Why This Crash Will Be Fast & Furious

We’ve written a bit about the lack of volatility in the US sharemarket of late.  The VIX hit single figures last week, just as it did before the GFC and now another new record…. It has now been 243 days since the US sharemarkets dipped more than 3% in a day.  That is the longest streak in history.  Everything is awesome.

SovereignMan’s Simon Black is warning that this phenomenon is contributing to what he thinks will be a very big, but importantly, very fast crash when the next sizeable ‘dip’ happens.

But first the core reason why… This bull market we are witnessing on most valuations measures is ‘only’ the 3rd most overvalued in history (after 1929 and 2000).  However this one is different in that everything is overvalued not just one or two sectors.  History’s most overvalued market was the dot com bubble but blue chips were sold to get on the tech stock bullet train and that meant you had what’s called ‘dispersion’ in the market.  That is not the case now, with everything being overvalued.  Morgan Stanley recently noted:

“We say this not as hyperbole, but based on a quantitative perspective… Dispersions in valuations and growth rates are among the lowest in the last 40 years; stocks are at their most idiosyncratic since 2001.”

Black thinks a lot of this has to do with the proliferation of passive investment ETF’s and their outsized effect on markets.  No less than $391 billion dollars poured into ETF’s to July 2017, up on the already record high $390b in 2016.

These passive ETF’s care little for valuations but just spread their buy across the whole index they are designed to track.  The record inflows into these funds of course have the effect of pushing the valuations even higher.

Bank of America believes 37% of the S&P500 is now managed passively.  The world’s largest are BlackRock and Vanguard who collectively have over $10 trillion in assets, $7.3 trillion of which are passive, and growing by $3.5b per day. 

So what happens when (not if) the turn comes?  Over to Mr Black:

Humans are emotional creatures. And when we do finally see that 3% (or even larger) down day, investors will rush for the exits.

And the computers will pile on the selling (every model based on historically low volatility will completely break when volatility spikes).

But when the wave of selling comes, who will be there to buy?

“As these passive funds dump the largest stocks in the world, we’ll see an air pocket… nobody will be there to hit the bid.

And when the drop comes, it will come faster than anyone expects.

So, while most investors are ignoring risk, I’d advise you to use this record-high stock market to your advantage…

Sell some expensive stocks to raise cash. Own some gold. And allocate capital to sectors of the market that haven’t been blown out of proportion thanks to the popularity of passive investing. That means looking at smaller stocks and stocks outside the US.

Even if stocks go up for another year, which they may, it’s simply not worth the risk to chase them higher… Because the downturn will be devastating.”