The rise in passive investing has fuelled and extended what could have been a short-lived market melt-up, distorting traditional capital rotations and leading to unprecedented volatility in the S&P 500
The US stock market had started the year on a roll. Following a bullish end to 2019, the S&P 500 extended its gains in January, breaking one all-time high after the next until it hit a record $3,386.15 on 19 February.
It seemed as if American equities were unstoppable, even in the face of the global health concern spurred by the coronavirus. Reality, however, hit soon after the viral outbreak began to dramatically spread around the world.
Just two days after hitting a record high, the S&P 500 suffered its fastest-ever weekly decline since the 2008 financial crisis, falling more than 10% between 24 and 28 February. The US blue-chip index wiped out $3.6tn in market value over the course of seven days of selling from its peak.
Amount wiped off S&P 500 market value over 7 days
The past week has been one of the most trying stretches for traders, as investors and analysts pore over news and reports about quarantines, illness counts and death rates, The Wall Street Journal reports.
Wall Street is puzzled over whether the coronavirus is a short-term disruption or a more lasting threat that could be the catalyst to unhinge the record-long bull run in stocks, and the S&P 500 specifically.
“Everybody’s just trying to figure out where are the next rumours coming from and where the viruses are hitting and how bad they are,” Thomas di Galoma, managing director of rates trading at Seaport Global Securities, told The Wall Street Journal.
“Everybody’s just trying to figure out where are the next rumours coming from and where the viruses are hitting and how bad they are” - Thomas di Galoma
Financial markets enter unsettling new territory
Looking at the current market structure, which has been distorted by the rise of passive investing, gains across major indices are likely to precede any proper correction, according to KCI Research.
This is evident in the S&P 500’s recent uptick when it climbed 4.6% on Monday (2 March) on the news that global central banks were preparing to increase stimulus amid the viral outbreak.
According to KCI Research, the rise of passive investing primarily through ETF vehicles over the last several years has fuelled “a US stock market melt-up that has superseded 1999’s peak valuation levels”.
Based on this understanding, KCI believes that the recent correction in equity markets is temporary because trends are currently being amplified, making any sell-off likely to be preceded by gains, putting the market on “the precipice of a historic capital rotation”.
“From my personal perspective, the self-fulfilling melt-up from price-insensitive and valuation-insensitive passive, ETF, and dividend buying has gone to extremes that I never fathomed it would. Still, looking back with the benefit of hindsight, the progression makes logical sense, as trend-following investors amplified the trends in place,” writes KCI in Seeking Alpha.
“Unfortunately, this market structure works in both directions, and now it is set to work in reverse with an accelerated decline in the SPDR S&P 500 Index ETF [SPY] sparking additional selling.”
“Unfortunately, this market structure works in both directions, and now it is set to work in reverse with an accelerated decline in the SPDR S&P 500 Index ETF [SPY] sparking additional selling” - KCI Research analysts
For professor Russell Napier, who is the co-founder of investment research portal ERIC and author of the 2005 classic Anatomy of the Bear: Lessons from Wall Street’s four great bottoms, the effects of passive investing are not good news for corporate returns or society.
“There is nothing quite like this, though some draw comparisons with the portfolio insurance automated system that contributed to the 1987 crash,” Napier tells Bloomberg’s Quint.
“In terms of financial market impacts, it should make it easier for active managers to outperform when the machines become too big as market players. Of course, none of us knows when that might happen, but watching equity value indices for any sign of life relative to momentum may provide some indication of when it arrives.”
“In terms of financial market impacts, it should make it easier for active managers to outperform when the machines become too big as market players. Of course, none of us knows when that might happen, but watching equity value indices for any sign of life relative to momentum may provide some indication of when it arrives” - Russell Napier
The S&P 500 has since resumed its downward trend, falling 2.8% on Tuesday (3 March), following the Federal Reserve’s surprise 50 basis point cut – its biggest single cut in more than a decade. Fed Chairman Jerome Powell had slashed interest rates in an attempt to contain the coronavirus’s economic fallout.
While US markets sit in correction territory, downgrades to the global outlook continue to roll in with some predicting three more Federal Reserve cuts before the end of the year. However, could these short-term blips prove just bump in the road for this historic bull-run, before a meltdown eventually comes to pass?