First of all, let me say that I love investing. I really do. The fact that you can take a few dollars, invest them, and then make even more dollars, is like a magical dream come true.
Except sometimes in investing things don’t always go smooth. Sometimes those dreams turn into nightmares, and the investor loses both capital gains AND their initial investment.
This kind of nightmare turns into reality when big investing bubbles break.
Lately, there’s been a lot of talk on the interwebs about a new investing bubble that could be forming right under our feet — The Passive Investing Bubble.
A Passive Bubble?
Most experts consider passive index investing to be a pretty safe way to invest. With the removal of active management, low costs, and extremely broad diversification, passive index investing has grown immensely in recent years. It’s an easy way for the average Joe (or Jane) to invest for retirement.
Passive investing has gotten so popular that (according to Moody’s Investors Service) passively invested funds now account for 36% of the U.S. stock market.
It’s now “common knowledge” that if you buy index funds and dollar-cost average you’re bound to do pretty well over the long-term. So well in fact, that I’m now frequently hearing the mantra, “stocks always go up”.
Frankly, everybody’s indexing these days. Most personal finance blogs, news sites, and even investing books now recommend investing in passive index funds.
Actively managed funds are still dominant, but it’s not going to last long. (Moody’s predicts passively manage funds will exceed actively managed funds sometime in 2021.)
So successful is index investing that only a few rare-individuals have dared suggest that passive investing might have a flaw — It could be building into a bubble. These odd-ducks predicting a bubble have mostly been ignored as quacks.
Lately though, investor Michael Burry has been talking about a passive investing bubble… and people are starting to wonder if he might have a point. Why would they listen to him? Not only was Burry the first to bet against sub-prime housing before the 2008 Global Financial Crisis, but he and his investors profited greatly from that disaster.
This is the true story told in the Oscar winning movie The Big Short. If you haven’t seen the movie yet (and your even the slightest bit interested in money), I highly recommend watching it. (FYI: The Big Short was #5 on my list of best money movies of all time)
Long story short: Michael Burry is no dummy.
What’s the Problem?
What exactly is the problem with index investing? Isn’t passive index investing supposed to be more efficient and low cost compared to actively managed funds?
Absolutely! The problem investors like Michael Burry are pointing at isn’t about fees or under-performing the market. To put things simply, the problem is asset prices.
In efficient markets, prices are usually set by supply and demand — A selling investor asks for a price, and a buying investor offers a price. These two prices are known in stock market parlance as the ‘Bid’ and the ‘Ask’.
In the old days this is how prices were set for stocks (a process called price-discovery), but in the index world investors aren’t setting prices — They’re saying “buy at whatever the current price is”, and leaving the price-discovery to fewer and fewer active investors.
A huge number of savers now funnel their income into index funds every month, buying stocks “at any price”. Sometimes at even really silly prices. This is exactly what’s been happening over the last decade, as more and more people have shifted from active funds to passive index funds. Stock prices have risen steadily over the last decade, and many people now believe that — “Stock prices will always go up, so the price I pay doesn’t matter”.
Meanwhile the number of active investors setting rational prices continues to shrink every year.
What happens when this happy little cycle ends and a large number of people rush for the exit “at any price”? The bubble breaks and asset prices decline dramatically. In other words, a big market crash.
This might sound a little far fetched, but think back to the housing bubble of the early 2000’s. People were buying homes “at any price” because “real estate always goes up”. Bidding wars were pushing-up prices for almost every home on the market. The most surprising part was that lenders were actually willing to loan people money for that lunacy.
We all know how that bubble ended. Could passive index investing create a similar bubble? It’s possible — a large number of unsophisticated investors buying assets “at any price”, could easily distort markets into silly prices. The good news is: I don’t think we’re there yet.
How To Survive When The Passive Bubble Breaks
While I’m certainly not qualified to predict stock market bubbles, equity prices certainly don’t seem to be trading at absurd prices today. With a TTM PE of 22, the S&P 500 index seems only slightly expensive to me (given current interest rates). Likewise, index fund buying and selling activity does not yet constitute the majority of stock market activity.
It’s important to remember the financial markets are always in flux. Interest rates can rise, economies can slow, and assets types can fall into or out of favor when the wind changes. Under the right conditions, there is the potential for a index bubble to form.
Perhaps a few years from now a bubble will build and asset prices start to look a little silly. How can an enterprising financially independent type person prepare for this kind of crash?
Well, if you want to “survive the madness of crowds”, the most certain way is to avoid the crowds entirely. In other words — Invest differently, instead of just following the passive index crowd.
What exactly do I mean by “invest differently”?
1. Keep plenty of cash on-hand. First and foremost the best way to survive any bubble when everyone rushes for the exit, is to not need the exit. For financially independent folks this means holding through the volatility and not relying on asset sales to fun your lifestyle. There could be months, years, or possibly even whole decades where stock prices are depressed. Be ready for it and keep cash on-hand to pay your expenses. Know that it could take up to a decade before prices return to previous highs.
2. Avoid obvious trouble spots. This might sound completely obvious, but if index investing turns into a bubble the most certain way to avoid the bubble is to avoid the stocks that are most commonly indexed (i.e. the S&P 500). Instead, seek out investments that are under-represented among the indexes. Today, many people point to small-cap stocks as one example of stocks that aren’t widely indexed.
3. Diversify your asset base. Investing fads come and go, and stocks are the ‘investing fad’ of our era. Stocks might not always be this popular however. (In the 1970’s bonds were more popular than stocks for example.) So play it safe by diversifying into different asset classes. There’s lots of options to consider besides stocks — Rental real estate, bonds, REITs, MLP’s, money markets and even CD’s! You might under-perform the indexes in banner stock years like 2019, but when the weather turns you’ll be extremely glad you diversified.
4. Contemplate the rationality of prices you pay. While it’s currently popular to “index and forget” with index investments, I believe this is a superbly wrong-headed strategy. All investors should think carefully about what they’re doing and only index when prices make sense. All investors should be trying to pay intelligent prices for assets, regardless of whether that asset is an index fund, a banana, or a rental house.
A Passive Conclusion
While I don’t see a passive bubble today, there certainly is the potential for one to develop in the future, as a larger and larger percentage of stocks are held in index funds. That said, the sky isn’t falling (yet). Asset prices still look “reasonable-ish”, and I’m still holding all my index fund assets today.
I consider dire warnings by smart folks like Michael Burry a “canary in the coal mine”. They’re probably too early.
Index funds are still the easiest way for the average investor to invest in a broadly diversified portfolio of stocks at extremely low costs. In most cases, index funds are even going to out-perform actively managed funds. That’s still a pretty decent deal.
With that said, investors shouldn’t just cover their eyes and “hope for the best”. Keep your eyes open and pay attention! Blindly ignoring the stock market is a recipe for eventual disaster. Start preparing your portfolio NOW, not when the bad weather appears.
As the old investing parable goes — You don’t start building the ark when the rain starts falling.