INDEX FUNDS Investing – NEXT Market CRASH WILL BE UGLY

Mortgage crisis Dr. Burry – Compares Index funds to subprime bubble!

Dr. Michael Burry, famous for predicting the subprime mortgage crisis and for being impersonated by Christian Bale in the movie The Big Short, is out with a new prediction. 

Source: The Big Short

This time he is comparing index funds and passive investing vehicles to the subprime mortgage crisis and collateralized debt obligations. When the trend reverts, the meltdown will be ugly. That is what he said in a Bloomberg interview, but what does that mean and how can what he said impact your long-term investing plans is what we are going to explain today.

By going through dr. Burry’s comments, we are going to explain:

  • The flood of money going into index funds and ETFs – passive investing vehicles
  • The absence of price discovery
  • Liquidity risk and how this can end badly
  • What can you do about it? Simple solutions (Lifelong investing is about common sense after all) (for the passive to aggressive investor)

Dr. Burry’s comments

To quote dr. Burry:

Source: Bloomberg

The flood, or flow of money is what we have to understand. Index funds are definitely the predominant investing mantra in the current decade. However, it wasn’t always so. If we check Vanguard’s assets under management over the past decades, we see that Vanguard was not an important player three decades ago. Assets under management were $55 billion while now those are $5.2 trillion!

Source: Vanguard

Total flows have been extremely positive for index funds. Passive investing schemes haven’t seen a negative flow year for the past 20 years.

Source: Bloomberg

For 20 years, assets have been piling into passive investment vehicles without even considering the fundamentals nor the price paid. Most of these assets, that are being invested blindly, went into US equities or fixed income. 

Source: Bloomberg

It is very simple, we as humans are social beings and we always look for the crowd’s confirmation. If an asset goes up in price, it must be a good thing to own. Consequently, many others flock in, and sooner or later it creates a bubble. “The S&P 500 must be the best investment out there as it is up 4.5 times since March of 2009” (irony 😊).

Source: FRED

Why is there more money flowing into the S&P 500 now that the level is above 3,000 than in 2009 when the index was at 666? Shouldn’t the opposite be logical? Well, this shows how we humans are not rational and how Nobel prize models actually fail the test when confronted with human logic, or better to say stupidity. To quote dr. Burry, what is going on reminds very much of what was going on in the 2000s with the subprime bubble. The fact is that nobody cares about price, this creates bubbles and the longer bubbles last, the worst the crash will be. 

Source: Bloomberg

It will not end well because at some point someone will yell the king is naked, flows will revert and the exit door will be too small, thus it will lead into a catastrophe of 2009 or even bigger proportions. 

Source: Bloomberg

Nobody cares about price, thus it is all about sentiment. When things are going well, everybody is happy. When things turn bad, people will panic. The situation is well represented by Icahn’s cartoon of the low interest party bus.

Source: Carl Icahn

Let’s us discus the absence of price discovery. 

The absence of price discovery

Over the long-term, investment returns will be perfectly correlated with the business performance of the underlying investments. Long-term here means over cycles: debt cycles, interest rate cycles, economic cycles etc. Over the last 35 years, we have practically been living in only one part of a normal economic boom and bust cycle. We have lived the part with declining interest rates, expanding valuations and consequently bubbles. We had the dot-com bubble in the 1990s, an emerging market and collateralized debt obligations bubble in the 2000s and we now have a passive investments/interest rate bubble developing in this decade. 

Source: Bloomberg

When the flows revert, it gets ugly. And the flows eventually revert because asset prices get disconnected with reality. 

Over the past 35 years, prices have really detached themselves from reality. Stocks represent part ownership of a business. Businesses usually make money and that is translated into an earnings yield. 

Source: Multpl

The S&P 500 earnings yield declined from 14% in 1980 to the current 4.48%. It is logical that the S&P 500 delivered returns of 11% per year since the beginning of the 1980s because its business yield was above 11%. Those flooding index funds with new money now, cannot expect long-term returns to be above 4 or 5%. Actually, it is most likely that their returns will be negative for a decade or two. 

Source: YouTube – Mohnish Pabrai

Index funds have had a pretty good run over the past 10 years, but also over the past 40 years. However, periods of above 20 years where returns are zero or negative are not uncommon. Especially for real returns. 

During the 1980s, the business yield from stocks was 10%, that led to great returns in the future. But today, people expect the same returns on a 4.5% business yield. It will not happen. Actually, if investors start requiring a 9% earnings yield from stocks, the S&P 500 would fall to 1,500 points. Such a move would be detrimental to the economy, spending, retirement plants and it would create a negative spiral worse than the 2009 crisis.

On the other hand, the longer this bubble continues to be inflated, the harder will the landing be. Politicians and others keep thinking in short-term parameters. Trump is pushing for 0% interest rates while the ECB just restarted their money printing machine.

Source: The Real Donald Trump

The crucial point is that what you can expect from index funds is around 5% nominal returns in the long run. This means it could be really bad for a decade or two. Later in the investment part, I’ll explain why is this so important and how can you do better for yourself by using common sense. 

Common sense tells us that S&P 500 earnings have declined in the last reported quarter. It wasn’t an important fact and the S&P 500 broke new highs.

Source: FACTSET

In an environment where prices don’t matter, it is all about sentiment and sentiment can’t last forever. When the sentiment turns, there will be a crisis. 

Liquidity crisis like 2009

When the flow of funds reverts, and all things revert in life, there will be no market for the ETF to sell the 321st stock it owns. If there is no market, prices plunge. This can be easily explained with bond ETFs, or fixed income ETFs. 

If we take a look at the iShares iBoxx $ High Yield Corporate Bond ETF, it has a market capitalization of $17 billion. 

Source: iShares

And, on first sight, it owns a very diversified portfolio of 1,000 high-yield (read: junk) bonds. The largest holding of $110 million is an Altice bond while Bausch health holds 5th place with a bond of $64 million. $64 million on $18 billion is not much. 

Source: iShares

However, if I download the complete list of 1,000 holdings, I see that the ETF owns many Bausch Health bonds. Actually, it owns $319 million of them. $319 million is already something on an $18 billion capitalization and it is even more significant when compared to Beusch’s market cap of $8 billion.

The risk is that, if forced to close down positions due to money outflows, something that hasn’t happened over the past 18 years, the ETF would have a lot of trouble to unload $354 million of Bausch bonds that nobody would want. Firstly, there is little liquidity for such bonds, and secondly who would want to buy if you know the counterparty is forced to sell.

A similar situation is in many other index holdings, very little volume on high stakes and lots of tracking derivatives. All is well, until it isn’t. Exactly the same as it was in 2008. It was all ok in 2007 while in 2009 it was all doom and gloom. 

Your portfolio – simple solutions for low risk and higher rewards

I have divided the solution strategy into a 3-part pyramid for each type of investor out there.

The passive investor

There is only one thing a passive investor, not interested in thinking, has to do. He or she has to invest in index funds constantly on a monthly basis. You simply allocate a fixed amount to your retirement account, forget about, don’t care about stock prices go up or down and you will do well in life. The only catch is that you have to add money especially when the doom and gloom scenario, the ugly meltdown materializes. When buying low, you will reap the rewards that those buying in 2009 are enjoying now. So, automatic investments into dollar cost averaging are the answer. You should expect 4% from the current level, hope stocks drop so that you get a bigger dividend and a better long-term return on the reinvested money and newly invested money. 

The passive investor who is ready to think in life

This is a simple financial planning exercise. If index funds will give you 4% over the long-term, they you should compare that yield with your student loan, mortgage, credit card loan, buying a house (look at rent versus mortgage cost) etc. 

The above should include 98% of the people.

The 2% remaining that want more

You should look at the opportunities out there that are not pushed to extremes due to the index fund bubble. Emerging markets are cheap when compared to the developed world. I’ve recently discussed how diversifying into China makes sense now. 

There are plenty of investment opportunities that offer low risk and high returns. Commodities have been shunned by passive investors over the past 5 years, thus copper miners that have a positive long-term outlook thanks to the electrification trend look cheap. So, you can find investments that offer investment returns above 10% for even less risk than the largest global indexes as there it not much institutional ownership and thus no fear of liquidity crunches. I firmly believe, that a value investing approach, where you add businesses with a good earnings yield and positive prospects to your portfolio, will do wonders over the long-term when compared to what index funds will deliver over the next few decades. 

By investing in value and business, you also don’t have to care about when will this meltdown arrive, as by owning businesses, you will be protected by the panic. As dr. Burry says, nobody can time things. We can only invest in value. If you are interested in my research where I look for value investment opportunities with a healthy business yield in positive sectors, please check my Stock Market Research Platform. We are covering more than 30 stocks and managing two portfolios where I am sure you will find interesting investment opportunities to diversify your portfolio.

Receive a weekly overview of published articles, videos and research reports straight to your inbox for boring long-term investing knowledge!


×