Is there a bubble coming?

Is there a bubble coming?

Between retail investors and passive funds, there could well be and here’s why.

The GameStop fiasco shouldn’t have come as a surprise. Stock trading is no longer a privilege of the rich, it’s investment for the masses and no less accessible than a bank account. People feel safe in a crowd so if you have a stock account but don’t know what to do, just do what the guy next to you is doing.

This sheep like trading on sites such as Reddit, will always create bubbles, or ‘trends’ as they could be referred to until the bubble bursts. Retail investing is growing incredibly quickly, but this was the case well before the lockdown of March 2020, even if it has only really hit the headlines since then.

We are living in an age of mobile phone app trading and investing. The generation of young professionals coming through will have known nothing else. The old economists will claim it is breaking their models with regards to p/e ratios, in the same way Roubini has declared cryptocurrencies ‘Shitcoins’, and an asset bubble waiting to burst; what he has failed to appreciate is the power of the masses. Retail investors are only going to increase in number and they don’t have any interest in selling out of their Apple or Microsoft shares, because these are the companies they know and trust, and they are part of their lives and they get to own a little piece of them.

Wall Street may sell out profits and look for value, and that causes the price to drop, but if nobody is selling, it won’t. Bitcoin is here to stay, and so are over inflated technology stocks. However, the problem may come further down the line, when flows into passive funds, turns negative.

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. They are relatively price insensitive. This hasn’t been a problem so much in the past because we haven’t seen hugely inflated prices like this before created by an external source, in this case, the retail investor.

In theory, as the proportion of assets invested passively increases, it is possible that the future market efficiency and effectiveness may decline and mispricing of assets become more common. At this point it is worth pointing out that the amount of money controlled by passive funds has doubled since 2011.

The FCA published a research note earlier this year that surveyed the academic literature on this point. And, indeed, the evidence suggests that an increase in the proportion of assets invested passively can adversely affect both market efficiency and effectiveness. For example, researchers have found that an increase in the proportion of assets managed passively leads to more price movements based on superficial effects rather than deep fundamentals of valuation – in the terminology, the prices are ‘noisier’.

The rise of passive investment has been a boon to investors and has undoubtedly driven competition. But it is wise to look ahead and consider where this trend may lead.

The ‘Robin Hood’ crowd buy the stocks they know. Passive investment funds increase holdings in the stocks that go up. If ever there was a case for asset inflation, I think we are seeing it. Cheap money leads to excessive speculation; this contributed to the 1990’s dotcom bubble, the 2000s housing bubble, and now, a tech bubble – at the very least, a US tech bubble.

If passive investment funds see a negative inflow of capital, the opposite starts to occur and they need to sell. This would create a massive problem. One could argue that in this instance, the demand for such mega-cap tech stocks might keep the bubble inflated, but if it doesn’t, it won’t.

Many investors are calling for stocks to drop. But I don’t think it’s all stocks, I think it’s the over inflated stocks. We don’t often see such a sector split like this where so many stocks are low, but one particular equity sector is so high. The p/e ratio of the Nasdaq is 40, the p/e ratio of the FTSE is 13.

Institutional investors will be looking for value at this time, and some capital will shift. The economy could be about to come out of a massive decline in growth, proceeded by a steep incline. Value stocks, and ‘going out’ stocks are surely the place to look for a solid return. However, for this to happen, I would expect the high value tech stocks to take a dip, at least, in normal trading circumstances. But once again, that would possibly be underestimating the power of the retail investor.

Having said that, for it to be a bubble, it must burst and if retail won’t sell, and investment funds won’t sell, then when will it burst? Lots of people foresaw the sub-prime crash, but the ones that got famous were the ones who were lucky with their timing. You can short the market, but if you get your timing wrong, you’re dead in the water and down a fortune.

IF the bubble bursts, the money will move from the many, to the few. Retail accounts will take a massive hit and all those who have enjoyed the ride up, will suffer from the fall down. We all hope that doesn’t happen and the appetite for long term tech investment will keep their dreams alive, but spreading risk is definitely the key at this juncture. Diversify. A well-diversified portfolio, makes for a profitable portfolio.

The Portfolio Platform can assist you to build a well diversified portfolio, that is robust and aims to perform regardless of the market climate.

Visit our website today, and view over 30 strategies that could add value to your investment structure in 2021.

View our strategies- Click here.

‍