed to make use of another medium to deliver Capital Matters’ defense of free markets. Financier and NRI trustee David L. Bahnsen hosts discussions on economics and finance in this National Review Capital Matters podcast, sponsored by National Review Institute. Episodes feature interviews with the nation’s top business leaders, entrepreneurs, investment professionals, and financial commentators.

In the fourth episode, Anthony Scaramucci of Skybridge Capital joins David to talk about what role we need government to play in a society that protects free enterprise. Anthony yearns for the good old days of the 1950s, and David offers some counterviews.

Around the Web
Snacking from Home

The Financial Times:

PepsiCo expects to increase sales this year after demand for chips and sodas from housebound consumers helped the food and drinks company produce a bigger than anticipated rise in revenues in the last three months of 2020.

The shift to remote working and learning has prompted consumers to munch on snacks more regularly at home, fuelling demand for the US-based group’s line-up of snack brands including Lays, Quaker Oats and Doritos.

About those green jobs . . .

Clean Energy Wire:

German metal industry association Nordmetall has warned that the country is at risk of losing large parts of its wind power industry to foreign competitors if domestic expansion of the technology and other energy transition projects are not pursued vigorously, the newspaper Welt am Sonntag reports. Nordmetall head Folkmar Ukena told the newspaper that the wind industry must not meet the same fate as Germany’s solar power industry, which largely succumbed to Chinese competition in the past decade . . .

Regulating Social Media

Douglas Murray in The Spectator:

The only thing messier than a barely regulated internet is one regulated by the people who would like to regulate it. Von der Leyen [the president of the EU Commission] and others believe that they have the answers on tech regulation because they believe that they have the answers on most things. But if they were so good either at forecasting problems or dealing with current ones, the EC would not have created the mess that it has. Anybody who likes how von der Leyen has organised the EU vaccine procurement programme is going to love how she tries to organise everything they are allowed to know and say.

All discussion over internet regulation is subject to nothing so much as a thousand examples of the Russell Conjugation. That is the tendency to inflect your judgment of a statement depending on the person making it. So, for instance, while I am exercising free speech, you may be demonstrating problematic speech and someone we dislike is practising hate speech. It is a version of the fact that while you are always entertaining at dinner, another person is garrulous and a third is a drunken bore.

So it is with fake news, disinformation, hate speech and all the rest of the things von der Leyen and Davos man worry about. People like them never spread disinformation or fake news, just as they never break the law. Only other people do that. Which is why it is always other people who must be stopped.

For more on the EU’s vaccine shambles, please take a look at two pieces we have recently run on Capital Matters hereand here.

Random Walk
A look at SPACs

SPACs (“blank check companies” as they are not altogether unfairly known) are one of the features of our current . . .excitable market.

But are they truly the cheap alternative to IPOs that has sometimes been suggested?

Michael Klausner, Michael Ohlrogge, and Emily Ruan examined this question in a paper that came out in the later part of last year.

Here’s the abstract:

A Special Purpose Acquisition Company (“SPAC”) is a publicly listed firm with a two-year lifespan during which it is expected to find a private company with which to merge and thereby bring public. SPACs have been touted as a cheaper way to go public than an IPO. This paper analyzes the structure of SPACs and the costs built into their structure. We find that costs built into the SPAC structure are subtle, opaque, and far higher than has been previously recognized. Although SPACs raise $10 per share from investors in their IPOs, by the time the median SPAC merges with a target, it holds just $6.67 in cash for each outstanding share. We find, first, that for a large majority of SPACs, post-merger share prices fall, and second, that these price drops are highly correlated with the extent of dilution, or cash shortfall, in a SPAC. This implies that SPAC investors are bearing the cost of the dilution built into the SPAC structure, and in effect subsidizing the companies they bring public. We question whether this is a sustainable situation. We nonetheless propose regulatory measures that would eliminate preferences SPACs enjoy and make them more transparent, and we suggest alternative means by which companies can go public that retain the benefits of SPACs without the costs.

— A.S.

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