A Warning Shot For Passive Investing: "That Wasn't 'The Crash'"

Authored by Lance Roberts via RealInvestmentAdvice.com,

Last week, investors received a “warning shot” about the dangers of “passive indexing.” 

While the idea of “passive indexing” sounds harmless enough, we have spilled a lot of ink on this site digging into the relative dangers of it.

The biggest risk to investors is when “passive indexers” turn into “panic sellers.” 

We witnessed it all first-hand last week.

The “sell off” proved our previous premise of the flaws of “passive investing.”

“While it is believed ETF investors have become ‘passive,’ the reality is they have simply become ‘active’ investors in a different form. As the markets decline, there will be a slow realization ‘this decline’ is something more than a ‘buy the dip’ opportunity. As losses mount, the anxiety of those ‘losses’ mounts until individuals seek to ‘avert further loss’ by selling.”

I have also stated that while “robo-advisors” are the new “shiny toy” for the markets to play with, and inexperienced investors to be lured into, when a crash does come, individuals will not be willing to just “ride it out.” To wit:

“The websites of two of the country’s biggest robo-advisers — Wealthfront Inc. and Betterment LLC — crashed on Monday as the S&P 500 Index sank. Complaints quickly spread across Reddit and other internet sites from people who had trouble logging onto their accounts.”

Yea….it’s that psychology thing.

Individuals just simply refuse to act “rationally” by holding their investments as they watch losses mount.

This behavioral bias of investors is one of the most serious risks arising from ETFs as the concentration of too much capital in too few places. But this concentration risk in ETF’s is not the first time this has occurred:

  • In the early 70’s it was the “Nifty Fifty” stocks,
  • Then Mexican and Argentine bonds a few years after that
  • “Portfolio Insurance” was the “thing” in the mid -80’s
  • Dot.com anything was a great investment in 1999
  • Real estate has been a boom/bust cycle roughly every other decade, but 2006 was a doozy
  • Today, it’s ETF’s and Bitcoin

Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing.

Until it goes in the other direction.

While the sell-off last week was not particularly unusual, it was the uniformity of the price moves which revealed the fallacy “passive investing” as investors headed for the door all at the same time.

Such a uniform sell-off is indicative of what we have been warning about for the last several months. For price chasing investors, last week’s plunge should serve as a warning.

“With everyone crowded into the ‘ETF Theater,’ the ‘exit’ problem should be of serious concern. Unfortunately, for most investors, they are likely stuck at the very back of the theater.

However, I am suggesting that remaining fully invested in the financial markets without a thorough understanding of your ‘risk exposure’ will likely not have the desired end result you have been promised.

As I stated often, my job is to participate in the markets while keeping a measured approach to capital preservation. Since it is considered ‘bearish’ to point out the potential ‘risks’ that could lead to rapid capital destruction; then I guess you can call me a ‘bear.’ 

Just make sure you understand I am still in ‘theater,’ I am just moving much closer to the ‘exit.’”

As we have previously discussed, when the “robot trading algorithms”  begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.

That Wasn’t THE Crash…

Fortunately, while the price decline was indeed sharp, and a “rude awakening” for investors, it was not a “crash.”

It was just a correction within the ongoing “bullish trend.”

For now.

But nonetheless, the media has been quick to repeatedly point out the decline was the worst since 2008.

That certainly sounds bad.

The question is “which” 10% decline was it?

From the amount of “digital ink” being spilled to telling investors “not to worry,” and given the fact markets remain in their currently “bullish trend,” this was probably the first. Regardless, as shown above, it was only a glimpse at what will eventually be the “real” decline when leverage is eventually clipped. I warned of this previously:

“At some point, that reversion process will take hold. It is then investor ‘psychology’ will collide with ‘margin debt’ and ETF liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

When the ‘herding’ into ETF’s begins to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments. Don’t believe me? It happened in 2008 as the ‘Lehman Moment’ left investors helpless watching the crash.”

 

“Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious and without remorse.”

Make no mistake we are sitting on a “full tank of gas.” 

Don’t Just Stand There

One of the biggest problems facing investors is ultimately when “something goes wrong.” When this happens, the initial response is paralysis, followed by a bit of panic, before ultimately falling prey to the host of emotional mistakes that repeatedly plague investors time and again.

Currently, I do not believe that we have begun the next major corrective cycle just yet. There is simply too much momentum and bullish psychology in the market. Last week, the majority of the questions I received were not about “selling,” but rather is “now the time to ‘go all in?'”

The correction was most likely only that, for now.

However, this should be a clear “warning shot” to investors who have piled into ETF’s in the hopes indexing will offset the penalties of not paying attention to the risk they have taken on. 

“While passive indexing works while all prices are rising, the reverse is also true.”

Importantly, it is only near peaks in extended bull markets that logic is dismissed for the seemingly easiest trend to make money. Today is no different as the chart below shows the odds are still heavily stacked against substantial market gains from current levels.

In the near term, over the next several months, or even a year, markets could very likely continue their bullish trend as long as nothing upsets the balance of investor confidence and market liquidity. However, of that, there is no guarantee.

As Ben Graham stated back in 1959:

“‘The more it changes, the more it’s the same thing.’ I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of the proverb is the phrase, ‘the more it changes.’

The economic world has changed radically and will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliché is sound,  then the stock market will continue to be essentially what it always was in the past, a place where a big bull market is inevitably followed by a big bear market.

In other words, a place where today’s free lunches are paid for doubly tomorrow. In the light of recent experience, I think the present level of the stock market is an extremely dangerous one.”

He is right, of course, things are little different now than they were then.

For every “bull market” there MUST be a “bear market.” 

While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering it will also “pace” just as well during the subsequent decline.

The correction had the “perma-bulls” scrambling to produce commentary as to why markets will continue to only rise. Unfortunately, that is not the way markets actually work over the long-term and why the basic rules of investing are REALLY hard to follow.

Think about it.

If investing was as easy as the media and Wall Street portray it to be, then everyone would be wealthy from investing. Right?

The vast majority aren’t because investing without a discipline and strategy has horrid consequences.

So, what’s your plan for when the real correction ultimately begins?

Comments

DillyDilly new game Mon, 02/12/2018 - 16:18 Permalink

"I come for the bullshit predictions and stay for the antisemitism"

 

I hand over my hard earned paycheck to jews who print money (out if thin air), give it free to their friends, and charge me interest for it, while 'entertaining' me with propaganda, and nation building terror initiatives.

 

I stay because I'm not quite ready to eat a bullet (but the gap is dwindling ~ which makes the jews mighty happy no doubt).

In reply to by new game

JimmyJones The_Juggernaut Mon, 02/12/2018 - 15:28 Permalink

I have the same feelings, I have invested over the years always looking for the big drop to come since 2008, Last week I pulled out after the rebound, I am chilling out for a few months to see how this plays out.  Typically we always have a big drop in the first year of a new president after 8 years with the previous, that didn't happen.  So will it happen this year, who knows but I am out for the next few month.  Still in Cyrpto though.

In reply to by The_Juggernaut

mototard Mon, 02/12/2018 - 15:27 Permalink

My first line of work was in the wonderful world of aviation - so I still tend to think in those terms.

 

What we have just seen was the stall warning indicator coming on. This will be followed by a wing stall and rapid descent.

 

Timing, of course, is yet to be determined....

juggalo1 Mon, 02/12/2018 - 15:28 Permalink

BTFD would have been the right strategy at the moment.  In addition it depends what the target or index is, but ETF in general are not an asset class.  To say "ETF / Passive" is overbought is like saying Mutual Funds are overbought.  SPY is an ETF.  But SPY is closely tied to the SP500, and is mostly backed by underlying S&P 500 assets.  So SPY cannot be overbought or crowded unless the SP500 index of largest American companies is overbought.  But in that case the problem is not ETF, it is concentration of stocks in general.

Charles Offdensen Mon, 02/12/2018 - 15:28 Permalink

The crash that's coming is gonna feel like you're sitting at a stop light and some asshat going 110mph in a 18 wheeler and not paying attention because they're texting and slams into the back of you!  BTW if that ever happens to me and I can walk, I'll get out of my vehicle to check on them to see if they are ok.  If they say yes I'll crack them right in the nose for texting while driving.  But what's is happening is banking while texting.  Mutha suckas!

onthedeschutes Mon, 02/12/2018 - 15:33 Permalink

You lost me at "The biggest risk to investors is when “passive indexers” turn into “panic sellers.” 

Seriously...you think panic selling of passive investors is really the biggest risk?  Moronic.  Simply moronic.

BOHICA2 Mon, 02/12/2018 - 15:41 Permalink

There are three kinds of people in this world: people who make it happen, people who watch what happens, and people who wonder what happened.
If you're a banker, you make it happen.  If you're us, you watch it happen.  Hillary wonders what happened.

 

verumcuibono Mon, 02/12/2018 - 15:46 Permalink

"If investing was as easy as the media and Wall Street portray it to be, then everyone would be wealthy from investing. Right?"

--this strategic seduction is for a reason; the more dumb money in the market the bigger the transfer.

"The vast majority aren’t because investing without a discipline and strategy has horrid consequences."

--well, yeah... and a little manipulation and fraud goes a long, long way. And they won't stop until it's all theirs.

MusicIsYou Mon, 02/12/2018 - 15:48 Permalink

There's no such thing as free financial advice. They're going to make sure the masses are at the back of the theater/ on the lower decks of the Titanic. And blocking access to accounts is the same thing as locking down the lower decks of the Titanic. I'm not a big shot insider so I have nothing in the Casino I can't afford to lose. I'm pretty sure Ray Dalio kinds of people don't get access blocked.

MusicIsYou Mon, 02/12/2018 - 16:06 Permalink

It's funny, most people think 401Ks were created for themselves, because that's what arrogance/self importance tells people, but it was created so they could play with other people's money giving themselves huge returns while putting small insignificant returns in people's accounts. And when the house of cards finally comes down you're going to get hammered.

inosent Mon, 02/12/2018 - 16:10 Permalink

No way was that a crash. Market NEVER crash from the highs. They crash from the LOWS. We have not seen a bear market since at least the 70s, or back to the 30s.

A real crash takes you far far away from the highs and you stay at the lows for a very long time. ALl we saw was selling off the highs to fill in a big hole in the chart, which basically takes the sell off the table. The game goes back to buyers putting the pressure on spec shorts who might want to bet against the current highs. And you can be sure the longs won't make it easy to stay short.

MusicIsYou inosent Mon, 02/12/2018 - 16:17 Permalink

That old rule of crashing from lows doesn't apply anymore because the game rules changed the last 20 years with bailouts, QE, and tons of stimulus, and also all the safety dampers. Today's high markets are the new "low." The Dow at 20,000 is the new baseline. The Dow is so high because currency has lost so much value.

In reply to by inosent

MusicIsYou Mon, 02/12/2018 - 16:23 Permalink

People are so simple that they don't realize the markets are trading so much volume because currency has lost so much value, velocity. Today's highs are the new low. The Dow could be 60,000 but the U.S will look like ashes. Eventually it'll get so high with so much nothingness holding it up that it will just collapse to nothingness. Eventually even the machines are going to figure out that it's nothingness.

romario Mon, 02/12/2018 - 16:35 Permalink

since we got Internet and Facebook now, and central banks got no ammo left, there will never be a crash again. Let's buy useless goods from Amazon delivered via drones and mine Bitcoin.

MusicIsYou Mon, 02/12/2018 - 16:39 Permalink

I'd rather have the markets not doing great and have currency have value, than to have things as they are with the markets doing great but currency continually losing value. But really the markets aren't doing great because the Dow is above 20,000. It's like having a piece of shit machine that constantly needs more and more voltage to make it operate. Eventually it's just going to blow the whole thing apart. The markets are a piece of shit decrepit machine close to breaking down. The markets are like the voltage is increasing, but the amperes to actually make it function are decreasing, and it continually needs more voltage to hold the ampere level. Eventually sparks will go blasting out of the markets blowing the whole damn thing apart. It's going to happen because markets function like electricity, that's why the dollar is called currency just like current/amperes.

Blankfuck Mon, 02/12/2018 - 17:56 Permalink

Hail to the media! Marketfarce, Bloomfucker, Business corrupt insider also Congrats to the CNBC CIRCUS FUCKERS all around interviews of pushers and addicts, THE CORRUPT TRADESMAN talking  of why the market just shouldn't  be down. FUCK YOU PUSHERS OF YOUR SLIME PONZI MARKET!